Humana HUM reported strong third-quarter results driven by an improvement to its Medicare medical cost ratio (medical costs as a percentage of premium revenue). While management's 2010 earnings outlook is well ahead of the estimate incorporated in our model, we are maintaining our fair value estimate as we remain pessimistic about the future of the Medicare Advantage program.

Humana's quarter was saved by the government segment, where pretax income increased 75% compared to the prior-year quarter. Medicare Advantage membership increased 11% year over year, and 62% of the company's Medicare Advantage members are now in network-based products (as opposed to the private-fee-for-service program, which will be eliminated in 2011). The government segment medical cost ratio improved by 220 basis points to 81.9%, and administrative expenses consumed 10.2% of this segment's operating revenue. Management reiterated its operating margin target of 5% for Medicare business, compared to our long-run expectation of around 2.5%.

Humana's management projected 2010 earnings per share to decline approximately 16% to between $5.05 and $5.25, which assumes the company loses its TRICARE contract in October of next year. Humana protested the transition of its contract to UnitedHealth UNH, and its protest was recently upheld by the Government Accountability Office. It is unclear what effect this decision might have on the Department of Defense's handling of the contract. However, we continue to believe reimbursement cuts to Medicare Advantage, the end of private-fee-for-service, and major health-care policy reform will be the biggest challenges facing Humana over the next several years.

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