Aetna Appears Undervalued

| About: Aetna, Inc. (AET)
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Aetna Inc. (NYSE:AET), the successor to a company formed in 1853, is primarily a healthcare benefits company that has been transformed into a free cash flow machine. I own it as a moderately predictable growth and income vehicle. The company has had steady income growth for ten years except for the recession year of 2009, and is well into record sales, earnings, dividends and book value-- but its share price is only now challenging its 2007 previous record of $60.

The diversified and rather stodgy Aetna Life and Casualty Company began to be reshaped by merging with U.S. Healthcare in 1996. The transformation to the "new" Aetna was completed in December 2000 with the sale of its Financial Services and international businesses to ING Groep.

This long-term chart shows that between the mid-1980s and Y2K, AET went nowhere. In a pattern that could be relevant to the next year or two, the stock resisted the 2001-2 bear market, then surged:

Chart forAetna Inc.

The company has certain similarities to CVS Caremark (NYSE:CVS), about which I have written bullishly twice, most recently on May 5 in CVS Caremark: Earnings Up, Valuation Up Even More, But The Stock Remains Attractive.

As is the case with CVS, Aetna's GAAP earnings understate its cash generation. Last week, the company completed on time a major acquisition of Coventry Health Care, Inc. (formerly traded as CVH). With that acquisition, Aetna increased its earnings guidance for 2013 to roughly $5.80 per share (excluding modest acquisition expenses). Based on owning the stock and watching analysts' estimates, my guess is that the company is continuing to be conservative. Consensus estimates are now $5.80 and $6.25 per share for 2013 and 2014, but even before the Coventry deal, goodwill and intangibles comprised $7 B of the company's $10.3 B book value, so non-cash amortization of those assets understated cash flow. Reasonable estimates for free cash flow may be in the range of $6.30 and $7 for each year.

While Aetna did take on debt to help fund the Coventry deal, leading to a modest downgrade to its debt ratings (still within investment grade), portents are favorable for shareholders in my view.

The company has aggressively been shrinking shares outstanding over the years while bumping up the dividend. In 2005, there were 567 million shares outstanding. By 2008, there were only 454 million outstanding. By 2012, there were only 328 million out. The dividend was raised from a negligible 4 cents per share as of 2010 to 80 cents per share this year. The Street expects further hikes.

AET is one of a modest number of stocks I can identify as being undervalued by a variety of metrics. For example, the "value line" that Value Line (VL) uses as an estimate of fair value for AET is 12.5 times EPS. If forward earnings through Q2 2014 are $6/share, then fair value by this metric would be $75. (Technically VL's system suggests that price by yearend 2013, but reaching it by July 2014 that would be fine for shareholders as well). Not taking into account potential earnings growth due to the Coventry deal, Value Line was projecting $7.50 per share earnings for 2017 or 2018, and actually was projecting an expected P/E of 13.5, not 12.5. Thus they are looking for unusually strong price appreciation, plus continued dividend growth.

Similarly, Standard & Poor's stock research is positive on the shares. They give AET an extraordinarily undervalued fundamental value of $72.90 per share, one of their most undervalued assessments right now. I hope S&P doesn't mind if I quote from their updated writeup:

05/08/13 12:51 pm ET ... S&P UPGRADES OPINION ON SHARES OF AETNA TO STRONG BUY FROM BUY (AET 59.29*****): We raise our '13 EPS estimate $0.20 to $5.85 and '14's by $0.45 to $6.30, following AET's acquisition of CoventryHealth Care, and our target price by $6 to $70, on revised P/E analysis. We are encouraged by this acquisition, which expands AET's geographic presence and, we believe, its competitive position and growth prospects in the commercial, Medicare and Medicaid markets. We expect it to also benefit from improved economies of scale and Coventry's cost-control focus. We also see higher free cash flow generation, which should provide AET with improved financial flexibility.

Also nice to see is that a proprietary multivariate analytic tool shown by Thomson Reuters has this to say about AET:

AET is currently among an exclusive group of 171 stocks awarded our highest average score of 10.

A variant method of analyzing large cap stocks developed by Verus Analytics gives AET an 8/10 rating, also high.

Insider activity has been acceptable in my view. In February, EVP Karen Rohan made an outright purchase of 4035 shares of AET for $200,000 at $49.53/share. In December 2012, General Counsel William Cassaza exercised options for 137,000 shares for $4.4 M but only sold 86,000 shares for $4 M. Last September, director Ellen Hancock exercised 12,735 options at $10.53/share and apparently has sold none of them. CEO Mark Bertolini has been a steady seller, however.

My general and specific sense is that Aetna is joining CVS as a top-tier acquisition machine that is using inexpensive debt wisely in the secular growth field of healthcare and health insurance. Aetna continues to grow both domestically and internationally, having most recently announced a deal with Saudi Arabia:

The Company for Cooperative Insurance (Tawuniya), and Aetna (NYSE: AET), a leading global diversified health care solutions company, have entered into a strategic alliance to provide health care benefits and services to Saudi citizens in the Kingdom of Saudi Arabia or abroad and to foreign nationals living in the Kingdom.

Also recently, more positive news was announced:

Aetna (NYSE: AET) announced today that it has reached agreement on a new contract with Prime Health, returning 13 hospitals to Aetna's Southern California network for the first time since 2007.

While the uncertain economy and very uncertain path forward for healthcare benefit services over the next year or two are obvious concerns for AET, overall I like what I see here. The newsflow is strong, earnings estimates have steadily been increased, independent analysis as presented above suggests undervaluation relative to most stocks, and the company operates as a consolidator in a core industry of today and tomorrow.

Therefore I look at AET as possessing more prospective reward than risk in the months and years ahead, though as we all know, stock prices have moved rapidly and may be prone to profit-taking without warning and for no fundamental reason.

Investors who are looking for shares of dividend-paying stocks trading at reasonable P/E's, and that possess long-term charts that are not suggesting excessive optimism may be especially interested in looking more deeply into AET.

Disclosure: I am long AET, CVS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Not investment advice. I am not an investment adviser.