Aetna (AET) dropped almost 10% Thursday following weaker than expected earnings in the first quarter. EPS came in at $1.34 per share, $0.05 lower than what the Street was expecting. Compared to earnings of $1.43 reported in Q1 2011, profit clearly seems to be under pressure. Many of the headlines today proclaimed that "profits tumbled 13%" and "medical costs are rising 6% - 7%" in 2012. True, on the surface. However, a deeper look illustrates that Aetna reported what I would characterize as decent numbers, and exactly in-line with what management telegraphed beforehand.
Prior Year Development
First of all, in Q1 2011, Aetna had a positive prior year reserve development of $112mm. In 2012 there was no prior period development. Essentially estimated medical costs booked in 2010 and earlier years were too conservative, and they adjusted out the excessive costs in Q1 of 2011, last year. I prefer companies that tend to overestimate (or over-reserve) their medical costs, so that there aren't negative surprises in future years.
In any case, assuming a 35% tax rate, that was a $0.20 benefit to Q1 2011, and really had nothing to do with operating results in that quarter. So, Q1 2011 looked more like $1.23 in EPS on an operating basis (excluding capital gains too), not $1.43.
Therefore, using $1.23 as a pure apples-to-apples comparison makes the $1.34 in reported earnings this quarter seem pretty good. That is growth in EPS of 9.3% year over year.
On the conference call today, many analysts questioned why there was no positive prior period development this quarter. Concerns that peers have booked positive prior period development seem valid. However, management did note that reserves in Q1 were up 6% in the first quarter, compared to premium increases of 4%. Aetna has not changed its reserving policy either. In all, $170mm in gross reserves were booked, and the endless questioning on the subject by analysts seemed overdone.
The transcript can be found here.
Secondly, concerns of higher costs and lower margins are also a concern. Q1 pretax operating margins came in at 9.4%, compared to 11.4% a year ago, quite a big hit to margins. Competitive pressure and increasing healthcare utilization were much to blame. But again, management choreographed margin pressure from normalizing medical cost trends at 4 different conference presentations in the past two months. This should not have come as a surprise. 2011 also was quite a good year, abnormally so, making the year over year comparisons tougher.
CFO Joe Zubretsky summed it up well. "Throughout 2011, Aetna's commercial trend assumptions decreased by over 250 basis points from the midpoint of our original guidance. That meant we were consistently reserving, forecasting, and pricing into a declining trend environment, which led to favorable reserve development and margin expansion. Currently, we believe that the trend estimates supporting our reserves in the fourth quarter of 2011 have stabilized, and that we have made prudent assumptions regarding medical cost trends for 2012."
In fact back in February, management guided to Medical Loss Ratios (or Medical Benefit Ratio's as they call it) of around 81.5% in their commercial insurance business. That is up from 77.9% last year, so lower margins should not have come as a surprise. Medical cost trends appear to be running at 6.5%, up from 5.5% last year. Accelerating cost inflation is always difficult to pass through to customers. For more in-depth info on this, there are several informative presentations on Aetna's website here.
Also impacting all of the insurers today was a report from the Kaiser Family Foundation, which calculated that the insurance industry will face $1.3BB in rebates in 2012. (Goldman similarly estimated $1.1BB in payments). Because of provisions of Obamacare, insurers are required to pay out 80% of premiums for health care services for their members, or 85% for large employers. If they don't, then customers are due a rebate after the fact. Goldman's math was that Aetna would owe $177mm in rebates, which works out to $0.50 per share.
Good news was the fact that management re-affirmed their $5.00 in EPS for 2012. And while on the surface it appears that this is down from $5.17 in 2011 EPS, again backing out the one-time prior period developments last year results in normalized EPS of $4.82. Overall, that is growth in EPS in 2012 of just under 4%. Not great, but not a disaster either. Management believes rebates this year will be lower than 2011 too, and they have accrued for this in their guidance.
Over the past 5 years, Aetna has grown EPS at a compounded annual growth rate (CAGR) of 12.3%. Going forward, management has guided to growth in operating EPS of around 10%, 4% of which comes from growth in their core business, and 6% coming from "deploying capital" which include acquisitions (of either their own stock, or other companies at attractive prices). Given that the business is generating 18% Returns on Equity (ROEs), prudent buybacks should prove beneficial to earnings over time.
Speaking of buybacks, Aetna repurchased 7.4mm shares in the first quarter, and fully diluted share count has fallen from 391mm shares in Q1 2011, to 357mm shares today. That is quite a large drop.
Overall, Aetna reported 17.9mm medical members at the end of Q1, which was exactly in line with guidance. While they did lose 544,000 members compared to year end, most of this was Commercial ASC losses that were expected by management, as well as the company exiting the Connecticut Medicaid program (losing 98,000 members).
By year end, management forecasts that they will see growth of 300,000 members, taking total membership to 18.2mm members (including adding back members in the Commercials ASC segment).
At $45.00 per share, Aetna is now trading at 9.0x 2012 estimates. The market trades at 13.8x 2012 earnings. EPS growth is clearly slowing at Aetna, from 12% over the past five years, to 4% in 2012. The cycle for insurers is more related to healthcare inflation though. When it is accelerating, insurers sometimes suffer margin pressure as there is a lag in raising premiums. 2012 looks to be a year of higher medical costs (as well as higher utilization), and may cause some hiccups in quarterly numbers.
But on the whole, even with sweeping healthcare legislation, these are good businesses. ROEs likely will fall as minimum medical loss ratios are enforced, and especially as the annual health insurer fee kicks in beginning in 2014. (see my Cigna piece for more on that here). But overall, high teen ROEs will result in mid teen ROE businesses, not bad really.
Once the market has digested the new healthcare legislation in a couple years, I strongly suspect that companies like Cigna and Aetna and Wellpoint will not continue to languish at single digit P/E ratios. In Aetna's case for instance, it appears that the company generated well over $5.00 in FCF per share last year. The stock consistently traded at market level multiples for years, that is, up until 2009 and drafting of healthcare legislation began. Long term that implies at least $60 in fair value on the equity.
In the near term there should be a bounce in Aetna I believe too. Q1 results simply weren't as bad as initial reactions, meaning I would not be surprised to see Aetna stock moving back up. However, since I am admittedly terrible at making short term predictions, I will look to initiate a position in the low 40's.
The earnings release can be read here.