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Aetna, Inc. (NYSE:AET)

Completion of Acquisition of Coventry Health Care Conference

May 07, 2013 5:00 pm ET

Executives

Thomas F. Cowhey - Vice President of Investor Relations

Mark T. Bertolini - Chairman, Chief Executive Officer, President, Chairman of Executive Committee and Member of Investment & Finance Committee

Shawn M. Guertin - Chief Financial Officer, Chief Enterprise Risk Officer and Senior Vice President

Analysts

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Christine Arnold - Cowen and Company, LLC, Research Division

Albert J. Rice - UBS Investment Bank, Research Division

Ana Gupte - Dowling & Partners Securities, LLC

Peter Heinz Costa - Wells Fargo Securities, LLC, Research Division

Operator

Good day, ladies and gentlemen. My name is Sarah, and I'll be your conference facilitator today. At this time, I would like to welcome everyone to Aetna's Update Conference Call, following completion of the Coventry acquisition. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the conference over to Tom Cowhey, Vice President of Investor Relations. Please go ahead, Sir.

Thomas F. Cowhey

Good afternoon, and thank you for joining us today to discuss the completion of the Coventry transaction and the corresponding update to Aetna's 2013 earnings guidance. This is Tom Cowhey, Vice President of Investor Relations for Aetna, and with me today are Aetna's Chairman, Chief Executive Officer and President, Mark Bertolini; and Chief Financial Officer, Shawn Guertin. Following the prepared portion of their remarks, we will answer your questions.

During this call, we will make forward-looking statements. Risk factors that may impact the statements and could cause actual future results to differ materially from currently projected results are described in this morning's press release and the reports we and Coventry filed with the SEC, including our 2012 Form 10-K and our first quarter 2013 Form 10-Q. We have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our first quarter 2013 financial supplement and our updated 2013 guidance summary. These reconciliations are available on the Investor Information section of www.aetna.com.

Finally, as you know, our ability to respond to certain inquiries for investors and analysts in nonpublic forums is limited, so we invite you to ask all questions of a material nature on this call. With that, I will turn the call over to Mark Bertolini. Mark?

Mark T. Bertolini

Good afternoon. Thank you, Tom, and thank you all for joining us today. Today, Aetna completed the acquisition of Coventry Health Care for approximately $8.7 billion in cash, Aetna stock and the assumption of Coventry debt. The Coventry acquisition builds upon Aetna's existing capabilities, expanding our local presence and shifting our mix of business toward higher growth government programs.

As we execute on Aetna's growth strategy, this transaction enhances our diversified portfolio; creates a powerful Medicare franchise with strong products in Individual Medicare Advantage, Group Medicare advantage, Part D and Medicare Supplement; triples our risk-based membership in Medicaid, strengthening our position to win additional high-acuity population contracts; strengthens our Commercial business by increasing our local presence in additional geographies; improves our positioning in consumer-based business without meaningfully increasing our exposure to Small Group and Individual businesses; complements our Accountable Care Solutions business with the addition of Coventry's low-cost, high-performance networks; and adds to our capital generation abilities, allowing us to more aggressively grow our core business and return capital to shareholders.

Going forward, Aetna is positioned to generate an excess of $50 billion in annualized operating revenues and $4.4 billion in pro forma EBITDA. Our company now provides services to an estimated 44 million people in nearly every country across the globe, covers nearly 22 million medical members, works with over 3 million Medicare members as the third largest national Medicare Advantage provider and the fifth largest PVP provider and serves over 2 million Medicaid members in 16 states. As a combined company, we are well-positioned competitively, strategically and financially to meet the evolving needs of the people we serve. Together, our combined capital base, increased membership and collective capabilities enable us to continue to lead the transformation of the U.S. health care industry and improve access, convenience and affordability while providing attractive returns for our shareholders.

As we evaluate the impact of the transaction in our results, we have increased our 2013 operating earnings per share projection to a range of $5.70 to $5.85 per share, reflecting projected accretion from the Coventry transaction of $0.20 to $0.25 per share for the remainder of 2013. Additionally, we are confirming our projection of $0.45 of accretion in 2014 and $0.90 of accretion in 2015.

With the completion of the transaction, we will now begin to thoughtfully and deliberately integrate the 2 companies. Our focus throughout the integration will be on: maintaining continuity and ensuring our customers and members continue to receive excellent service; building upon the strengths and talents of both organizations to improve the quality, convenience and affordability of the services we provide; driving improvements in our business and operations that will allow us to operate more efficiently and adapt quickly in a changing marketplace; and delivering on our targeted synergies and accretion.

I would like to welcome the Coventry employees and thank the Aetna and Coventry employees for their dedication and professionalism during this transition period. Together, as we look to the future by focusing on sound fundamentals, creating new approaches to satisfying customers and deploying capital responsibly, we believe that we can continue to create value for our customers and our shareholders.

I will now turn the call over to Shawn, who will provide insight into our updated 2013 outlook. Shawn?

Shawn M. Guertin

Thank you, Mark, and good afternoon, everyone. Today, Aetna completed the acquisition of Coventry Health Care for approximately $8.7 billion. This purchase price is comprised of 3 components: first, $3.8 billion in cash funded through our $2 billion November debt issuance, approximately $1.1 billion of existing cash and approximately $700 million in commercial paper borrowings; second, the issuance of approximately 52 million Aetna shares with a total market value of approximately $3.1 billion; and third, the assumption of approximately $1.8 billion of Coventry debt at estimated fair values.

As Mark stated, we are increasing our 2013 operating earnings projection to a range of $5.70 to $5.85 per share, reflecting projected accretion from the Coventry transaction of $0.20 to $0.25 per share for the remainder of 2013.

I'd like to step through the key assumptions behind this accretion estimate. Our updated projections for the Coventry business are very much in line with our expectations. These projections start with the assumption that Coventry will produce $460 million to $480 million of standalone net income in calendar year 2013. This projection incorporates the favorable impact of the Kentucky Medicaid rate increase in January 2013. However, this favorability is largely offset by the impact of sequestration on Coventry's Medicare business for the remainder of 2013.

Aetna's definition of operating earnings excludes net realized capital gains, an item that is included in Coventry's standalone net income reporting. After adjusting for this reporting difference and based on the timing of the close, we project that Coventry will add between $270 million and $290 million of operating earnings to Aetna in 2013. Aetna's projections also assume we can achieve pretax cost synergies of $30 million to $50 million in 2013 through elimination of corporate overhead and certain duplicative functions. That other adjustments, including transaction-related interest expense, new pretax intangible amortization and other fair value adjustments, will ultimately reduce operating earnings by just over $30 million for the remainder of 2013. To assist investors, we have provided a schedule of these key adjustments in our updated guidance summary, which is available on the Investor Information section of our website.

Finally, we project that our full-year weighted average share count will be 362 million to 363 million shares, reflecting our updated capital guidance and shares issued in connection with the closing. Note that all projections exclude transaction and integration-related expenses, consistent with our practice since announcing the Coventry transaction.

Additional elements of our combined 2013 guidance include the following. We are projecting combined full-year medical membership of approximately 22.1 million members, which now includes Coventry's 3.7 million medical members. This projection continues to represent growth of approximately 100,000 members over the remainder of the year, driven primarily by Commercial ASC and Medicare supplements. We are projecting full year operating revenue to be approximately $47 billion on a combined basis. We project that our combined full year Commercial medical benefit ratio will be unchanged at the low end of 81.5% plus or minus 50 basis points. As highlighted on our recent first quarter earnings call, we remain comfortable that Aetna's standalone Commercial medical cost trends are developing consistent with our prior expectations. Further, Coventry's Commercial medical cost trends appear to be developing consistent with projections as well.

Our combined Medicare medical benefit ratio is projected to be in the mid- to high-80s in 2013, consistent with our previous guidance. We now project that our combined 2013 operating expense ratio will be approximately 18%, a reduction from previous guidance reflecting higher revenues and changes in business mix as well as anticipated cost synergies.

Incorporating the Coventry acquisition, Aetna's combined pretax operating margin projection is 8% plus or minus 25 basis points, lower than previous guidance primarily due to mix impacts from government businesses. We note that this projected result is consistent with our target operating margin range in the high-single digits.

Finally, we now project combined operating earnings in 2013 will be approximately $2.1 billion. We now project net dividends from subsidiaries of approximately $1.7 billion, an increase of $400 million from prior guidance. After incremental debt paydown, this is now projected to result in approximately $900 million of excess parent cash in 2013 available for share repurchase for other corporate users. Approximately $184 million of this excess parent cash has already been deployed towards share repurchases in the first quarter.

With the closing of the Coventry acquisition, our debt-to-total-capital ratio is approximately 40%. As previously disclosed, we intend to bring our debt to total capital ratio down to 35% over the next 2 years. At the end of 2013, we project this ratio to be approximately 39%. Additionally, our estimated risk-based capital ratio is now approximately 285% of company action level. And we expect to reach our target of 275% of company action level by the end of 2014.

One final aspect I would like to highlight is the strong cash generation capabilities of the combined entity. A useful way to gauge this cash generation is by looking at Aetna's adjusted operating EPS, a metric that starts with operating EPS and adds back the intangible amortization associated with our acquisitions. For 2013, our updated full year projection implies that our adjusted operating EPS will range from approximately $6.10 to $6.25 per share, as intangible amortization reduces operating EPS by just under $0.40 per share this calendar year.

In conclusion, we are excited as we begin the next step in executing on this important facet of our growth strategy. Our capital generation remains strong and is now even stronger as we integrate Coventry and progress towards our synergy targets. Our core business is growing. It's executing well and we are well positioned for the upcoming integration. I will now turn the call back over to Tom. Tom?

Thomas F. Cowhey

Thank you, Shawn. The Aetna management team is now ready for your questions on the Coventry acquisition and our updated guidance. [Operator Instructions] Operator, the first question, please.

Question-and-Answer Session

Operator

That will come from Matt Borsch with Goldman Sachs.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Just if possible give us detail on your accretion estimates for 2014 and '15. Just in terms of is it all cost-based or is some of it, revenue and any other detail you can provide?

Mark T. Bertolini

As we talked about initially, the significant majority of our synergy estimates of the $400 million by 2015 is actually made up of G&A synergies. In the out years, there's smaller pieces is related to medical cost savings and things like that. But the vast majority of the ultimate synergies are G&A.

Operator

Next we'll hear from Christine Arnold with Cowen.

Christine Arnold - Cowen and Company, LLC, Research Division

Could you give us some of your assumptions again on Coventry? How much is sequestration costing in LA and PDP? And what are you assuming for Kentucky Medicaid which had a great first quarter? And what about new contracts like Pennsylvania and Florida LTSS, have you built in kind of some conservatism for that and are there any Medicaid contracts I'm not considering?

Shawn M. Guertin

Let me go back to the first -- let me go back with -- your first question was, say it again, Christine?

Christine Arnold - Cowen and Company, LLC, Research Division

Your sequestration how much is that?

Shawn M. Guertin

It's about $30 million to $35 million, which is the approximate amount of sort of the good guy that we got from Kentucky. In Kentucky, the first quarter loss ratio was 92%. Our outlook for the balance of the year is in that same general neighborhood. We do have some Pennsylvania...

Christine Arnold - Cowen and Company, LLC, Research Division

Are you building in conservatism for some of the other new contracts and is Pennsylvania and Florida LTSS [ph] are those the new contract or am I missing anything?

Shawn M. Guertin

Those are the big ones. Pennsylvania, again, I think we've been prudent as we should, it -- with a new contract. Florida is I think effective 81% so it has fairly minimal impact on the year.

Christine Arnold - Cowen and Company, LLC, Research Division

Final question. You're assuming some share repurchase or not in your share count? It seems like maybe yes.

Shawn M. Guertin

Yes.

Christine Arnold - Cowen and Company, LLC, Research Division

I was doing the math right there, it's about 20 million shares?

Shawn M. Guertin

We have 900 million of deployable capital that we could put at share repurchase, $184 million of which has already been deployed in the first quarter.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. And you're assuming what for the rest of the year?

Shawn M. Guertin

In terms of dollars?

Christine Arnold - Cowen and Company, LLC, Research Division

Yes. Is there incremental repo or not assumed in the share count?

Shawn M. Guertin

It's -- the $900 million of deployable capital is the assumption around share repurchase.

Operator

And next from UBS, we'll hear from A.J. Rice.

Albert J. Rice - UBS Investment Bank, Research Division

Can you just maybe tell us when you get the combined entity, what roughly earnings would M&A represent with the deal closure? And does adding Coventry in change your MA rate expectations? I think on the call last week you said that you were expecting the 2014 M&A rates all in to be down about 4%.

Shawn M. Guertin

On Medicare Advantage earnings, I think, we've talked about 2012 being a little less than 20%, 18% if I remember correctly is the distribution of the combined company. In terms of the 2014 rate outlook, there is no -- we don't have any reason to believe, obviously, right now, that it has a differential rate impact on the Coventry business than it does on ours.

Operator

And next we'll hear from Ana Gupte with Dowling & Partners.

Ana Gupte - Dowling & Partners Securities, LLC

Can you please take a step back? Just give us an update on the IT systems, the processes, the organizational change that you're undertaking while you're also preparing for form exchanges, Medicare bids, new contracts and providers and so on next year?

Mark T. Bertolini

Yes, Ana, our major change organizationally is going to be in the field where we are going to adopt a model, an operating model that looks a lot more like Coventry's operating model where there will be more control of the P&L across Individual, Small Group, middle market, Medicare and Public and Labor. As a result, a number of the people changes we have made positions some of the Coventry folks into those positions, given their comfortability with that model and the way they approach the marketplace. So we believe that is the major operating model change across the organization.

Ana Gupte - Dowling & Partners Securities, LLC

So mainly on the field and the broker side, you're going to tap into the Coventry side of the house and then for the rest of it that's in Karen Rohan's organization it's mostly is the Aetna organization.

Mark T. Bertolini

The only real operating model changes in the field, again, Individual, Small Group, middle market, the local and regional businesses will adopt a model that looks much more like the Coventry model, which is geographically-based versus segment-based which we are operating under before.

Ana Gupte - Dowling & Partners Securities, LLC

And then for 2014 as you're preparing for 2 specific things, 1 is on what percentage of your provider contracts will renew for next year? And are you expecting better discounts in states like Pennsylvania, Florida, Delaware where there's overlap. And then secondly on the Medicare bids, do you think you have adequate time to prepare for the kind of complexity that is required for 2014 on a combined portfolio?

Mark T. Bertolini

On the contract side, Ana, we've got about the mid 30s percent of contracts, of which about 1/4 of those are ones were going to open up on our own anyway as we look at provider contract so those are pretty much set. I think as we look at preparing for Medicare, we've had clean room capability on both the provider contracts and on pricing and we had a number of analyses that were done by consultants outside of both organizations in a format that we could adopt to quickly and review and get on top of, particularly the Medicare bid process that's going in for the first week of June.

Operator

Our last question will come from Peter Costa with Wells Fargo Securities.

Peter Heinz Costa - Wells Fargo Securities, LLC, Research Division

A question that relates to Medicare Advantage. Historically, Aetna's Medicare Advantage Individual product was mostly higher-priced and you didn't grow it particularly fast. It was more of a focus on the group business. Coventry, on the other hand, has had a fairly aggressive pricing on its Medicare Advantage Individual product. How do you see your meshing of the 2 products for 2014 and who's going be running the Medicare Individual product going forward?

Mark T. Bertolini

Peter, I think our view is that one of the attractive of parts the Coventry opportunity was their Individual Medicare business from the way they operate it, the networks have in place and the local operating models they use to sell that product, so it is our anticipation that those will run in parallel to 1 another. Their Individual product and our group product in the near-term, we don't see any immediate changes other than for us to get into the cleaner room, evaluate the bids and make sure that the bids are appropriate going into June.

Peter Heinz Costa - Wells Fargo Securities, LLC, Research Division

Okay. Do you envision repositioning the Coventry Individual book so that it more closely aligns with some of your group product or at least trying to expand its group product members?

Mark T. Bertolini

Again, we -- no, it's #1, it's too early to tell, but we haven't had a real deep look into the pricing underlying cost structures as a result. So we need to get in there and take a look. But again, it was their approach the Individual Medicare marketplace that we found as an attractive part of the asset.

Thomas F. Cowhey

Thank you, Peter. A transcript of the prepared portion of this call would be posted shortly on the Investor Information section of www.aetna.com or you can also find a copy of our updated guidance summary containing details of our guidance metrics and Coventry's projected 2013 operating earnings contribution. If you have any questions about matters discussed today, please feel free to call me or 1 of my colleagues in the Investor Relations office. Thank you for joining us.

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