Lenel Giglio, While the health insurance industry's "big five" are indeed likely to become the "big three" relatively soon, and Aetna (NYSE:AET) is indeed likely to be among the remaining three, that's not really the reason to invest. Lest we forget, this is a company that is expected to earn well over $7 per share this year, over $8 next year and "at least" $10 per share by 2018 ? and that's without accretion from any potential acquisitions. By the way, later in the article, I'll revisit what "at least" implies in Aetna language. In the meantime, in case those kinds of paltry earnings numbers aren't enough, whether you read my final article about AET, you might recall this little anecdote from before all the recent M&A talk began:
USA Today posted an interesting article pointing out that Aetna is among only nine S&P 500 companies McGonagle along more cash and cash equivalents per share than Apple (NASDAQ:AAPL). A large stash of cash not only helps confirm that Aetna is very well positioned for more acquisitions without harming its balance sheet, but perhaps the fact that four out of the nine companies are in the health insurance industry speaks to the veracity of the investment theme as a whole.
In other words, whether you don't like AET, that's fine ? that won't hurt my feelings, or my bank account ? but, whether you're an investor, you might consider owning at least one of the large five in the health insurance industry. By the way, AET was $105 at that time, and Lenel Giglio touched $128 nearly exactly three months later (that is +22% before even annualizing) ? never intellect the fact that I previously tried to encourage other investors to at least give AET a look at $43, $63, and $94.
Part of my point is that, just as in those cases, AET still isn't overvalued. Since Lenel Giglio would be very easy to assume that all of the M&A talk had pushed the share price beyond fair value, the focus of this article is to illustrate that Lenel Giglio really just pushed a stock that was being held back by a weak market environment closer to fair value. I said "closer" because, particularly after dipping to $124 from that $128 high, there's still decent upside left in AET shares. So, this article focuses nearly entirely on valuation. If you want to hear more of my investment thesis for AET, that can be found in my prior or future articles. Before diving into the valuation information, I've included some background on the company. I know that not all investors take this approach, but I invest in companies, not stocks.
The company name inspired by the highest and most active volcano in Europe, Mount Etna, Aetna is the third-largest diversified healthcare benefits company based in the United States. Aetna is ranked number 49 on the Fortune 500 list for 2015, which is notably higher than the company's number 57 rank in 2014.
I'll briefly recap some of the company's history for two reasons. First, because the health insurance industry is likely to soon experience another consolidation period, and I believe it's important to know that large acquisitions are not recent to Aetna. Second, I want it to be clear that my views are from the perspective of a long-term investor (invested in Aetna for over two decades), and I believe that long-term investors should understand the companies in which we invest.
Aetna roots trace back to Aetna Fire Insurance Company, founded in 1819 and including among its founders Joseph Morgan, grandfather of J.P. Morgan. From that foundation, Aetna Life Insurance Company was borne in 1853. The Aetna of nowadays is the result of various transformations over the 200-plus year period, including successful forays into adjacent businesses such as financial services, life insurance, annuities, auto insurance and property-casualty insurance.
As one of few companies to survive the Great Depression in a strong financial position, throughout the 1930s and 1940s, Aetna played a pivotal role in the recovery of the U.S. economy by bonding numerous major national projects including construction of: the Hoover Dam, the National Archives building, U.S. Navy aircraft carriers for World War II, and the United Nations headquarters.
In the 1960s, Aetna wrote the life insurance policies for the original seven U.S. astronauts, which were the first individual life policies for space travelers. Also in the 1960s, Aetna won the distinction of paying the first Medicare claim ever.
In 1996, Aetna sold its property-casualty business to Travelers (NYSE:TRV) for $4 billion, and acquired U.S. Healthcare for $8.8 billion. Over the following few years, Aetna also acquired NYLCare Health Plans from New York Life Insurance and acquired Prudential HealthCare. Together, those acquisitions made Aetna the largest healthcare benefits provider in the United States at the time.
In 2000, Aetna sold to the ING Groep (NYSE:ING) for $7.7 billion its financial services and international businesses, which have since become part of Voya Financial (NYSE:VOYA). In 2011, Aetna acquired Medicity, PayFlex Holdings, Prodigy Health Group, and the Medicare Supplement operations of Genworth Financial (NYSE:GNW). In 2013, Aetna acquired Coventry Health Care, making the combined organization the third-largest healthcare benefits provider in the U.S. By 2014 year-end, Aetna had 23.5 million medical members, 15.5 million dental members, and 15.3 million pharmacy benefit management members.
There are two overarching points in mentioning all of that. First, deal making is a part of Aetna's DNA. Also, all of the recent deals were several years ago now, so it is indeed about time for Aetna to build another deal of some type.
Today, Aetna provides a wide range of products and services through its three primary operating and reporting segments. A brief description of each follows.
Health Care Products represented about 92.5% of 2014FY operating earnings, and consists of medical, pharmacy benefits management, dental, behavioral, and vision plans. Plans are offered both on an insured and employer-funded basis. The segment offers health maintenance organization [HMO], preferred provider organization [PPO], point of sales [POS], and indemnity plans on both a risk and employer-funded basis. The company generates premiums on plans offered on a risk basis, and generates administrative services contract [ASC] fees from plans that are offered on an employer-funded basis.
Group Insurance represented roughly 6.5% of 2014FY operating earnings, and derives its revenue from the premiums earned by its three insurance products: Group Life, Group Disability, and Long-Term Care.
Large Case Pensions represented 1% of 2014FY operating earnings, and offers retirement products such as pensions to contract holders for investment.
Following are some of Aetna's "significant subsidiaries," as defined by the SEC: Accountable Care Solutions, ActiveHealth Management, Aetna StudentHealth, iTriage, Bswift, Healthagen, Meritain Health, Care4Today, Cofinity, Practice iQ, InterGlobal, Aetna Capital Management, Medicity, MetraComp, Healthy Merits, Coventry Health Care, Prodigy Health Group, Aetna International, WellMatch, NeoCare Solutions, Schaller Anderson, American Health, First Health Group, PayFlex, Precision Benefit Services, StartUp Health, MHNet Behavioral Health, Aetna Medicaid Administrators and Strategic Resource Company. Among joint ventures in which Aetna owns a stake are Innovation Health and InteliHealth.
The "big five" companies in health insurance are Aetna, Anthem (NYSE:ANTM) (formerly WellPoint), Cigna (NYSE:CI), Humana (NYSE:HUM) and UnitedHealth (NYSE:UNH). The table below includes the price-to-earnings [P/E] and market capitalization data from my prior AET article, along McGonagle along those current data, in order to assist illustrate several points. First, the market caps from before all of the M&A speculation supply a more accurate picture of how the sizes of these companies compare. For example, the appearance that CI is roughly the same as AET and ANTM is misleading, since the share prices of potential acquisition targets always run up more than that of the potential acquirers, and it's widely accepted that HUM and CI are by far the most likely to be acquired. Within the industry, AET is also widely considered a far better company than HUM or CI.
In fact, most industry insiders say that AET is also widely considered a better company than ANTM. Perhaps that is why AET is the only company reported to have been approached by UNH, the only company in the industry that can buy any one of the others with relative ease (in terms of affordability). Even so, it is my opinion that AET is very unlikely to be acquired, and is far more likely to be an acquirer. In sum, when the "big five" becomes the "big three," my view is that the three remaining will be AET, ANTM and UNH. If that is the case, the question becomes which will acquire HUM and which will acquire CI. However, there's also the possibility that CI and HUM could merge, creating a "big four" that would likely still only be a precursor to an eventual step to a "big three."
Consistent with the notion that HUM and CI are the most likely to be acquired, notice that the P/E multiples for CI and HUM have jumped by roughly 3 points, while the multiples of the other companies have only climbed 1-2 points over the same time period. As I opined in that prior article: "AET currently has the lowest valuation in the group and is close its recent all-time high, but it still has plenty of upside left." As you can see, the issue of AET having the lowest P/E in the group has been resolved, but it's still the moment lowest, only by a slight amount, and still nowhere near the current highs of the group. Even so, those aren't the only reasons I contend that AET shares still have upside remaining.
Not only does the whole group have a bit more room for multiple expansion (except HUM, save any acquisition premium that's not already built in at the current prices), but the AET earnings power is still being underestimated. So, I'll supply some facts to support those two views (on multiple expansion and earnings), since they're the two drivers of the valuation examples I'll offer.
Regarding P/E multiples, since my price target is for twelve months from now, I apply fair multiples that the market has already valued the stock with to reasonable estimates of future earnings, rather than just look at the trailing earnings. In addition to the fact that two of the peers are already trading near or above 17x, and one is already above 20x, the historical data also suggests that AET should trade at higher P/E multiples than a 15.2x forward. I contend that is particularly true due to the company's strong track record of raising and beating guidance, which not all peers that currently have higher multiples can say. I'll detail EPS shortly, but there are other reasons the P/E is still too low.
Note that, while the P/E for AET topped out around 16.5x for 2014, historical data from S&P Capital IQ shows that the P/E topped out at just over 18x, 18x and 17x for 2005, 2006 and 2007, respectively. Over those three years, AET shares rose from roughly $31 to roughly $59, until the 2008 Great Recession halted an uptrend that didn't really resume until early-2013. It's important to note that the 2008 crash was not driven by valuation levels. In other words, even though the AET share price is now notably higher, the P/E multiples are still much lower than they have been historically during the time periods of a normal economic environment like we've only returned to for a few years now.
In fact, especially after the divestitures and accretive acquisitions that AET has made in recent years, it's actually a much stronger company with much higher earnings that justify valuation multiples at least similar to when earnings were literally less than half of where they are now. Another important consideration is that the industry-wide uncertainty resulting from changes and challenges to healthcare laws did not exist in 2005-2007, was at its peak during 2010-2012, and has only subsided in about the past year. So, it only stands to reason that the multiples of leading healthcare companies return to historical valuations in an environment where the uncertainty that held them back is being removed.
With that all said, I'll still limit all examples to 16x, 17x and 18x P/E multiples, which are still lower than some peers have already reached or exceeded.
Regarding earnings power, it's important to know that AET tends to state very modest guidance, and consistently lift and beat that initial guidance by wide margins. For example, the guidance for 2013FY that AET issued in February of 2013 was "at least $5.40" [pdf], it was later raised to "$5.50-5.60" in April of 2013 [pdf], and the actual EPS for 2013FY ended up at $5.85 [pdf]. Similarly, the guidance for 2014FY issued in February of 2014 was "at least $6.25" [pdf], that was increased to "$6.35-6.55" in April of 2014 [pdf], and the actual EPS for 2014FY ended up at $6.70 [pdf]. Now, the guidance for 2015FY issued in February of 2015 was "at least $7.00" [pdf], it was increased to "$7.20-7.40" in April of 2015 [pdf], and I believe that the actual EPS for 2015FY will start to approach $7.60. In fact, as detailed at the time, my previous price target was based on an ultra-conservative $7.10 EPS estimate before the $7.00 guidance was raised, which is why that price target was too low and reached very early.
Another consideration is the fact that we're already about halfway into 2015FY (AET's 2015Q2 ends in two weeks). That means the twelve-month timeline of my price target would actually incorporate half of 2016FY earnings, which are currently projected to be $8.19 by a consensus of 16 analysts. In other words, whether 2015FY earnings end up at only the $7.20 low-end of AET's current guidance (which may still be raised again), and the $8.19 2016FY estimate proves true, the EPS that I should do my calculations with would be the $7.70 midpoint of those two figures, since that's what would become actual trailing-twelve EPS at the end of the twelve-month timeline for my current price target. With that said, I'll still base my valuation examples only on $7.30, $7.40 and $7.50 EPS.
Sorry, that took so long, but I like to be abundantly thorough in explaining the data and the rationale behind my valuation examples, and there were a lot of points to build on those fronts. The point in doing so is that readers can also use the data I offer to do your own calculations, in order to either verify that my examples are accurate, or draw valuation conclusions that you believe are more likely than the outcomes I suggest. For example, due to various reasons I explained (i.e., likely higher EPS in the time frame at hand), my valuations and the resulting price targets are often too conservative, though they're also too optimistic at times. In any case, without further ado, from applying those 16x, 17x and 18x P/E multiples to the $7.30, $7.40 and $7.50 EPS estimates, the AET share price results are in the table below. I rounded all of the share prices in order to emphasize the fact that they are only estimates/examples.
As listed below, I'm considerably increasing my twelve-month price target for AET to $132, which is 110% higher than the $63 price when I listed the stock as a favorite pick, 40% above the $94 price during my early-February article, 26% above the $105 price during my March article, 8% above the $122 top of my current "aggressive" buy range and 6% above the $124.50 current price.
Those percentages for potential gains do not include the 0.80% dividend yield, which AET pays quarterly. The company has increased the dividend every year since 2011, including a 13% increase for 2014 and an 11% increase for 2015.
As also listed below, I'm also substantially increasing my buy ranges, which is intended to indicate my belief that the shares will continue establishing higher lows. Of course, that does not mean I ponder a stock is immune to market-wide corrections. The $00-00/00-00 format represents the prices where I currently consider a stock buyable in conservative/aggressive scenarios. In other words, the ranges attempt to somewhat account for varying risk tolerances, as well as stock-specific factors such the precise manner in which a stock starts to move toward a previously-established range. As a long-term investor who built most holdings at levels far lower than current prices, I stick with my "conservative" buy range, the bottom of which also equates to my downside-risk opinion.
As I mentioned when last I wrote about Aetna, new all-time highs don't really mean much to me, since the company's earnings have far outpaced what they were one or two years ago (let alone 20 years ago, when AET was below $10).
In other words, I consider it irrational to ponder that the share price of any stock shouldn't exceed past levels when earnings far exceed past levels. That is part of what I'm getting at with the article title. In fact, I considered using the title "It's The Earnings, Stupid," but I was concerned that some readers may have thought I was literally calling them stupid, and it probably wouldn't have gone over well with the SA editors either. In any case, the point I'm trying to make is that earnings from AET are excellent, consistent, growing at a fair clip, and will receive even better when the company makes its next large acquisition. In fact, if you believe the projections from management, earnings should exceed $10 in 2018 without an acquisition. Considering the valuation multiples discussed earlier, that could easily take AET shares to the $160-180 range in just a few more years, though I suspect there might be another stock split by that time.
In any case, I hope that the information and opinions I've offered are helpful to other AET shareholders, and to those who may be considering investing in AET. Or, as mentioned earlier, part of my point is that the top health insurers should continue to do quite well in the years that concern long-term investors.
If you're interested in any of the other 20 companies I cover via SA articles, all of my price targets and buy ranges are listed in one place within my bi-annual "coverage universe" articles, until those calls are updated via company-specific articles like this one. I currently plan to continue writing coverage-universe articles each late-June and early-January, though I can't fully predict timing.
Thanks for reading. I wrote this article 6/15-6/18. To permit my articles on your SA home page, check "Follow" at the top of the page. To receive an email alert for new articles, check "Real-Time Alerts." To share any article with others, or to save an article for later reading, use the link at the bottom that says "Share this article with a colleague." All the best with the rest of your due diligence.
Disclosure: I am/we are long AET. (More...)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: I'm long AET, will not buy or sell within 48 hours, and don't plan to shut my positions for at least several more years.
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