Humana Inc. (HUM, Financial) has suffered from a sharp sell-off this year, losing a quarter of its market capitalization. The stock should be able to recover in 2025 as headwinds fade and investors realize the company's fundamentals are unchanged, if not strengthened. Humana is one of the largest health insurance providers in the U.S., along with UnitedHealth Group Inc. (UNH, Financial), CVS Health Corp. (CVS, Financial) and Elevance Health Inc. (ELV, Financial).

The company's business model is concentrated on providing its Medicare Advantage plan, contracted with the U.S. federal government and which pricing and offering is decided with and by the Center for Medicare and Medicaid Services.

All four major health care providers experienced periods of sell-off this year due to the CMS' decision to increase the payment too lightly (3.70% in 2025, too little for Humana's and Wall Street's taste, equivalent to a -0.20% actual payment difference when taking rising cost levels into account) while medical costs continue rising. Humana's concentrated business model caused the stock's valuation to be more impacted than others by these headwinds. However, these headwinds are likely to be only temporary and do not justify the sharp decline in the stock price. The fundamentals of the company remain unchallenged.

Despite the long-term rising trend in share price, its history has been regularly marked by sharp sell-offs that consistently led to new all-time highs. There is reason to believe the long-term tailwinds will prevail over the short-term headwinds once again.

Headwinds and tailwinds

While the CMS decision seems irreversible, the acceleration in medical cost inflation due to supply chain issues and labor market tightness should slow down and reverse as unemployment rises, the economy weakens and supply chains normalize. These are external and temporary factors impacting the company and not related to the business model's long-term fundamentals.

The fact of the matter is Humana continues to grow sales; it is only the profitability that took a temporary hit and is expected to recover as debt cost declines and inflation in medical treatment softens. Markets are forward-looking, so waiting for when we start seeing signs of improving profitability could prove to be too late.

The number of people enrolled in Medicare Advantage is expected to continue to increase steadily over the next decade, adding approximately 2 million people per year. While these numbers continue to grow, Humana been able to capture about 18% of the total enrolled people, slightly up from 2010.

The above chart shows an interesting trend: the concentration of enrollments in a handful of plans, namely UNH, Humana, CVS Health and BCBS (Elevance Health). The top four now represent 73%, up from 57% in 2010. This growing concentration in the sector is an opportunity for Humana, showcasing brand recognition and customer satisfaction.

Further, from 2023 to 2024, Humana enrolled more people in Medicare Advantage than its primary competitor, UNH, showing a surge in growth and a narrowing of UNH's market lead.

Financials and valuation

Humana has had astonishing revenue growth rates, with an acceleration in recent years well into the double digits as the sector continues being more concentrated toward the main health insurance providers. The growth rates accelerate as look forward, and it is estimated the company's sales will continue rising.

Source: GuruFocus

However, when it comes to profitability and earnings, we can see a sharp drop this year with earnings per share and free cash flow slashed in 2024. The road to recovery will be bumpy and it could take two to three years to see earnings per share return to previous levels, but that also means the share price could return to above $500 prior to that (40% to 50% upside within 24 months) as markets anticipate the recovery.

The company has been suffering from high debt levels with long-term debt reaching $11.8 billion in the last 12 months. The debt servicing in a high interest rate environment eats some of the company's earnings, having had to finance $2.25 billion of its debt in March of this year. There are reasons not to worry about Humana's rising debt level (yet): the company holds $16.70 billion in equity, providing it with a sufficiently large net cash position to cover all of its debt. Additionally, it is widely expected for interest rates to decline in the next several quarters, potentially permitting Humana to refinance some of its more expensive debt.

Humana's management has proven to be efficient for many years now with a consistent, double-digit return on equity, with a median around 15%. The management prefers not to turn the company into a dividend stock (currently around 1% dividend yield, below the S&P 500 average) and rather reinvest the money in business growth and share buybacks.

At around $350 per share at the time of writing, the stock is cheap, trading at a mere 0.45 times revenue and below the 0.70 times average of the last five years (reconfirming the minimum 40% to 50% upside in case of profitability recovery). Humana's concentrated business allows for easier forecasts and valuation calculations than its three main rivals, all of which have more diversified businesses. The company's historical valuation metrics are, therefore, more relevant, particularly revenue multiples for the next couple of quarters as earnings recover (earnings multiples are distorted when earnings suddenly drop).

The stock is currently trading at a forward price-earnings ratio of 20, a 10% discount from the sector median of 22 times, justifying the higher concentration risk. The valuation multiple is even more attractive given the company's earnings have not yet recovered to the normal growth trajectory. Indeed, with the earnings recovery, the forward valuation of the stock is 16 times 2025 earnings, 12.60 times 2026 earnings and 9.70 times 2027 earnings. This means the market cap is likely to double by 2027 if earnings do recover, providing an attractive upside. It is not without risks, however.

Risk factors to my case

As for every trade, there are business and macro risks that come with the potential rewards. New lawsuits similar to the litigation that caused Humana to pay $90 million this year to resolve a False Claims Act could add to the turbulence it is already facing. The case alleges that Humana overbilled the CMS for prescription drug contracts between 2011 and 2017. While the amount is not material to the multibillion-dollar company, further lawsuits of a similar nature could compromise the positive trust relationship between the CMS and Humana. This could potentially affect its fundamentals.

In relation to the macro risks, the most evident ones are the extension in time and magnitude of the current headwinds: rising medical costs, high interest rates pushing debt financing costs up and a reluctance of the CMS to match these rising cost levels by sufficiently increasing Medicare Advantage payments. While these macro risks are likely temporary headwinds, prolonged adverse conditions could cause cracks over time in the business growth of Humana.

Bottom line

The health care insurer could turn into a long-term opportunity despite short-term headwinds. Humana is a relatively easy trade within a diversified portfolio if investors believe in the long-term rising trend in Medicare enrollment and continued concentration in the main players.

The stock has suffered a sharp sell-off this year, but with a likely recovery within 24 to 36 months, Humana could provide 24-month upside of 40% to 50%. The concentration of the business model into Medicare Advantage plans make it predictable and easier to forecast. The fundamentals are unchanged, given the steady and continued rise in revenue. The temporary drop in profitability due to rising medical costs and a reluctance of the CMS to increase beyond the 3.70% tabled in for 2025 relative to 2024 are likely to be short-term headwinds with little risk to the long-term growth story of Humana.