Humana Inc. Case Study

Case#4 Humana Inc.                                                                      Jingwei Li A52669984

1. Why did Humana’s integrated strategy fail?

According the case reading material, as the middle of 1992 approached, the company had just reported its steepest quarterly earnings decline in five-and-a-half years, setting the stage for its first annual earnings decline since 1986. In addition, hospital stocks currently traded at historically low price-earnings multiples, while multiples for HMO stocks were generally much higher.

It also says that in conducting its internal review of Humana’s strategy in late 1991, management had identified a number of disturbing recent trends, particularly in the hospital segment. In addition, the long-term prospects of the firm’s two business were growing increasingly divergent, causing some to question whether an integrated strategy was still appropriate.

Basically, there are two separate business part for Humana Inc. such as Hospitals and Health Plans. From the reading materials we learn that Health plans looked extremely bright while Hospitals were in problems. So the hospital business segment drag down the share piece and has negative effects on the health plans. And before the hospital and health plan spinoff, it is necessary to allocate corporate overhead. This process can be very inefficient. So the downturn of hospital and some management inefficiency caused the integrated strategy fail.

1. Why do you think a spinoff might add value for shareholders?

The theory of Modigliani and Miller (1958, 1961), Coase (1960), and Vickrey (1961) can be applied to corporate restructuring and divestitures. Their concepts suggest that in a world of zero information and transaction costs, corporate organization is irrelevant. In other words, whether a firm is comprised of two divisions, or the two divisions are instead separate firms, the combined value will be the same.

The lessons from the theoretical research for corporate restructuring are two-fold. First, a corporate manager cannot improve firm value by arbitrarily chopping a company into pieces. Second, the theory guides analysis of restricting toward factors such as information and transaction costs as possible sources of wealth creation.

So theoretically, the value of the hospitals and health plan business part after spinoff is the same as the value of company as whole. But many empirical researches have shown that positive spinoff has the potential to create value. The reasons are as follow:

1. Spin-offs can reduce agency conflicts between managers and shareholders.
2. Spin-offs allow firms to tie manager’s compensation more closely to the performance of firms’ individual business units.
3. Spin-offs can allow company allocate resources on the most competitive business part and improve business performance
4. If some business parts are not consistent with company’s whole operation strategy, maintaining these business parts cannot improve the value of company but decrease it. i.e. (1+1<2) so spin-offs can reduce dissynergies.
5. Normally, the stock market has preference on market information transparency. The company after spin-offs as an independent entity need to disclose financial information and some other information that investors need to know regularly.

In this way, the investors can analyze the value of the company easier. And this continuous and regular information disclose would have a positive effect on the operation performance of the company.

1. How would you go about quantifying the value added by a spinoff?

We don’t have detailed cash flow from the case material so I think that we can use P/E multiples to value the spinoff.