AET Aetna Inc. (delisted)

We have reiterated our Outperform recommendation on Humana Inc. (HUM) based on its consistent operational performance despite the challenging regulatory and economic environment.

The company’s second-quarter operating earnings came in at $671.4 million or $2.50 per share, surpassing $566.4 million or $2.11 per share in the year-ago quarter. This also compares favorably with the Zacks Consensus Estimate of $2.07 per share.

The better-than-expected results were attributable to higher year-over-year earnings in Humana’s Retail and Health and Well-Being Services business segments, which were partially offset by lower earnings in the company’s Employer Group business segment.

Humana’s Medicare business is witnessing a modest performance and accounts for a majority of premiums and ASO fees. Besides, the growing membership base provides it greater leverage to expand the network of PPO and HMO providers.

Going foreward, the projected acquisition of AMS is further expected to expand Humana’s Medicare coverage and enhance the quality of its healthcare services. The acquisition is expected to be accretive to earnings beyond 2011.

Additionally, Humana’s acquisition of Concentra and the joint venture with South Africa-based Discovery Holdings Ltd. complement the company’s long-term growth strategy. Humana is actively working on expanding its size, not just through acquisitions, but also by increasing its employee base. Going forward, the projected reinvestment spending in the second half of 2011 will further accentuate growth in 2012 and beyond.

The company’s investment portfolio also enjoys an investment-grade rating from most rating agencies. Moreover, the company’s debt-to-total capital ratio improved to 18.0% in the second quarter of 2011 from 18.7% at the end of the prior quarter, reflecting a modest investment and debt strategy.

Besides, Humana enjoys a strong cash and capital position that enables it to absorb the capital expenditure and add to shareholders value thereby, inspiring confidence in the stock. The rising visibility of enhanced earnings growth is also validated by the company's guidance, which was recently raised.

However, risks related to the uncertain impact of healthcare reforms, pricing pressure and intense competition from arch rivals such as Aetna Inc. (AET), WellPoint Inc. (WLP) and Health Net Inc. (HNT) remain the primary causes of concern. Additionally, Humana has been incurring higher-than-expected expenses owing to increases in depreciation and amortization, interest and tax expenses along with operating costs. Higher benefits have also led to deteriorating benefit ratios across most operating segments.

Overall, given the higher scope for growth and ability to mitigate risks related to operations and finances, the Zacks Consensus Estimate for earnings is currently pegged at $2.02 per share for the third quarter of 2011, implying stability. For 2011, earnings are expected to grow about 7% year over year to $7.68 per share.

Our six-month target price of $89.00 equates to 11.6x our earnings estimate for 2011. Combined with the $1.00 per share annual dividend, the target price implies an expected total return of 20.7% over that period. This is consistent with our Outperform recommendation on the stock.

Additionally, the quantitative Zacks Rank for Humana is currently #1, indicating a strong upward pressure on the shares over the near term.

 
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