Introduction: Sometimes there are stocks whose time has come. One such equity might be Aetna (AET), which is meeting and exceeding analyst's expectations in several respects. I previously wrote about AET on Seeking Alpha on May 16, in Aetna Appears Undervalued.
AET continues to appear undervalued to me, and in view of its latest earnings report and conference call, this article is contributed as a follow-up. This is so even though AET has doubled since the beginning of 2011 and has risen over 7% since that article.
Some of that article reviewed various matters about Aetna, which I will not repeat. Please feel free to scan that article before or after reading this, if you are unfamiliar with several of the moving parts of this company. A very quick summary is that the multiline insurance company that Aetna was for many years transformed itself into a healthcare benefits company beginning with an important merger in 1996.
Fast forward to Q2 earnings, reported last week. Analysts were looking for $1.41 per share; operating earnings came in at $1.52. Earnings estimates are now rising for 2013 to $5.89 and $6.33 for 2014. My guess is that these will continue to be raised. The rationale for that view is that AET likes to under-promise and over-deliver.
The trend of published analysts' estimates has been moving upward, both before and after earnings were released; often that trend both continues and is associated with a more durable increase in the P/E ratio.
As we move into 2014, the future may become clearer and AET and its peers may move more toward a market multiple (which itself may decline, however). This article discusses these points in more detail below. First, let's see how AET has performed for shareholders over time.
Background: Without the complication of health reform to muddy the waters, in the last market cycle AET peaked somewhat after the average stock, in December 2007, after a tremendous multi-year run.
Here is AET's long-term price chart:
The stock price accelerated as that cycle moved along. Might the same thing happen again this cycle?
In evaluating total return to shareholders, note that a $35 cash payment to shareholders was received in December 2000, due to a sale of most of Aetna's non-healthcare businesses. That deal was associated with a 2:1 stock split, and there have been two more 2:1 splits since then, so it's not clear to me how heavily to weight that cash payment relative to today's price. In any case, it was material. AET has been a shareholder-friendly company for some time. I believe that this bodes well for the future; no guarantees, as always.
The Coventry acquisition: On May 7, Aetna acquired Coventry Health Care, adding several million members. It now insures 22 MM Americans. No. 3 in that statistic. Aetna is upbeat over the Coventry deal for a variety of reasons ranging from cost synergies to adopting certain operating methods Coventry used.
A critical question is whether operating profit margins will eventually get squeezed further. In the last boom, they were around the current level of 11%. An investor in AET or any other insurer will have to trust that the evolution of health insurance in the U.S. will allow these companies to maintain margins appropriate to American businesses overall.
Assuming no major downside issues to the changing health benefits landscape, I'm hopeful that the Coventry acquisition will both provide new impetus to earnings growth and set Aetna on a further growth path as it gains experience integrating major acquisitions.
Between 2005 and 2007, AET traded around one time revenue per share and averaged a P/E of over 15X current year EPS. Currently, it has a market cap of $21 B, while revenues are estimated to be $55 B next year. There is no preferred stock. As of 12/12, unfunded pension liabilities were $900 MM, not enough to be a major stumbling block to a higher valuation.
Thus I'm hoping for a recurrent multiple expansion, as well as for steady EPS growth.
If things go well, perhaps at some point in 2016, AET could have forward EPS for 2016 of $8 and a prospective P/E of 15-16. if so, then the stock, could double again by early 2016.
The above is speculation and not a prediction, but I do not think it's a reasonable hope for AET shareholders. Because of the Affordable Care Act (ACA), there are going to be more people with health insurance, a growing population, and presumably more healthcare inflation; why should not AET grow earnings? Thing farther out, perhaps healthcare insurers might move in time to be viewed as quasi-utilities. As we know, these virtually no-growth companies now carry trailing P/Es in the 16-18 range. I think the same is possible for AET and its peers. There are definitely no guarantees here, but sometimes paradigm shifts occur, and I'm thinking this could be a possibility.
As mentioned above, part of the reason for my relative bullishness on the company is that it has no obvious reason to make the Coventry deal its last major deal. The Insurance Information Institute reports that in 2012, there were 806 health insurance companies in the U.S. Consolidation appears to be a reasonable possibility. I suspect that Aetna has the operational ability and desire to do more deals and do them wisely. I am not looking at Aetna as an acquiree, however.
Recent results: Aetna reported Q2 earnings last week. Operating earnings exceeded consensus by 8%; the company increased its EPS guidance for the year to $5.80-$5.90. Results for the past quarter included 2 months of the Coventry acquisition, so there is limited comparability to Q1 or to Q2 of 2012. Revenues were $11.6 B, up 31% from the prior year. In its prepared remarks, management did indicate on the conference call the following:
At its midpoint, our revised 2013 guidance would represent 14% operating EPS growth in 2013 and 17% compound annual growth from 2010 through 2013, a 3-year growth rate that is well in excess of our diversified managed care peers.
The key to an upward revaluation of AET's P/E relative to its peers and to the stock market as a whole will, I believe, be related in large part to whether the Street believes that AET is better-managed than its competitors. The above quote suggests that management is attempting to make that case.
Later in the conference call, the theme that Aetna is a superior health solutions company was brought in again, in a different context:
It is important to remember that Aetna's Accountable Care Solutions, powered by Healthagen technologies, represent an advanced form of provider collaboration and risk sharing. As evidenced on our advanced capabilities, early this month, KLAS, an independent research of technology and solutions in the health care provider market, said that Aetna is having the most transformational accountable care relationships as compared to other payers.
The company's goal is to have 45% of its revenues come from value-based contracts by 2017, up from 15% today. If it can be a true leader in this regard, the Street may respond by increasing AET's relative P/E both versus the overall market and its peers.
Independent analysis: S&P Capital IQ's (SPCI) Stock Report believes that amongst the largest health insurers, AET deserves the highest P/E. It ascribes this to numerous operational strengths. SPCI's proprietary analysis places AET as one of an elite group of what they view as heavily undervalued stocks, with a '5+' degree of undervaluation. With a trading price around $64, SPCI's analysis is that fair value for AET is $74.
SPCI does not feel that AET is a 'blue chip' though. Its quantitative risk assessment for the stock is that it carries average risk. That is in line with its quantitative quality rating of B+, basically marginally above average.
Value Line's statistical data shows that AET has grown revenues at a compound annual rate of 9% over the past 10 years and 15.5% over the past 5 years. It shows profits having grown 41% annually over 10 years, 10% over 5 years and projects profits will grow about 10% per year through 2017. Free cash flow is copious. (This growth projection was made before Q2 results were released.) Cash flow this year is expected to be $7 or more per share, whereas both capital spending and debt repayment should only come in around $1.10/share. Value Line also projects that AET will be able to continue to shrink shares outstanding, which it has done aggressively in recent years, further; modestly raise the dividend; and pare net debt by about 40% by around 2017.
Value Line reports that AET's earnings predictability is in the 75% percentile of companies covered.
The conclusion that I draw from reading Aetna's documents and presentations and from considering what two leading independent mainstream stock rating services believe about Aetna is that it is a forward-looking, well-managed company that has a sensible, proactive approach to the many uncertainties regarding the United States healthcare and health insurance system.
Risks: The overriding current risk to Aetna's business involves the many uncertainties regarding implementation of the ACA.
A less obvious risk is that the company and its peers have all enjoyed some relief from medical cost inflation by recent under-utilization of healthcare by enrollees. This has primarily been attributed to difficult economic circumstances causing people to have trouble paying deductibles and co-pays. It has also been attributed to some people waiting until the ACA is more fully implemented next year. The companies are anticipating normalization of utilization, and setting rates on that basis. Failure of utilization to normalization could lead to price-cutting amongst insurers, causing profit growth to decelerate or decline.
Overall, though, economic weakness including an outright recession will tend to harm both AET and the company's fundamentals. More prosperity may temporarily harm margins, but beyond those short-term concerns, the more people who are working and improving their economic circumstances, the better it should be for AET.
Regulatory, legal, operational and stock market risks are present for AET shareholders, as well.
It's also important to recognize that AET has a reasonable price:book ratio close to 2:1, but that tangible book value is a small portion of total book value. Most of AET's book value consists of intangibles and goodwill. I have no reason to mistrust its valuations, but some investors may consider this a potential source of risk.
Summary: AET is widely regarded as a well-managed, forward-looking healthcare benefits company that appears to be in the process of successfully completing a major acquisition. It sports relatively rapid growth rates at a time of slow economic growth, yet sells at a below-market multiple of not much over 10X next 12-month estimated earnings per share. It has substantial free cash flow and looks forward to the growing insured potential members as the ACA takes full effect, presumably by 2015.
AET might become a serial acquirer and if so, may do so effectively.
Numerous uncertainties both related to the ACA and to well-understood economic and competitive circumstances exist, among other risks.
Investors may wish to evaluate this security for its earnings and income growth potential.
Additional disclosure: Not investment advice. I am not a registered investment adviser. Purchase of any stock involves possible permanent loss of capital.