With the health care industry in all sorts of turmoil, we might well ask why any sane investor would buy in. After all, it’s filled with legislative uncertainties, regulatory and litigation certainties, not to mention technological change and more.
Yet, investors looking for capital appreciation should give some attention to Aetna Inc. (AET, Financial), the long-lived health insurance company. It has delivered strong, consistent earnings in the past and appears capable of continuing along that path for at the least the next few years. It carries with it a storied history and enough mass to survive in a turbulent environment.
Its predictability in generating earnings, along with its fair intrinsic valuation, gives it a place on the current Undervalued Predictable screener at GuruFocus.
Here’s how the company’s earnings (blue line) and revenues (green line) have grown over the last 20 of its more than 160 years:
History
1853: The Annuity department of Aetna separates from the rest of the company, becoming Aetna Life Insurance Company (the original company founded in 1850, took its name from the volcano in Sicily).
1899: Enters the field of health insurance.
1961: First international expansion takes it into Canada.
1968: Lists on the New York Stock Exchange (AET, Financial).
1973: Creates a health maintenance organization (HMO) subsidiary.
2000: Sells its financial services and international businesses to ING, spins off its health business to shareholders and focuses as an independent health and group benefits company.
2001: Launches Aetna HealthFund®.
2004: Adopts end-of-life care through the Aetna Compassionate CareSM.
2007: Acquires Schaller Anderson and begins running plans for Medicaid and the State Children's Health Insurance Program.
2008: Begins selling pet health insurance.
2011: Acquires Medicity, a health information exchange technology company.
2013: Acquires Coventry Health Care, Inc., the combined organization is now the third-largest health care benefits company in the country.
History based on information from the company website, Wikipedia.org, and FundingUniverse.org .
Comments: This history touches briefly on a few essentials, and a few of the indicative events in the company’s past. Although not shown here, the company has, throughout its history, bought, sold, and reorganized assets many times. Today’s company is an amalgam of much previous corporate jockeying.
Aetna’s business
Aetna calls itself “one of the nation's leading diversified health care benefits companies.” Products and services offered to its 46 million customers include:
- medical, pharmacy, dental, behavioral health, group life and disability plans,
- medical management capabilities,
- Medicaid health care management services,
- Medicare Advantage and Medicare supplement plans,
- workers' compensation administrative services and
- health information technology products and services, such as Accountable Care Solutions.
Operations are divided into three segments:
- Health Care: medical, pharmacy benefit management services, dental, behavioral health, and vision plans.
- Group Insurance: includes group life insurance and group disability products.
- Large Case Pensions: various retirement products (including pension and annuity products), mainly for tax qualified pension plans.
As this excerpt from the 10-K for 2014 shows, the biggest share of revenue comes from Health Care:
Competition
According to Aetna, competition is tough: “The health care benefits industry is highly competitive, primarily due to a large number of for-profit and not-for-profit competitors...” (10-K for 2014)
Yahoo! Finance lists its competitors as Anthem, Inc. (ANTM, Financial), Cigna Corp. (CI, Financial) and UnitedHealth Group Incorporated (UNH, Financial). To that list, GuruFocus adds Express Scripts Holding Co (ESRX, Financial) and Humana Inc. (HUM, Financial).
UnitedHealth is the biggest player in the group, with a market cap of more than $112.5 billion; Aetna comes in at just above $37.5 billion. See my article, UNH: A Strong Candidate For Income And Capital Appreciation, for a profile of UnitedHealth.
GuruFocus provides data we can use to compare these companies; here are some highlights:
Comments: Health Care Plans is a busy space, and although Aetna is not the biggest player, it is also not the smallest. While it does have two other segments, Health Care (the Plans' business) is by far the largest. And within that segment, it has multiple lines of insurance for diversification.
Opportunities, risks and growth
Opportunities (10-K for 2014)
Changes in the American health care system (officially, the Patient Protection and Affordable Care Act, and the Health Care and Education Reconciliation Act of 2010 (collectively, “Health Care Reform”)) offer opportunities while at the same time adding to regulatory burdens.
More specifically, and as the following chart illustrates, it sees growth opportunities in Medicare Advantage, public exchanges, duals (dually eligible for both Medicare and Medicaid), Medicaid expansion and private exchanges.
The preceding chart comes from a company presentation to the Raymond James 36th Annual Institutional Investors Conference, March 3, 2015.
Risks (10-K for 2014)
In the Risk Factors section of the 10-K, Aetna notes, “Health Care Reform implementation (including the collection of, or other solutions to, the significant assessments, fees and taxes first imposed on us in 2014; and participation on Public Exchanges); Medicare Advantage and PDP rates for 2015; and U.S. Government fiscal policy present overarching risks to our enterprise in 2015.”
Given the speed and magnitude of changes, the company may not be able to change itself quickly enough to take advantage of opportunities.
Rates offered and/or paid by government entities are uncertain, and shifts in payment rates or schedules could have an adverse effect on the company.
Health Care Reform imposes what it calls "significant" assessments, fees and taxes; if it cannot include those costs in its premiums and fees, there could be adverse financial effects.
A "substantial" amount of its revenue and earnings come from the U.S. federal government, and issues such as debt ceilings could have an adverse effect.
Growth
The following chart plots the growth of revenue (green line) and Earnings Per Share (blue line) over the past two decades:
Over the past five years, revenue has grown by an average of 16.40% per year. Over the same period, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) has grown by an average of 9.10% per year.
The company projects operating earnings per share of at least $7.00 in 2015, about a 4.5% increase over 2014’s $6.70. Analysts followed by Yahoo! (YHOO) Finance project earnings of $7.19 for 2015, and $8.04 for 2016.
Additionally, in its Raymond James presentation, Aetna management says it believes it can deliver earnings of $10 a share in 2018. Overall, it says it is aiming for low double-digit earnings growth over time.
Comments; Despite the snakes and ladders environment of the health care industry, Aetna thinks it can find enough opportunities (and avoid enough risks) to grow its earnings by at least 10% per year in the coming years.
Management
Chairman of the Board and Chief Executive Officer: Mark Bertolini, age 58, has been CEO since 2010 and chairman since 2011. Before joining Aetna, he held senior management positions at Cigna, NYLCare Health Plans and SelectCare, Inc.
President: Karen Rohan, age 52, held senior positions at Magellan Health Services and CIGNA Group Insurance. Prior to joining those companies, she was a Certified Public Accountant (CPA) at Ernst & Young.
Chief Financial Officer: Shawn Guertin, age 49, also serves as executive vice president and chief enterprise risk officer of Aetna Inc. Before joining Aetna in 2011, he had served as a consultant to Coventry Health Care, Inc., which Aetna purchased in 2013.
Board of Directors: The board is made up of Chairman Bertolini and 12 independent directors. Members of the board have connections in medical technology, medical innovation, consumer products distribution, power generation and distribution, banking, academia, consulting, information technology and politics. (based on information at Reuters.com)
ISS Governance QuickScore: 5, based on a range from 1 (less governance risk) to 10 (more governance risk). It receives four red flags, for Related Party Transactions, Pay for Performance, Equity Risk Mitigation and Termination. It also receives one green star, for Other Issues.
Comments; The management team and the board has competently steered through the many recent changes in health care, including the introduction of the Affordable Care Act. Prudent investors will want to review issues flagged in the ISS survey of board activity.
Ownership
Gurus: 10 of the gurus followed by GuruFocus hold positions in AET. Vanguard Health Care Fund (Trades, Portfolio) (an institutional investor) has the biggest holding, 7,119,383 shares (2.0% of shares outstanding), while David Einhorn (Trades, Portfolio) has the second-largest position, 1,349,551 shares.
Institutional Investors: Nasdaq.com puts institutions at just under 88% of shares outstanding:
The biggest institutional investor (a category which includes pension funds, mutual funds, banks, and insurance companies) is State Street Corp. with 23,726,520 shares.
Short Interests: GuruFocus puts the shorts at 1.29% and provides the following chart to show this number in historical context:
Inside interests: Among those who work for, or are connected to, the company in some way, CEO Bartolini is the biggest holder, with nearly three-quarters of a million shares. Other insiders are shown in this GuruFocus table and chart:
Comments: Very much an institutional holdings type of company, one which professional investors expect will provide steady earnings, with minimal ups and downs. Management shares risk/reward perspective with investors.
Aetna by the numbers
Comments: This insurance company is nearing its 52-week high and has a capitalization of more than $37 billion; its trailing P/E is just above 19, while its P/S is well below 1.0; a small dividend, yielding less than 1%, while the company bought back almost 3.5% of its shares in 2014.
Financial strength
Aetna generates a 7/10 for Financial Strength and 8/10 for Profitability & Growth in the GuruFocus automated system.
To get a better understanding of AET’s financial condition, let’s review its debt, On the Financial Strength table, we see it receives a red flag because its Cash-to-Debt ratio is not as good as it was in the past. The Long-Term Debt line in AET’s 10-Year Financials at GuruFocus show us the company went from roughly $6.5 billion at the end of 2012 to $14.5 billion at the end of 2013 (it’s remained at about that level since then).
Whether that’s a little, a lot, or too much is a relative assessment so we will compare its indebtedness with that of its peers. GuruFocus reports Aetna’s Cash to Debt ranks higher than 58% of the 43 companies in the Global Health Care Plans industry. This chart shows Aetna in much the same space as its peers:
We can also look at its Interest Coverage ratio, which comes in at 12.92, which means it has enough cash to meet its next interest payment 13 times over.
That leads to free cash flow, how much money the company is bringing in to cover not only its interest and principal repayments, but also its operating costs, as well as funds for acquisitions, share buybacks and dividends.
Comments: Although we’re warned about Aetna’s debt, through a red flag on its historical Cash-to-Debt ratio, we consider that somewhat overblown because the company’s debt load is similar to that of most of its peers, and because of its strong free cash flow.
Valuation
Free cash flow is one of the key reasons why we find Aetna on the Undervalued Predictable screener at GuruFocus. Here’s how the two parts of the listing look on the screener:
After the name, there is the predictability rating, based on the number of stars, then the current price of the stock, the intrinsic value of the stock and the discount represented by the difference between the current price and the intrinsic price.
In this case, the current price (after the close on March 30, 2015) is $108.57, while the intrinsic price is $158.00, so the current price is 31% below the intrinsic price/value.
Note there is a difference between the intrinsic value reached using this screener and using the DCF screener. This difference is explained on the screener; bring up the Undervalued Predictable screener and then click on the text near the top of the page that says, “Click to Show / Hide.”
When considering future valuations, I consider it helpful to mentally invoke the Rule of 72, which, as you may recall, tells us how long it will take a compounding investment to double. We do that by dividing the number 72 by the interest rate; so for example, if the interest rate is 6%, it would take 12 years for a compounding investment to double (72/6=12). In Aetna’s case, if "low double digits" turns out to be 12%, then we would expect our investment to double in six years. Admittedly, this is a quick-off-the-top-of-your-head analysis, but one that gives us an immediate sense of the listed intrinsic value.
The other key ingredient for an Undervalued Predictable stock is its predictability, its ability to generate consistently increased earnings. As we saw above, AET is one of the elite stocks, with a 5-Star (out of 5 rating). This means its earnings are among the most predictable of all stocks trading on American exchanges. GuruFocus backtesting found that 5-Star stocks average a gain of 12.1% per year, and only 3% will still be in a loss position if held for 10 years.
Comments: Aetna combines the two virtues that qualify a stock for Undervalued Predictable status. Its intrinsic value is greater than its current share price, and it has a history of strong earnings growth. As we saw in an earlier section, the company expects to grow earnings in the low double digits in coming years, which should steadily pull the price upward from its current level.
Conclusions
The word "solid" comes to mind in assessing Aetna Inc.; a big company that’s been around for some time, with a strong earnings history and a fair valuation. We don’t expect it to rocket up in value, but at the same time, we don’t expect it to crater, either. Not surprisingly, it’s a favorite of the institutional community.
Solid is not a word we’d apply to Aetna’s industry, though. Volatility is more fitting here, as the industry deals with everything from the Affordable Care Act to new technologies and new consumer expectations. To that, you can add a veritable maze of regulations, compliance issues, and litigation.
The AET dividend won’t attract many income hunters, but its solid prospects for future growth should get the attention of value investors.
