Aetna Worth $60, UnitedHealth Looks Riskier

Includes: AET, ANTM, UNH
by: Takeover Analyst

In an earlier article here, I argued that UnitedHealth Group (NYSE:UNH) was a clear "strong buy" despite risks. Since the article was published, the stock has appreciated by 12.2%, beating the Dow Jones by by 1,000 basis points. Going forward, I find that the company has closed much of its value gap and is at fair value. A more attractive pick would be Aetna, which has benefited from unexpected trends in utilization rates and lower operating expenditures.

From a multiples perspective, Aetna is the cheaper of the two. It trades at a respective 9.4x and 8.7x past and forward earning while offering a dividend yield of 1.6%. UnitedHealth Group, meanwhile, trades at a respective 11.7x and 11x past and forward earnings while offering a dividend yield of 1.2%. With WellPoint (WLP) also below a 10x multiple, investors may be challenged to justify the premium. With that said, there are a few inflated picks amongst peers that will stay inflated just in time for what could be a full recovery.

In the event of a recovery, Aetna is well positioned to gain. At the third quarter earnings call, Aetna's CEO, Mark Bertolini, noted strong performance:

[W]e reported third quarter operating earnings per share of $1.40, a 40% increase over 2010. These results were a continuation of our strong operating performance in the first and second quarters, bringing our year-to-date operating earnings per share to $4.19. Underlying these results, commercial underwriting performance continued to benefit from lower-than-projected utilization, our pricing discipline and our medical cost management strategies. These drivers resulted in the third quarter 2011 commercial medical benefit ratio of 77.8% and year-to-date ratio of 77.5%. Further, our Medicare business posted another strong quarter with a third quarter 2011 Medicare medical benefit ratio of 81.4%.

Based on these results and our outlook for the balance of the year, we have adjusted our 2011 guidance. Our full year 2011 operating earnings projection has increased to $5 per share. Projected net dividends from subsidiaries for 2011 have increased to approximately $2.9 billion, up from our previous projection of $2.6 billion.

There is considerable fear surrounding the healthcare reform law. A decision will be made most likely sometime in June, which will drive volatility for commercial insurance providers. Aetna has less exposure to government programs and a great deal of diversification. At the same time, it is experiencing rapid growth in Medicaid enrollees.

Over the last twelve months, Aetna had the greatest enrollment growth in Florida, nearly doubling there. At the same time, medical utilization rates unexpectedly declined while operating expenses were cut, causing analysts to raise estimates. Thus, the company is uniquely positioned to take a step back and control for future scenarios. Management has noted that its diversified offering would be attractive to states looking to transition Medicated to managed care and I agree.

Consensus estimates for Aetna's EPS are that it will grow by 39.7% to $5.14 in 2011, decline by 1% in 2012, and then grow by 9.6% in 2013. Of the last 17 revisions to estimates, all have gone up for a meaningful 2.1% net change. Assuming a multiple of 12x and a conservative 2012 EPS of $5, the rough intrinsic value of the stock is $60, implying 35.9% upside. If the multiple were to decline to 8.5x and 2012 EPS is 9.8% below the consensus, the stock would fall by 11.6%. Overall, I find the former case to be significantly more probable and, accordingly, agree with the near "strong buy" rating on the Street.

UnitedHealth Group, on the other hand, is note the kind of defensive play that it is used to be. In my view, the market has now accounted for much of the company's liquidity, strong operational performance, and Optum catalyst. During the third quarter, the company had a solid EPS of $1.17 and grew the top-line by 7%. Going forward, higher utilization rates and rebate obligations will cause margin erosion and keep investors on the hold.

Consensus estimates for UnitedHealth Group's EPS are that it will grow by 8.8% to $4.58 in 2011 and then by 4.1% and 13.6% more in the following two years. Assuming a multiple of 13x and a 2012 EPS of $4.62, the rough intrinsic value of the stock is $60.32, implying 14% upside. If the multiple falls to 9x and 2012 EPS is just 4.2% below consensus, the stock would fall by 22.3%. As there are several companies trading in the 7x - 10x range, the latter case, however improbable, is not to be entirely discounted. Analysts nevertheless rate the stock a "strong buy."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.