Humana Inc.’s (HUM - Analyst Report) third-quarter 2014 operating earnings came in at $1.85 per share, lower than the Zacks Consensus Estimate of $2.01. Moreover, results compared unfavorably with $2.31 per share earned in the year-ago quarter.

The year-over-year decline was due to investment in healthcare exchanges and state-based contracts, along with increase in specialty drug costs related to a new treatment of Hepatitis C. However, these factors were partially offset by increased membership, higher utilization from increased membership in clinical programs and a decline in share count.

Humana Inc - Earnings Surprise | FindTheBest

Revenues at Humana for the reported quarter climbed 18.6% year over year to $12.2 billion. Higher medical membership in the Retail segment and group Medicare Advantage membership in the Employer Group segment led to an increase in premiums and services revenues that mainly drove overall revenues in the reported quarter. Revenues were a tad lower than the Zacks Consensus Estimate of $12.3 billion.

Quarterly Review

Humana’s consolidated benefit ratio, which reflects the percentage of benefit expenses in premium revenues, were 83.3%, in line with the year-ago quarter. The year-over-year decline of the ratio in the Retail segment, along with Humana’s previously announced exit from the Puerto Rico Medicaid business in Sep 2013, was mitigated by an increase in the ratio in the Employer Group segment.

Humana’s consolidated operating cost ratio, which reflects the percentage of operating costs in total revenue less investment income, rose 50 bps year over year to 15.6%. The increase primarily resulted from an increase in ratios in the Retail and Employer Group.

Quarterly Results by Segment

Retail Segment: The segment’s pre-tax income declined 4.7% year over year to $322 million due to higher operating cost ratio. 

Reported premiums and services revenues increased 28.1% to $8.6 billion in the reported quarter. The upside primarily reflects an 18% year-over-year increase in average individual Medicare Advantage membership and higher membership associated with healthcare exchanges.

The benefit ratio was 83.8%, improving from 84.1% in the prior-year quarter. This improvement stemmed from growth in memberships in clinical programs and the inclusion of health insurance industry fee in the product pricing.  Operating cost ratio deteriorated 170 bps to 12.4% in the reported quarter. This deterioration stemmed mainly from investment spending related to the health care exchanges and new state-based contracts, and non-deductible health insurance industry fee as per the healthcare reform.

Employer Group: This segment of Humana incurred pre-tax income of $13 million, comparing unfavorably with $76 million in the year-ago period. This decline came from a rise in benefit and operating cost ratio in the segment.

The benefit ratio was 86.5%, up 220 bps year over year, reflecting the impact of transitional policy changes and an increase in utilization that stemmed from costs related to the new treatment for Hepatitis C. 

Operating cost ratio increased 20 bps to 15.7% due to effect of the non-deductible health insurance industry fee and other fees, and an increase in the percentage of small group commercial group business with a higher operating cost ratio than large group business.

Meanwhile, reported premiums and services revenues increased 8.9% to $3.1 billion, primarily on the back of an increase in average group Medicare Advantage membership.

Healthcare Services: Pre-tax income for the segment rose to $202 million from $149 million in the third quarter of 2013. The upside was attributable to higher revenues from an increased Medicare membership.

Revenues at this segment rose 27.3% year over year to $5.2 billion, mainly on improvement in the pharmacy solutions and home-based services businesses. Operating cost ratio was 95.4%, in line with the year-ago quarter. This was because growth in the pharmacy solutions business was offset by the build-out of home based services and other businesses across the segment.

Other Business: The other business segment reported a pre-tax income of $14 million, comparing unfavorably with $23 million in the year-ago quarter. The decline was largely owing to the exit of the Medicaid contracts in Puerto Rico.

Financial Update

Humana’s operating cash flow was $954 million in the third quarter of 2014 against $1.15 billion a year ago. Remittance of the health insurance industry fee to the federal government, increase in receivables associated with the 3Rs and lower net income in the reported quarter mainly led to the downside. 

As of Sep 30, 2014, cash, cash equivalents and investment securities of Humana were $12.7 billion, higher than $10.94 billion as of Dec 31, 2013. The increase was owing to the proceeds from debt issuance in the third quarter and collection of the Medicare Risk Adjustment (MRA) payments from the Centers for Medicare and Medicaid Services (CMS).

The debt-to-capital ratio of Humana as of Sep 30, 2014 was 30%, representing an 820 bps deterioration from 21.8% as of Dec 31, 2013. The deterioration stemmed from the latest debt issuances of the company that increased debt balances.

Moreover, in Oct 2014, Humana entered into a commercial paper program that requires it to issue short-term, unsecured commercial paper notes worth $1 billion or less. Net proceeds from this issuance will be used for share repurchases and other general corporate purposes. Thus, as of Nov 6, 2014, the company had $150 million outstanding under its commercial paper program.

Share Repurchase Update

In Sep 2014, the board of directors of Humana replaced the previous $1 billion share repurchase authorization with a new $2 billion program. The previous authorization had shares worth $816 million remaining to be repurchased. The new program is scheduled to expire on Dec 31, 2016.

In the third quarter of 2014, Humana spent $118 million to buy back nearly 1.0 million shares. This brings the nine months’ tally to 1.9 million share repurchases worth $230 million. From Oct 1, 2014 to Nov 6, 2014, Humana bought back 0.8 million shares for $100 million. As of Nov 7, 2014, the company is left with shares worth approximately $1.87 billion under this program.

Additionally, on Nov 7, 2014, Humana declared that it will ink a deal with a third-party financial institution to realize a $500 million accelerated share repurchase program, under the $2 billion share repurchase program authorized in Sep 2014.

Outlook

2014

Humana updated its earnings per share (EPS) guidance for 2014 to $7.40–$7.60 per share from $7.25–$7.75 on revenues of $48–$49 billion from $47–$49 billion. The guidance lies below the Zacks Consensus Estimate of $7.72 for 2014. Additionally, operating cost ratio is expected in the range of 15.75%–16.25% as against the earlier guidance of 15.4%–16%.

Net investment income guidance of Humana was reiterated at $350–$400 million.

Interest expense guidance was raised to $190–$195 million from $140–$145 million guided earlier.

Operating cash flow guidance was reiterated at $1.1–$1.4 billion.

2015

Humana expects its 2015 earnings to be in the range of $8.50–$9.00 per share. The Zacks Consensus Estimate of $8.86 lies within this range. Revenues are expected to be in the $53.5–$54.5 billion range.

Investment income guidance for 2015 lies in the band of $350–$400 million.

Humana projected the 2015 interest expense guidance at $185–$190 million.

Operating cash flow is expected in the range of $575–$625 million.

Zacks Rank

Humana currently carries a Zacks Rank #2 (Buy).

Performance of Other HMOs

Among other health maintenance organizations (HMOs), Molina Healthcare Inc. (MOH - Analyst Report), WellPoint Inc. (WLP - Analyst Report) and Aetna Inc. (AET -Analyst Report) outperformed the Zacks Consensus Estimate in third-quarter 2014.

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