The purpose of this memo is to analyze Humana’s business model and its spin-off solution. We think Humana’s problems were severe enough to implement restructuring plans within the company. First of all, Humana’s administrative cost ratio was 16.1% and medical loss ratio stood at 85.9% (increased from 84.4% in 1991). The stock price was declining from $34.5/share in May 1991 to $21.63 in May 1992. In addition, the entire hospital industry is suffering losses in the long-term because of increases in operating costs, decreases in average hospital stays (occupancy rate declining to 47%, national average occupancy rate was 69%), and growing competition. The margin is diminishing and the PE ratio is lower in both industry averages. Spin-off is ideal since the hospital industry is shrinking and Humana’s profit from hospital starting to decline. A decision made early will still allow Humana a higher valuation on hospital business.
The separate income statement is listed below. As presented, the after-tax net income of Humana Hospital and Health Plan are $314M and $ 41M. After we compare the asset sizes of comparable companies, we decided that the PE ratio for the Hospital business should be 13.0x, equal to that of National Medical Enterprises, as they are closer on the asset size. The PE ratio for Health Plan business should be 17.0x, equal to the average of United Healthcare and U.S. Healthcare, for the same reason. Thus, the value of these two businesses separate will be $4,087M and $694M. The Market value using current PE ratio for the whole Humana Company is $3,550M. Therefore, a spin-off of these two segments (assuming tax rate is 36%) will create an extra value of approximately $1,231M. Humana should assign most of its debt to the hospital business and keep sufficient cash in the health plan segment.
According to the exhibits, the proportion of debt distributed to hospital and health plan is 5:1. Health Plan business could expand itself and enjoy further profit and growth, while the hospital business could start eliminating parts that are not profitable or carries much capacity. Kaiser has 6.5 million members and 7700 beds. This means feeding more people into the hospitals and a higher occupancy ratio. Humana has 1.7 million members and 17829 beds, significantly less occupancy. Both of the hospital and health plan industries enjoy higher PE valuation ratio than Humana as a company does, which indicates that this integrating strategy doesn’t fulfill the fullest of their respective potential.
There is no other option that’s more sensible since they all have their respective flaws. New price structure compensates their margin to sell more services, yet their hospital’s occupancy ratio will not increase and they will lose on the Medicare deals. Selling off hospitals may help gain profit and independence. However, it will be extremely undervalued (6.0x EBITDA ratio). Leverage buyout is not feasible either because Humana’s marketable securities are occupied, thus no sufficient fund. Stock buyback will not help Humana to deal with hospital section’s occupancy and profitability problem. Finally, the feasibility of ESOP remains uncertain, as it didn’t measure whether employees have the ability to purchase and whether synergy has been compensated.