If at first you don't succeed in M&A, keep bidding until you do. That might be the mantra that Aetna (AET) followed, letting other players in the health insurance space pay more for other assets, but ultimately getting a pretty solid company of its own in Coventry Health (CVH). While there are certainly some risks in buying a health insurance company about two months away from the U.S. presidential election, the long-term logic of the deal seems likely to hold.
The Terms Of The Deal
Aetna is buying Coventry for about $5.7 billion or a total deal value (including Coventry's debt) of about $7.3 billion. At $42.08 per share, Coventry shareholders are getting a 20% premium for a stock that has spent most of the last two years chopping between $26 and $36. As to the strange-looking $42.08 per share value, that is because this is a hybrid deal including both stock and cash - Coventry shareholders will get $27.30 per share of cash and 0.39 shares of Aetna.
All in all, it strikes me as a reasonable deal. While Coventry once enjoyed high returns on equity, a combination of medical cost pressure and pricing pressure (driven in part by the leverage enjoyed by larger rivals) had been taking its toll. At $42, Aetna's deal seems to price in a middle ground scenario of improved returns in the next five years, but not a return to the high levels of the past. As such, it seems fair to both sides - Aetna takes on the risk that things won't get significantly better, and gets the upside if they do.
The Deal Makes Sense For Aetna
Although Aetna had said it didn't want to do an expensive deal for a high-multiple Medicaid/Medicare pureplay (like WellPoint's (WLP) deal for Amerigroup), it is still getting a solid asset in terms of government-funded programs. If the deal goes though without any major alterations, Coventry (which gets about 55% of its revenue from government programs) will boost Aetna's government business to about 30% of revenue and make it the #4 player nationwide in Medicare Advantage, Part D, and Medicaid.
But this deal also makes sense outside of the Medicare/Medicaid businesses. Coventry's individual and small group businesses ought to improve Aetna's exchange offerings. What's more, management's estimate of $400 million in synergies (and opportunity to cut 15% of Coventry's SG&A) should be attainable if not conservative.
What About The Political Risk?
Any company that makes strategic plans on the basis of what the insurance industry is likely to look like in 2013 or 2014 cannot ignore the political risk factor. While the Supreme Court may have upheld the Affordable Care Act, a Republican victory in the Presidential race could lead to significant alterations in the plan. Depending upon election results (including Congress) and the difference between campaign promises and political realities, the anticipated changes to the insurance industry could range from non-existent to a complete repeal.
Arguably the biggest risk is on the side of Medicaid, where the health insurance reforms would expand Medicaid coverage. Medicare is not likely to go anywhere, and likewise it seems unlikely that state-based insurance exchanges won't happen. Nevertheless, even if Medicaid expansion does not occur, the synergies inherent to being a big player in this program are significant. Likewise, a repeal of the act would also likely mean a repeal of the mandated medical spending minimums, so I don't see how Aetna is really risking all that much.
A Bad Deal For Pretty Much Everybody Else
If this is a good deal for Aetna (which I believe it is) and a reasonable deal for Coventry, it's not great news for companies like Centene (CNC), Health Net (HNT), Molina (MOH), or WellCare (WCG). While it probably seems obvious that this news takes away a potential suitor (Aetna), I think it actually takes away two. Of that tier below the major health insurance companies like WellPoint, Aetna, and Unitedhealth (UNH), I gave Coventry not only the best chance of building into the next major, but also the most interest in trying to do so. Now, though, it's clear that Coventry won't be looking for a deal of its own.
Likewise, I'm not sure another major deal is going to come soon. Cigna's (CI) debt would seem to preclude an accretive deal, while Humana (HUM) seems quite content to use partnerships to increase its senior/government exposure. Last and not least, Unitedhealth would not only likely face antitrust issues, but probably seems little reason to pay a premium for growth it can probably attain organically.
The Bottom Line
Investors have been moving back into healthcare names this year across the device, drug, and biotech spectrums. Hospitals and other service providers (like AmSurg (AMSG)) have also been quiet strong. Though it hasn't been a bad year for health insurance stocks, they do seem like the relatively cheaper play left on the board. Some of that apparent cheapness has to be tied to the political risks and uncertainties, but I still valuations look interesting.
Using an excess returns model, if Aetna can maintain its past long-term average return on equity into the future, the shares seem substantially undervalued. Even if various regulatory changes to insurance were to strip away one-quarter of that past ROE, the shares would still be undervalued by more than 10%. Accordingly, this is a stock that might be worth further due diligence for investors willing to brave some elevated political risk and a sector that the Street still isn't completely comfortable with today.