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Risk-Reward With Humana

- By Jonathan Poland

As a major partner in health care in the United States, Humana Inc.'s (HUM) fortunes rise and fall with the state of Medicare, Medicaid and other government programs that make up three-fourths of its membership.

That's good news, except for the unfunded liability totaling $29 trillion that these programs are responsible for, roughly 130% of the U.S.'s national debt and 23% of the country's total unfunded liabilities. That said, will the U.S. allow over 75 million Medicaid and over 59 million Medicare enrollees to go without health coverage? Doubtful. And as long as the market has its current system, Humana should continue to grow and profit.

From a purely financial standpoint, Humana is rock solid. Over the last decade, it has grown sales from $30 billion to over $56.9 billion, net income from $1 billion to over $1.6 billion and book value from $33.94 to $74.91, all while spending less than 40% of its profit on capital spending and buying back 18% of its stock. The government partnerships have been very lucrative for the company, but that's also likely going to be a target in the 2020 election as health care costs will be a big topic for discussion.

During an investor event on Wednesday, Humana Chief Financial Officer Brian Kane voiced concerns about the return of an Obamacare tax based on the company's market share, saying the tax could trim 2020 earnings per share by roughly 10%, or $2.15 per share. That would bring it down to the $17 range, which would place the company's forward earnings multiple just shy of 16. Historically, Humana's stock trades closer to 24 times earnings. The industry average price-earnings ratio is 24.9.


Maybe this is the new normal, but not likely as long as interest rates remain low. Again, considering its scale, the only thing that would actually disrupt Humana's position is a collapse of the medical system. The company is also building a provider network in key geographic areas to better control the cost of health care services and products, which will only deepen its necessity in the coming years.

Humana has 3.6 million members in its Medicare Advantage plan, up 8% year over year. It is the fourth-largest pharmacy benefit manager and owns 40% of the nation's largest home health and hospice operator, Kindred at Home, which could be huge as baby boomers continue to live longer.

Investors will get a better understanding of the outlook on April 3, as Humana executives will be a part of a group of health care companies that will testify in front of the Senate Finance Committee. U.S. health care spending is set to rise 5.5% annually for at least the next decade, reaching north of 20% of gross domestic product by 2027 according to the Centers for Medicare & Medicaid Services. More importantly, federal, state and local governments are expected to fund 47% of the spending.

By the end of 2020, Humana should be earning upwards of $2 billion on $70 billion in revenue. It's market capitalization is $37.5 billion right now, one-tenth of many bigger companies that aren't even close to being necessary to same number of people as Humana. If the market revalues the company at 24 times earnings, its cap could easily rise to $48 billion in the next couple of years, good for a 28% gain. While not a high flyer, the shares have very little downside risk at this price.

Disclosure: I am not long or short HUM.

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This article first appeared on GuruFocus.