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Humana's Messy Mix

Shares slip despite solid guidance for 2007.

Thanks to the booming Medicare business,


(HUM) - Get Humana Inc. (HUM) Report

sees better days ahead.

The company's third-quarter profit, while up more than threefold from a year ago, fell shy of Wall Street's lofty expectations. But the company's guidance should please investors who are focused on the future.

Humana reaffirmed its 2006 forecast for profits of $2.82 to $2.88 a share, with even the low end of that range topping the consensus estimate. Moreover, the company issued new 2007 earnings guidance of $3.90 to $4.10 a share that came in well ahead of Wall Street's current $3.50 target.

Meanwhile, however, Humana's latest results did miss the mark.

Third-quarter revenue jumped 48% to $5.65 billion but fell short of the $5.9 billion consensus estimate. Net income rocketed to $159 million from $46.8 million due to lucrative enrollment gains - particularly in the Medicare Advantage business - and the absence of year-ago charges. Earnings per share came in at 95 cents, matching the low end of management's guidance but missing Wall Street targets by 2 cents.

For its part, Humana still feels confident that it can hit its targets for the full year. Meanwhile, Humana credited "substantial earnings increases in both of the company's business segments" for its recent success.

As usual, Medicare proved to be the real story. The company saw its Medicare Advantage enrollment nearly double from a year ago, fast approaching the 1 million-member milestone.

Sequential gains looked much smaller, however. Membership in Humana's Medicare Advantage program rose just 3% over the course of the third quarter, with gains in the company's Medicare Part D business coming in at 2%.

Meanwhile, Humana's commercial business posted only modest growth from a year ago and actually lost some ground sequentially. The company's consumer-driven health plans continued to gain traction, however.

Humana reported mixed cost trends for the quarter. The company's medical expense ratio climbed higher in the government segment - due primarily to Part D expenses - while it fell in the commercial division. The company continues to benefit from low hospital admissions in particular.

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Looking ahead, Humana clearly expects the good times to continue.

"Our third-quarter results kept us on track to increase earnings per share by approximately 60% over 2005," stated Humana CEO Michael McCallister. "With year-to-date revenues up nearly 50%, 2006 is playing out as planned and positioning us for another year of robust earnings and revenue growth in 2007."

Medicare Story

Bear Stearns analyst John Rex expected solid results from the company.

In a research note published last week, Rex predicted that Humana would top Wall Street expectations due to higher enrollment and lower costs in the Medicare-related business. He stopped short of recommending the stock, however, because of the lofty expectations that, he feels, have already been baked into the shares.

"Humana remains a story heavily leveraged to the privatization of Medicare," Rex wrote ahead of the company's quarterly update. "While we continue to like the Medicare privatization opportunity, with the stock at a 30% premium to the group, the current valuation appears to already incorporate the best case from our earnings sensitivity analysis (well above our posted view), a factor that makes us at least somewhat cautious at current levels, exacerbated in part by the approaching elections."

For the most part, Humana has been chasing a different Medicare opportunity than other players in the field. The company specializes in Medicare Advantage plans, which are far more extensive - and lucrative -- than the simple drug benefits being offered under the new Medicare Part D program.

For every 100,000 new MA members that Humana adds, Rex estimates, the company's profits rise by 10 cents to 20 cents a share. In contrast, he figures, the same number of Part D additions lifts company earnings by just a penny instead.

Looking ahead, Rex believes that Humana's future rests on both adding new MA members and shifting some of its current Part D customers into the fuller plans.

"While 2006 was aided primarily by the company's major expansion of private fee-for-service products in new markets, 2007 could also be about conversion of some portion of Humana's 3.5 million Part D members to Medicare Advantage," he wrote. "Certainly, it is this 'inventory' of Medicare Part D members - and the ultimate conversion potential - that creates the long-term bullish backdrop for the stock."

Rex has a peer-perform rating on Humana's stock. His firm has provided non-investment banking services to the company over the past 12 months.

Rex sees challenges ahead, however. Notably, he points out, Humana has enjoyed several advantages in 2006 that will diminish in 2007. He cites a longer open enrollment period, a broader geographical expansion and a milder competitive landscape as specific examples.

He throws in post-election changes as a possible wildcard as well.

"In particular, we believe that should Congressional hearings focus on Medicare in 2007, the most likely area to be addressed would be the somewhat controversial private fee-for-service component of the Medicare Advantage program - which has been the key contributor to Humana's MA enrollment gains," Rex stated. "While not likely to happen in the next couple of years, the threat of a rollback of premium levels to more closely match costs under the government-sponsored Medicare program would quickly change the economics of such markets."