Kansas State University
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program Name of the firm: HUMANA (NYSE: HUM) Analyst Group # 2 Jessica Barnes Rahul Khambaswadkar Sree Nakka Rahul Sharma
Sector: Health and Medical Insurance Estimated value / Current price: $ 88.22/ $71.40 Recommendation: BUY
Date of report: 04/27/2011
Summary data as of : 04/27/2011 Shares outstanding ('000)
168,545
EPS (Act., 03/2011)
6.52
Market capitalization ($ mill)
12198.04
EPS (Exp.,03/2012)
7.17
Dividend yield (%)
N.A.
EPS (Exp.,03/2013)
7.89
2010 P/E (Price / fiscal year EPS)
11.18
Change in operating EPS (2010 over 2009)
5.4%
2010 P/E (S&P500, as of 03/2011)
15.84
Change in operating EPS (2010 over 2009) for S&P 500, as of 03/2011
47.07%
15.34
Change in operating EPS (2010 over 2009) for S&P 500 Financials, as of 03/2011
247.74%
2010 P/E (S&P500 Financials, as of 03/2011)
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Sector Overview The health and medical insurance sector is an important part of the US economy, and its growth is expected to be supported by aging baby boomers who will supplement their government sponsored insurance with some form of private health insurance1. While the recent recession and increasing costs have been a setback for health insurance companies, the Health Insurance Reform Act is believed to have a significant impact on the profitability of this sector when enacted in 2014. However, since it is a mature industry, revenue is expected to grow at roughly the same rate as the US economy in the long run. Market & Competitive Analysis: The estimated market size for this sector is $677.3Bn in revenue and is expected to see a growth of 5% annually1 for years 2011-2016. Government sponsored plans and employer sponsored private health insurance (PHI) are the major drivers of this sector, making up 78% of its market share. The revenues generated by these segments have remained relatively stable over the years. Major players include UnitedHealth Group Inc (UNH) and WellPoint Inc with the rest of the market split between Aetna, Humana and other players.
Market Segmentation
17%
Market Share
18% Government-sponsored
5%
5.5%
5.7%
Humana
Employer-sponsored PHI
9.1%
Individual-purchased PHI
14.7%
Aetna Wellpoint Inc
65.0%
Uninsured
UnitedHealth Group Others
60%
Source: IBIS World Industry Report
Profit Margins have historically been low, as the industry has seen a consistent increase in healthcare expenditures. As revenue has remained stable, it has caused profitability to become stagnant.
1
IBIS World Industry Report 52411b: Health and Medical Insurance in the US
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Demographics & Industry Trends: The US Census Bureau2 has projected that 80.7 million people would be 65 years or older by 2050 as compared to 40.2 million in 2010. This percentage of aging baby boomers will increase the revenues of this sector because people will supplement their government sponsored plans with PHI.
The per capita healthcare expenditure in the past has grown at an average rate of 4.3% annually, except during 2008 where it grew at the rate of 1.9% due to the economic recession. But the Affordable Care Act which is to be enacted, in 2014, is projected to increase the national spending on healthcare in the next decade. By 2019, roughly 93 percent of the U.S. population is expected to have health insurance driven, in part, by growth in Medicaid3.
Operating Margins: Healthcare costs account for a major portion of the revenues made. In general, the medical cost – benefit ratio is 80-85%, but this percentage is higher for government sponsored plans like Medicare and Medicaid. Also, the SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
profits in this sector, while being steady from year to year, are quite slim at 7%. The profitability of the sector is highly dependant on the ability to properly price policies, and with the mandated cost-benefit ratio that is in effect, it is important for companies to strategically price their products. In the event that companies fail to meet this ratio, they will take a hit in their revenues because of rebates paid out to policy holders.
2
“Midyear Population, by Age and Sex”, U.S. Census Bureau, International Data Base (IDB). 10 Apr. 2011,
http://www.census.gov/ipc/www/idb/country.php> 3
“National Health Expenditure Projections, 2009-2019”, Centers for Medicare & Medicaid Services, Office of the Actuary,
National Health Statistics Group
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Stock Screening Stock selection was done based on three screening variables. 1. Percent Accruals Percent accrual refers to accruals scaled by net income as compared to total assets in traditional accruals. The percent accrual is calculated as follows: Percent Accruals = (Net Income – Cash from Operations)/Net Income Firms with higher negative percent accruals generate average annual abnormal return of 5.53%. This return is obtained over a holding period of 6-12 months4. The investor’s inability to understand the impact of information hidden in “accrual” component of earnings is the primary reason for abnormal alpha generated by this strategy. 2. Jensen’s Alpha Historic evidence suggests that there is momentum associated with abnormal returns generated by stocks with recent strong performance. The stocks that perform well in the past 6 month period continue to perform better in the next 6-12 months. Abnormal returns associated with selecting past winners was 6% annually5. Delayed overreaction by the investors pushes the value of stock above its intrinsic value for a short duration.
3. Price to Earnings Ratio On average, stocks with low P/E ratio perform better for a holding period of 12 months. Stocks with low P/E ratio provide abnormal returns of 3.5% annually6 for a 12 month holding period. The slowness of market to accurately reflect the information embedded in the P/E ratio is the main reason behind the abnormal return earned by the stocks.
All the stocks in the healthcare industry were passed through the three screening variables and ranked according to their performance on each particular screening variable. A weight was assigned to each screening variable according to the expected abnormal return associated with the strategy behind each variable. For each stock in the industry, a weighted score was calculated by multiplying its rank in each screening variable category by the weight associated with that screening variable. The stocks with the lowest overall score were selected for analysis. 4
Hafzalla, N., Lundholm, R., Winkle, E (2011). Percent Accruals. The Accounting Review, 86 (1), 209-236.
5
Jeegadeesh, N., and Titman, S. (2001), Profitability of momentum strategies: An evaluation of alternative explanations.
The Journal of Finance, Vol. LVI (2), 699-72 6
Basu, S. (1977), Investment performance of common stocks in relation to their price-earnings ratios: A test of efficient
market hypothesis. The Journal of Financial Research, Vol. XXXII (3), 663-682. SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Investment Thesis Humana Inc owns roughly 5.5% of the healthcare and medical insurance sector in the United States and comprises two business segments – Government and Commercial. The Government sector includes three lines of business: Medicare, Medicaid, and Military contracts. A major portion of Humana’s total revenues come from the Government sector. The Commercial segment includes medical and specialty benefit plans and products directed at employer groups and private individuals.
The recommendation for Humana Inc is a BUY. The stock was valued at $ 88.22 and is currently underpriced. The most important issue in the valuation was the growth rate of sales subject to the impending HealthCare Reform Act, the mature stage of the industry, the size of competition, the current demographics, and the past performance of Humana Inc.
Past Company Performance As observed from the DuPont Analysis for the past five years, profit margin hit a low in the year 2008. This can be attributed to the recession, which caused severe unemployment and reduced spending on healthcare. The profit margin also dropped in 2010 owing to the loss of a huge government contract. The equity multiplier has decreased over the last five years, which is a good sign for Humana because it implies Humana is relying less on loans to finance its assets. The asset turnover ratio has stayed relatively constant in the range of 2.1-2.2.
3.50
4% 4%
3.00
3% 3% 2% 2%
2.50 2.00 1.50 1.00
1% 1% 0%
0.50 0.00 2006
2007
2008
2009
Profit Margin
Asset Turnover & Equity Multiplier
DUPONT ANALYSIS
Asset Turnover Equity Multiplier Profit Margin
2010
Risks Given the mature stage of the industry, revenues are expected to grow at an average rate similar to that of the economy, which is roughly 3%. Also, barring a few major players, the industry is quite fragmented with small players constituting 65% of the market share. Humana’s revenues come primarily from the Government sector and these are highly dependant on Humana’s ability to renew contracts on a periodic basis. Humana’s revenue stream is less diversified because of their huge investments and expansion in the Medicare program. With the SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
level of competition being high in this sector, Humana must price its policies effectively in order to maintain profit margins and thrive. The Health Insurance Reform Act can have a two-way effect on Humana Inc. With the growing percent of population that will require health insurance, revenues could be positively impacted. But the mandated benefit ratio (that is the ratio of total benefit expenses to premiums) which is already in effect since January 2011 will cause a hike in costs in the form of rebates to policy holders in the event that the ratio is unmet.
Projected Company Performance The average growth rate of revenue for the industry is projected to be 5% according to the IBIS industry report, and we believe that Humana Inc. will grow at this rate for the next 5-6 years. After this period, Humana Inc. will grow at the economic growth rate of 3%. The reason for the stated growth rate is that Humana owns only a small percentage of the total market share in a relatively mature industry, so revenues will grow at a rate slightly below the industry average. With strong players like UNH in the market, Humana needs to maintain a profit margin by competitively pricing its products. However in the recent recession, the company took a hit because of the mispricing of its products. Costs are projected to remain a huge percent (94%) of sales. Given that its majority revenues are from the Government segment, the operating expenses for this segment are and will remain relatively high. The company has grown a lot due to strategic acquisitions in the last few years, which will enable Humana Inc. to expand its national reach. While the slow economic recovery and the ongoing transition due to the HealthCare reforms might impede immediate growth, we believe Humana will outperform the market and place a BUY recommendation on it.
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Valuation Humana (HUM) is currently trading at $72.34 in the market with a 52 week low-high range of $ 43.17 and $74.65. Valuation analysis was carried out using Free Cash Flow to firm (FCFF) and Residual Income (RI) methods. Based on the analysis, our target price for the stock is $88.22.
Sales Revenue Growth Analysis: Projections for the growth in net sales for HUM were driven by the following factors: 1. Changes in Population: The health care industry is strongly driven by the population growth in the US. The growth in population, especially in people below 65 years old, has a significant impact on the demand for private health insurance. A regression analysis was carried out to study the correlation between Humana’s total annual revenues and the US population below 65 years of age. A strong correlation of 98.54% was found, indicating a strong dependence of sales revenue on the annual
Population (in 000's)
population aged less than 65 years. 265,000 264,000 263,000 262,000 261,000 260,000 259,000 258,000 257,000 256,000 255,000
R2 = 0.9854
0
5,000,000 10,000,000 15,000,000 20,000,000 25,000,000 30,000,000 35,000,000 Humana Sales (in 000's of dollars)
2. Changes in Annual Disposable Income: The health insurance sector is also significantly dependent on the annual household disposable income in the US. Higher household disposable income indicates that a greater percentage of the population will have health insurance coverage. A dependence study using regression analysis was carried out to study the correlation between the total annual revenues and the annual disposable income in the US. In this instance too, a strong correlation of 96.22% was obtained. The strong correlation found indicates a strong dependence of sales revenue on the annual disposable income.
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Annual healthcare expenses (in bn. dollars)
2500 2000
R2 = 0.9622
1500 1000 500 0 -
5.000
10.000
15.000
20.000
25.000
30.000
35.000
Humana Sales (in bn. dollars)
Humana’s sales grew in the past four years, and the growth rate averaged roughly 10%. The impact of the Health Care Reform Act, which makes health insurance mandatory, is projected to increase Humana’s sales in the next 5-6 years. But given Humana’s small market share compared to its competitors, and the above correlations, we believe that its sales will grow more in line with the industry average growth rate of 4-5%.
Operating Margin Analysis: The total operating costs for Humana include benefit claims and selling and general administrative expenses (SG&A). These operating expenses make up a significant portion, roughly 94%, of the total sales revenue. The fact that Humana’s total sales come from its Government segment explain its high operating costs. The medical cost-benefit ratio of this segment is, in general, higher than the average ratio of 80-85%. Also, the Health care reform act which mandates a certain cost-benefit ratio will only increase the operating costs for Humana in the future. Therefore, the operating expenses were projected to grow based on their historical percentage of sales.
Weighted Average Cost of Capital: The weighted average cost of capital (WACC) of 10.53% was used as the discount rate. The key determinants for estimating WACC were as follows: 1. Beta: The average insurance industry beta7 of 1.21 was used as a starting point. This beta was then levered up using the firm’s debt-to-equity ratio of 0.24. The obtained beta of 1.39 was used to determine WACC. 2. Cost of Capital (Re): The cost of capital was calculated using the above beta value, risk free rate8 for a 20 year constant maturity Treasury bond as on January 1, 2011, and a historic market risk premium of 5.2%. We thus found Re to be 11.51% using the Capital Asset Pricing Model (CAPM). 3. Cost of Debt (Rd): The cost of debt was estimated using the average spread between a 20 year corporate bond9 (HUM.GE) and a 20 year Treasury bond. Rd was calculated as 7.79%. SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
The price of Humana was calculated as $88.22, and the Free Cash Flow Valuation technique substantiates the same. While other financial valuation techniques such as the Residual Income method and Relative Valuation method were employed, we believe that the Free Cash Flow technique is a better tool because it estimates the potential for future sales revenue and cash flows that the firm is likely to generate.
7
Historical market risk premium. Damodaran, Aswath. Professor of Finance, the Stern School of Business, New York
University. 8
Board of Governors of the Federal Reserve System, Federal Reserve Bank, St. Louis
9
Monthly Bond Prices, Trace, Wharton Research Data Services (WRDS).
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Humana Inc. (NYSE: HUM) Assumptions: 1 Sales will grow at 5% per year 2 Fixed Assets at cost are 6.3% of sales. 3 Depreciation is 11.1% of average assets during the year 4 Total Current assets are 29.9% of sales 5 Total Current liabilities are 17% of sales 6 NWC (Receivables less Payables) is 1.04% of sales 7 8 9 10 11
0.05 0.063 0.111 0.299 0.170 0.010
Cost of Revenue is 94.2% of sales Interest on debt is 6.3% of beginning of year LTD Dividend payout is 0% Tax rate is 37.2%. All external financing is such that D/E ratio remains same as mentioned. The assets in place at the start of the year generate sales during the year.
0.942 0.063 0.372
Income Statement All amounts in 000's of dollars 2006 2007 21,416,537 25,289,989 Sales Cost of 20,442,713 23,746,999 Revenue 128,600 162,400 Depreciation 845,224 1,380,590 EBIT 63,141 68,878 Interest Earnings 782,083 1,311,712 before Tax 290935 487957 Tax 491,148 823,755 Net Income 0 0 Dividends Retained earnings
491,148
823,755
2008 28,946,372
2009 30,960,414
2010 33,868,208
2011 35,561,618
2012 37,339,699
2013 39,206,684
2014 41,167,019
27,652,885
29,002,537
31,750,676
33,503,860
35,179,053
36,938,006
38,784,906
183,300 1,110,187 80,289
213,000 1,744,877 105,843
225,100 1,892,432 105,060
236,989 1,820,769 100,376
252,187 1,908,459 117,371
264,797 2,003,882 135,102
278,036 2,104,076 153,609
1,029,898
1,639,034
1,787,372
1,720,393
1,791,088
1,868,779
1,950,467
383122 646,776 0
609721 1,029,313 0
664902 1,122,470 0
639986 1,080,407 0
666285 1,124,803 0
695186 1,173,593 0
725574 1,224,893 0
646,776
1,029,313
1,122,470
1,080,407
1,124,803
1,173,593
1,224,893
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Balance Sheet All amounts in 000's of dollars Total Current assets Fixed assets at cost Acc Depreciation Net fixed assets Total assets Total Current liabilities Long term debt Common Stock Retained earnings Total liabilities & equity
2006
2007
2008
2009
2010
2011
2012
2013
2014
7,303,963
8,732,846
8,396,042
9,252,816
10,137,699
10,644,584
11,176,813
11,735,654
12,322,436
1,391,087
1,593,261
1,845,401
1,934,336
2,059,448
2,222,935
2,334,081
2,450,785
2,573,325
846,083
956,020
1,133,909
1,255,194
1,244,111
1,481,100
1,733,287
1,998,084
2,276,120
545,004 7,848,967
637,241 9,370,087
711,492 9,107,534
679,142 9,931,958
815,337 10,953,036
741,835 11,386,419
600,794 11,777,607
452,701 12,188,355
297,204 12,619,641
5,113,958
5,791,851
5,183,945
5,259,992
5,744,626
6,031,857
6,333,450
6,650,123
6,982,629
1,269,100
1,687,823
1,937,032
1,678,166
1,668,849
1,594,446
1,864,399
2,146,061
2,440,036
30,491
31,123
31,309
31,634
31,707
31,707
31,707
31,707
31,707
1,909,098
2,732,853
3,379,629
4,408,942
5,531,412
6,611,819
7,736,622
8,910,215
10,135,109
8,322,647
9,370,087
9,107,534
9,931,958
10,953,036
11,386,419
11,777,607
12,188,355
12,619,641
Note: Mismatch of assets and liabilities in 2006 due to omission of certain items
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Humana Inc. (NYSE: HUM) Free Cash Flow Valuation Terminal growth rate
3%
Tax Rate
37.20%
Cost of debt
7.79%
Cost of equity
11.51%
Book Value of Debt
2.13
HUM stock price Common shares outstanding
72.34 168545
Market Capitalization
12.19
WACC
10.53%
From the 2010 10-K
billion dollars as of 04/25/2011 in thousands billion dollars
All amounts in 000’s of dollars 2010
2011
2012
2013
2014
EBIT*(1-T)
1,188,447
1,143,443
1,198,512
1,258,438
1,321,359
Add Depreciation Less: Change in Capex
225,100
235,817
248,567
258,510
268,850
125,112
142,316
88,071
91,593
95,257
Less Change in NWC
-104,543
450,376
14,708
15,296
15,908
FCF
1,392,978
763,033
1,320,991
1,387,040
1,456,392
713,853
1,118,314
1,062,555
14,855,964
Present Value of FCFs PV of terminal value Value of firm
2015
1,500,084
19,974,486 17,750,687
Less: Value of Debt
2,881,997
Value of equity Shares outstanding in 2010
14,868,690
Price per share
$88.22
168,545
thousand As of 04/27/2011
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Humana Inc. (NYSE: HUM) Residual Income Valuation Terminal growth rate
3%
Tax Rate
37.20%
Cost of debt
7.79%
Cost of equity
11.51%
Book Value of Debt
2.13
HUM stock price Common shares outstanding
72.34 168545
Market Capitalization
12.19
WACC
10.53%
From the 2010 10-K
billion dollars as of 04/25/2011 in thousands billion dollars
Beginning book value per share
2010 41.08
2011 47.6
2012 55.03
2013 63.51
2014 73.16
Common shares outstanding
168.545
168.545
168.545
168.545
168.545
Earnings per share (EPS)
6.52
7.43
8.47
9.66
11.01
Dividends per share (DPS)
0
0
0
0
0
Retained earnings (E-D)
6.52
7.43
8.47
9.66
11.01
Return on Equity (ROE) %
0.16
0.16
0.17
0.17
0.18
ROE-Re
0.04
0.05
0.05
0.06
0.06
Residual Income = (ROE-Re)* BV
1.80
2.31
2.94
3.71
4.66
PV of perpetuity
56.35
PV for residual incomes
2.15
BV @ T=0
41.08
Price per share Current Price per share
89.36 72.34
% Under / Overvalued
23.53%
2.45
2.77
40.91
as of 04/27/2011
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Humana Inc. (NYSE: HUM) Relative Valuation Relative Valuation using P/E ratio estimates: Company Name
Exchange
Ticker
HUMANA
NYSE
HUM
Price Estimate 2010 Target Price:
PE 2011 PE 2012 Average:
Mkt. Cap. (in $ Bn) 12.19
EBITDA
P/E 2010
EPS 2010
EPS 2011E
EPS 2012E
P/E 2011E
P/E 2012E
(in $ Bn) 2.12
11.2
6.55
6.35
6.9
11.4
10.75
$ 73.36 $ 72.39 $ 74.18 $ 73.31
Source: Estimates & Opinions, Standard & Poor's Net Advantage
Sensitivity Analysis
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Beta: 1.39 Assuming stock price = $ 99.12 Sensitivity of stock price with beta and growth rate $99.12 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7
0.02 $ 136.78 $ 124.07 $ 113.30 $ 104.05 $ 96.03 $ 89.01 $ 82.81 $ 77.29 $ 72.35 $ 67.91
0.025 $ 138.15 $ 125.31 $ 114.43 $ 105.10 $ 97.00 $ 89.91 $ 83.64 $ 78.07 $ 73.09 $ 68.59
0.03 $ 139.53 $ 126.56 $ 115.57 $ 106.14 $ 97.96 $ 90.80 $ 84.48 $ 78.85 $ 73.82 $ 69.28
0.035 $140.90 $127.80 $116.71 $107.19 $ 98.93 $ 91.70 $ 85.31 $ 79.63 $ 74.55 $ 69.97
0.04 $ 142.27 $ 129.05 $ 117.85 $ 108.24 $ 99.90 $ 92.59 $ 86.15 $ 80.41 $ 75.28 $ 70.66
0.045 $ 143.65 $ 130.30 $ 118.99 $ 109.28 $ 100.86 $ 93.49 $ 86.98 $ 81.19 $ 76.01 $ 71.34
0.05 $ 145.02 $ 131.54 $ 120.12 $ 110.33 $ 101.83 $ 94.38 $ 87.81 $ 81.97 $ 76.74 $ 72.03
0.055 $ 146.39 $ 132.79 $ 121.26 $ 111.37 $ 102.79 $ 95.28 $ 88.65 $ 82.75 $ 77.47 $ 72.71
0.06 $ 147.76 $ 134.03 $ 122.40 $ 112.41 $ 103.76 $ 96.17 $ 89.48 $ 83.52 $ 78.20 $ 73.40
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
0.065 $ 149.13 $ 135.27 $ 123.53 $ 113.46 $ 104.72 $ 97.07 $ 90.31 $ 84.30 $ 78.92 $ 74.08
Sector: Health and Medical Insurance Estimated value / Current price: $ 88.22/ $71.40 Recommendation: BUY
Date of report: 04/27/2011
Summary data as of : 04/27/2011 Shares outstanding ('000)
168,545
EPS (Act., 03/2011)
6.52
Market capitalization ($ mill)
12198.04
EPS (Exp.,03/2012)
7.17
Dividend yield (%)
N.A.
EPS (Exp.,03/2013)
7.89
2010 P/E (Price / fiscal year EPS)
11.18
Change in operating EPS (2010 over 2009)
5.4%
2010 P/E (S&P500, as of 03/2011)
15.84
Change in operating EPS (2010 over 2009) for S&P 500, as of 03/2011
47.07%
15.34
Change in operating EPS (2010 over 2009) for S&P 500 Financials, as of 03/2011
247.74%
2010 P/E (S&P500 Financials, as of 03/2011)
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Sector Overview The health and medical insurance sector is an important part of the US economy, and its growth is expected to be supported by aging baby boomers who will supplement their government sponsored insurance with some form of private health insurance1. While the recent recession and increasing costs have been a setback for health insurance companies, the Health Insurance Reform Act is believed to have a significant impact on the profitability of this sector when enacted in 2014. However, since it is a mature industry, revenue is expected to grow at roughly the same rate as the US economy in the long run. Market & Competitive Analysis: The estimated market size for this sector is $677.3Bn in revenue and is expected to see a growth of 5% annually1 for years 2011-2016. Government sponsored plans and employer sponsored private health insurance (PHI) are the major drivers of this sector, making up 78% of its market share. The revenues generated by these segments have remained relatively stable over the years. Major players include UnitedHealth Group Inc (UNH) and WellPoint Inc with the rest of the market split between Aetna, Humana and other players.
Market Segmentation
17%
Market Share
18% Government-sponsored
5%
5.5%
5.7%
Humana
Employer-sponsored PHI
9.1%
Individual-purchased PHI
14.7%
Aetna Wellpoint Inc
65.0%
Uninsured
UnitedHealth Group Others
60%
Source: IBIS World Industry Report
Profit Margins have historically been low, as the industry has seen a consistent increase in healthcare expenditures. As revenue has remained stable, it has caused profitability to become stagnant.
1
IBIS World Industry Report 52411b: Health and Medical Insurance in the US
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Demographics & Industry Trends: The US Census Bureau2 has projected that 80.7 million people would be 65 years or older by 2050 as compared to 40.2 million in 2010. This percentage of aging baby boomers will increase the revenues of this sector because people will supplement their government sponsored plans with PHI.
The per capita healthcare expenditure in the past has grown at an average rate of 4.3% annually, except during 2008 where it grew at the rate of 1.9% due to the economic recession. But the Affordable Care Act which is to be enacted, in 2014, is projected to increase the national spending on healthcare in the next decade. By 2019, roughly 93 percent of the U.S. population is expected to have health insurance driven, in part, by growth in Medicaid3.
Operating Margins: Healthcare costs account for a major portion of the revenues made. In general, the medical cost – benefit ratio is 80-85%, but this percentage is higher for government sponsored plans like Medicare and Medicaid. Also, the SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
profits in this sector, while being steady from year to year, are quite slim at 7%. The profitability of the sector is highly dependant on the ability to properly price policies, and with the mandated cost-benefit ratio that is in effect, it is important for companies to strategically price their products. In the event that companies fail to meet this ratio, they will take a hit in their revenues because of rebates paid out to policy holders.
2
“Midyear Population, by Age and Sex”, U.S. Census Bureau, International Data Base (IDB). 10 Apr. 2011,
http://www.census.gov/ipc/www/idb/country.php> 3
“National Health Expenditure Projections, 2009-2019”, Centers for Medicare & Medicaid Services, Office of the Actuary,
National Health Statistics Group
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Stock Screening Stock selection was done based on three screening variables. 1. Percent Accruals Percent accrual refers to accruals scaled by net income as compared to total assets in traditional accruals. The percent accrual is calculated as follows: Percent Accruals = (Net Income – Cash from Operations)/Net Income Firms with higher negative percent accruals generate average annual abnormal return of 5.53%. This return is obtained over a holding period of 6-12 months4. The investor’s inability to understand the impact of information hidden in “accrual” component of earnings is the primary reason for abnormal alpha generated by this strategy. 2. Jensen’s Alpha Historic evidence suggests that there is momentum associated with abnormal returns generated by stocks with recent strong performance. The stocks that perform well in the past 6 month period continue to perform better in the next 6-12 months. Abnormal returns associated with selecting past winners was 6% annually5. Delayed overreaction by the investors pushes the value of stock above its intrinsic value for a short duration.
3. Price to Earnings Ratio On average, stocks with low P/E ratio perform better for a holding period of 12 months. Stocks with low P/E ratio provide abnormal returns of 3.5% annually6 for a 12 month holding period. The slowness of market to accurately reflect the information embedded in the P/E ratio is the main reason behind the abnormal return earned by the stocks.
All the stocks in the healthcare industry were passed through the three screening variables and ranked according to their performance on each particular screening variable. A weight was assigned to each screening variable according to the expected abnormal return associated with the strategy behind each variable. For each stock in the industry, a weighted score was calculated by multiplying its rank in each screening variable category by the weight associated with that screening variable. The stocks with the lowest overall score were selected for analysis. 4
Hafzalla, N., Lundholm, R., Winkle, E (2011). Percent Accruals. The Accounting Review, 86 (1), 209-236.
5
Jeegadeesh, N., and Titman, S. (2001), Profitability of momentum strategies: An evaluation of alternative explanations.
The Journal of Finance, Vol. LVI (2), 699-72 6
Basu, S. (1977), Investment performance of common stocks in relation to their price-earnings ratios: A test of efficient
market hypothesis. The Journal of Financial Research, Vol. XXXII (3), 663-682. SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Investment Thesis Humana Inc owns roughly 5.5% of the healthcare and medical insurance sector in the United States and comprises two business segments – Government and Commercial. The Government sector includes three lines of business: Medicare, Medicaid, and Military contracts. A major portion of Humana’s total revenues come from the Government sector. The Commercial segment includes medical and specialty benefit plans and products directed at employer groups and private individuals.
The recommendation for Humana Inc is a BUY. The stock was valued at $ 88.22 and is currently underpriced. The most important issue in the valuation was the growth rate of sales subject to the impending HealthCare Reform Act, the mature stage of the industry, the size of competition, the current demographics, and the past performance of Humana Inc.
Past Company Performance As observed from the DuPont Analysis for the past five years, profit margin hit a low in the year 2008. This can be attributed to the recession, which caused severe unemployment and reduced spending on healthcare. The profit margin also dropped in 2010 owing to the loss of a huge government contract. The equity multiplier has decreased over the last five years, which is a good sign for Humana because it implies Humana is relying less on loans to finance its assets. The asset turnover ratio has stayed relatively constant in the range of 2.1-2.2.
3.50
4% 4%
3.00
3% 3% 2% 2%
2.50 2.00 1.50 1.00
1% 1% 0%
0.50 0.00 2006
2007
2008
2009
Profit Margin
Asset Turnover & Equity Multiplier
DUPONT ANALYSIS
Asset Turnover Equity Multiplier Profit Margin
2010
Risks Given the mature stage of the industry, revenues are expected to grow at an average rate similar to that of the economy, which is roughly 3%. Also, barring a few major players, the industry is quite fragmented with small players constituting 65% of the market share. Humana’s revenues come primarily from the Government sector and these are highly dependant on Humana’s ability to renew contracts on a periodic basis. Humana’s revenue stream is less diversified because of their huge investments and expansion in the Medicare program. With the SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
level of competition being high in this sector, Humana must price its policies effectively in order to maintain profit margins and thrive. The Health Insurance Reform Act can have a two-way effect on Humana Inc. With the growing percent of population that will require health insurance, revenues could be positively impacted. But the mandated benefit ratio (that is the ratio of total benefit expenses to premiums) which is already in effect since January 2011 will cause a hike in costs in the form of rebates to policy holders in the event that the ratio is unmet.
Projected Company Performance The average growth rate of revenue for the industry is projected to be 5% according to the IBIS industry report, and we believe that Humana Inc. will grow at this rate for the next 5-6 years. After this period, Humana Inc. will grow at the economic growth rate of 3%. The reason for the stated growth rate is that Humana owns only a small percentage of the total market share in a relatively mature industry, so revenues will grow at a rate slightly below the industry average. With strong players like UNH in the market, Humana needs to maintain a profit margin by competitively pricing its products. However in the recent recession, the company took a hit because of the mispricing of its products. Costs are projected to remain a huge percent (94%) of sales. Given that its majority revenues are from the Government segment, the operating expenses for this segment are and will remain relatively high. The company has grown a lot due to strategic acquisitions in the last few years, which will enable Humana Inc. to expand its national reach. While the slow economic recovery and the ongoing transition due to the HealthCare reforms might impede immediate growth, we believe Humana will outperform the market and place a BUY recommendation on it.
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Valuation Humana (HUM) is currently trading at $72.34 in the market with a 52 week low-high range of $ 43.17 and $74.65. Valuation analysis was carried out using Free Cash Flow to firm (FCFF) and Residual Income (RI) methods. Based on the analysis, our target price for the stock is $88.22.
Sales Revenue Growth Analysis: Projections for the growth in net sales for HUM were driven by the following factors: 1. Changes in Population: The health care industry is strongly driven by the population growth in the US. The growth in population, especially in people below 65 years old, has a significant impact on the demand for private health insurance. A regression analysis was carried out to study the correlation between Humana’s total annual revenues and the US population below 65 years of age. A strong correlation of 98.54% was found, indicating a strong dependence of sales revenue on the annual
Population (in 000's)
population aged less than 65 years. 265,000 264,000 263,000 262,000 261,000 260,000 259,000 258,000 257,000 256,000 255,000
R2 = 0.9854
0
5,000,000 10,000,000 15,000,000 20,000,000 25,000,000 30,000,000 35,000,000 Humana Sales (in 000's of dollars)
2. Changes in Annual Disposable Income: The health insurance sector is also significantly dependent on the annual household disposable income in the US. Higher household disposable income indicates that a greater percentage of the population will have health insurance coverage. A dependence study using regression analysis was carried out to study the correlation between the total annual revenues and the annual disposable income in the US. In this instance too, a strong correlation of 96.22% was obtained. The strong correlation found indicates a strong dependence of sales revenue on the annual disposable income.
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Annual healthcare expenses (in bn. dollars)
2500 2000
R2 = 0.9622
1500 1000 500 0 -
5.000
10.000
15.000
20.000
25.000
30.000
35.000
Humana Sales (in bn. dollars)
Humana’s sales grew in the past four years, and the growth rate averaged roughly 10%. The impact of the Health Care Reform Act, which makes health insurance mandatory, is projected to increase Humana’s sales in the next 5-6 years. But given Humana’s small market share compared to its competitors, and the above correlations, we believe that its sales will grow more in line with the industry average growth rate of 4-5%.
Operating Margin Analysis: The total operating costs for Humana include benefit claims and selling and general administrative expenses (SG&A). These operating expenses make up a significant portion, roughly 94%, of the total sales revenue. The fact that Humana’s total sales come from its Government segment explain its high operating costs. The medical cost-benefit ratio of this segment is, in general, higher than the average ratio of 80-85%. Also, the Health care reform act which mandates a certain cost-benefit ratio will only increase the operating costs for Humana in the future. Therefore, the operating expenses were projected to grow based on their historical percentage of sales.
Weighted Average Cost of Capital: The weighted average cost of capital (WACC) of 10.53% was used as the discount rate. The key determinants for estimating WACC were as follows: 1. Beta: The average insurance industry beta7 of 1.21 was used as a starting point. This beta was then levered up using the firm’s debt-to-equity ratio of 0.24. The obtained beta of 1.39 was used to determine WACC. 2. Cost of Capital (Re): The cost of capital was calculated using the above beta value, risk free rate8 for a 20 year constant maturity Treasury bond as on January 1, 2011, and a historic market risk premium of 5.2%. We thus found Re to be 11.51% using the Capital Asset Pricing Model (CAPM). 3. Cost of Debt (Rd): The cost of debt was estimated using the average spread between a 20 year corporate bond9 (HUM.GE) and a 20 year Treasury bond. Rd was calculated as 7.79%. SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
The price of Humana was calculated as $88.22, and the Free Cash Flow Valuation technique substantiates the same. While other financial valuation techniques such as the Residual Income method and Relative Valuation method were employed, we believe that the Free Cash Flow technique is a better tool because it estimates the potential for future sales revenue and cash flows that the firm is likely to generate.
7
Historical market risk premium. Damodaran, Aswath. Professor of Finance, the Stern School of Business, New York
University. 8
Board of Governors of the Federal Reserve System, Federal Reserve Bank, St. Louis
9
Monthly Bond Prices, Trace, Wharton Research Data Services (WRDS).
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Humana Inc. (NYSE: HUM) Assumptions: 1 Sales will grow at 5% per year 2 Fixed Assets at cost are 6.3% of sales. 3 Depreciation is 11.1% of average assets during the year 4 Total Current assets are 29.9% of sales 5 Total Current liabilities are 17% of sales 6 NWC (Receivables less Payables) is 1.04% of sales 7 8 9 10 11
0.05 0.063 0.111 0.299 0.170 0.010
Cost of Revenue is 94.2% of sales Interest on debt is 6.3% of beginning of year LTD Dividend payout is 0% Tax rate is 37.2%. All external financing is such that D/E ratio remains same as mentioned. The assets in place at the start of the year generate sales during the year.
0.942 0.063 0.372
Income Statement All amounts in 000's of dollars 2006 2007 21,416,537 25,289,989 Sales Cost of 20,442,713 23,746,999 Revenue 128,600 162,400 Depreciation 845,224 1,380,590 EBIT 63,141 68,878 Interest Earnings 782,083 1,311,712 before Tax 290935 487957 Tax 491,148 823,755 Net Income 0 0 Dividends Retained earnings
491,148
823,755
2008 28,946,372
2009 30,960,414
2010 33,868,208
2011 35,561,618
2012 37,339,699
2013 39,206,684
2014 41,167,019
27,652,885
29,002,537
31,750,676
33,503,860
35,179,053
36,938,006
38,784,906
183,300 1,110,187 80,289
213,000 1,744,877 105,843
225,100 1,892,432 105,060
236,989 1,820,769 100,376
252,187 1,908,459 117,371
264,797 2,003,882 135,102
278,036 2,104,076 153,609
1,029,898
1,639,034
1,787,372
1,720,393
1,791,088
1,868,779
1,950,467
383122 646,776 0
609721 1,029,313 0
664902 1,122,470 0
639986 1,080,407 0
666285 1,124,803 0
695186 1,173,593 0
725574 1,224,893 0
646,776
1,029,313
1,122,470
1,080,407
1,124,803
1,173,593
1,224,893
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Balance Sheet All amounts in 000's of dollars Total Current assets Fixed assets at cost Acc Depreciation Net fixed assets Total assets Total Current liabilities Long term debt Common Stock Retained earnings Total liabilities & equity
2006
2007
2008
2009
2010
2011
2012
2013
2014
7,303,963
8,732,846
8,396,042
9,252,816
10,137,699
10,644,584
11,176,813
11,735,654
12,322,436
1,391,087
1,593,261
1,845,401
1,934,336
2,059,448
2,222,935
2,334,081
2,450,785
2,573,325
846,083
956,020
1,133,909
1,255,194
1,244,111
1,481,100
1,733,287
1,998,084
2,276,120
545,004 7,848,967
637,241 9,370,087
711,492 9,107,534
679,142 9,931,958
815,337 10,953,036
741,835 11,386,419
600,794 11,777,607
452,701 12,188,355
297,204 12,619,641
5,113,958
5,791,851
5,183,945
5,259,992
5,744,626
6,031,857
6,333,450
6,650,123
6,982,629
1,269,100
1,687,823
1,937,032
1,678,166
1,668,849
1,594,446
1,864,399
2,146,061
2,440,036
30,491
31,123
31,309
31,634
31,707
31,707
31,707
31,707
31,707
1,909,098
2,732,853
3,379,629
4,408,942
5,531,412
6,611,819
7,736,622
8,910,215
10,135,109
8,322,647
9,370,087
9,107,534
9,931,958
10,953,036
11,386,419
11,777,607
12,188,355
12,619,641
Note: Mismatch of assets and liabilities in 2006 due to omission of certain items
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Humana Inc. (NYSE: HUM) Free Cash Flow Valuation Terminal growth rate
3%
Tax Rate
37.20%
Cost of debt
7.79%
Cost of equity
11.51%
Book Value of Debt
2.13
HUM stock price Common shares outstanding
72.34 168545
Market Capitalization
12.19
WACC
10.53%
From the 2010 10-K
billion dollars as of 04/25/2011 in thousands billion dollars
All amounts in 000’s of dollars 2010
2011
2012
2013
2014
EBIT*(1-T)
1,188,447
1,143,443
1,198,512
1,258,438
1,321,359
Add Depreciation Less: Change in Capex
225,100
235,817
248,567
258,510
268,850
125,112
142,316
88,071
91,593
95,257
Less Change in NWC
-104,543
450,376
14,708
15,296
15,908
FCF
1,392,978
763,033
1,320,991
1,387,040
1,456,392
713,853
1,118,314
1,062,555
14,855,964
Present Value of FCFs PV of terminal value Value of firm
2015
1,500,084
19,974,486 17,750,687
Less: Value of Debt
2,881,997
Value of equity Shares outstanding in 2010
14,868,690
Price per share
$88.22
168,545
thousand As of 04/27/2011
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Humana Inc. (NYSE: HUM) Residual Income Valuation Terminal growth rate
3%
Tax Rate
37.20%
Cost of debt
7.79%
Cost of equity
11.51%
Book Value of Debt
2.13
HUM stock price Common shares outstanding
72.34 168545
Market Capitalization
12.19
WACC
10.53%
From the 2010 10-K
billion dollars as of 04/25/2011 in thousands billion dollars
Beginning book value per share
2010 41.08
2011 47.6
2012 55.03
2013 63.51
2014 73.16
Common shares outstanding
168.545
168.545
168.545
168.545
168.545
Earnings per share (EPS)
6.52
7.43
8.47
9.66
11.01
Dividends per share (DPS)
0
0
0
0
0
Retained earnings (E-D)
6.52
7.43
8.47
9.66
11.01
Return on Equity (ROE) %
0.16
0.16
0.17
0.17
0.18
ROE-Re
0.04
0.05
0.05
0.06
0.06
Residual Income = (ROE-Re)* BV
1.80
2.31
2.94
3.71
4.66
PV of perpetuity
56.35
PV for residual incomes
2.15
BV @ T=0
41.08
Price per share Current Price per share
89.36 72.34
% Under / Overvalued
23.53%
2.45
2.77
40.91
as of 04/27/2011
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Humana Inc. (NYSE: HUM) Relative Valuation Relative Valuation using P/E ratio estimates: Company Name
Exchange
Ticker
HUMANA
NYSE
HUM
Price Estimate 2010 Target Price:
PE 2011 PE 2012 Average:
Mkt. Cap. (in $ Bn) 12.19
EBITDA
P/E 2010
EPS 2010
EPS 2011E
EPS 2012E
P/E 2011E
P/E 2012E
(in $ Bn) 2.12
11.2
6.55
6.35
6.9
11.4
10.75
$ 73.36 $ 72.39 $ 74.18 $ 73.31
Source: Estimates & Opinions, Standard & Poor's Net Advantage
Sensitivity Analysis
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
Beta: 1.39 Assuming stock price = $ 99.12 Sensitivity of stock price with beta and growth rate $99.12 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7
0.02 $ 136.78 $ 124.07 $ 113.30 $ 104.05 $ 96.03 $ 89.01 $ 82.81 $ 77.29 $ 72.35 $ 67.91
0.025 $ 138.15 $ 125.31 $ 114.43 $ 105.10 $ 97.00 $ 89.91 $ 83.64 $ 78.07 $ 73.09 $ 68.59
0.03 $ 139.53 $ 126.56 $ 115.57 $ 106.14 $ 97.96 $ 90.80 $ 84.48 $ 78.85 $ 73.82 $ 69.28
0.035 $140.90 $127.80 $116.71 $107.19 $ 98.93 $ 91.70 $ 85.31 $ 79.63 $ 74.55 $ 69.97
0.04 $ 142.27 $ 129.05 $ 117.85 $ 108.24 $ 99.90 $ 92.59 $ 86.15 $ 80.41 $ 75.28 $ 70.66
0.045 $ 143.65 $ 130.30 $ 118.99 $ 109.28 $ 100.86 $ 93.49 $ 86.98 $ 81.19 $ 76.01 $ 71.34
0.05 $ 145.02 $ 131.54 $ 120.12 $ 110.33 $ 101.83 $ 94.38 $ 87.81 $ 81.97 $ 76.74 $ 72.03
0.055 $ 146.39 $ 132.79 $ 121.26 $ 111.37 $ 102.79 $ 95.28 $ 88.65 $ 82.75 $ 77.47 $ 72.71
0.06 $ 147.76 $ 134.03 $ 122.40 $ 112.41 $ 103.76 $ 96.17 $ 89.48 $ 83.52 $ 78.20 $ 73.40
SunTrust Wolfpack Focus Fund Managed by students in the Jenkins MBA program, North Carolina State University
0.065 $ 149.13 $ 135.27 $ 123.53 $ 113.46 $ 104.72 $ 97.07 $ 90.31 $ 84.30 $ 78.92 $ 74.08
