Aetna AET
December 22, 2006 - 9:23am EST by
2006 2007
Price: 43.20 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 22,550 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Aetna trades at 13x 2007 earnings of 3.26 and about 14x free cash flow (measured as cash from operations, net of capex and net of estimated capital set asides for state-based regulatory reserve requirements).   For the foreseeable future , it will organically grow revenue in a range of 4-9%.  Assuming stable medical loss ratios, SG&A ratios should steadily decline and permit profit to grow more rapidly than revenues.  Free cash flow yield is now 7%;  an assumed 6-7% growth in profits for foreseeable future (5% revenue growth; plus  margin expansion of 15-20 basis points per year that would add 2% per year to profit growth) means an investor who bought Aetna now and never sold it would receive 13-14% returns on his money (r = fcf yield + g).  If the market reprices the stock to reflect a 12% return, that would imply 17x EPS (18x fcf).  Estimating 2008 EPS of $3.83 and fcf/share of $3.60 (assuming use of fcf to repurchase shares), implied price would be $65.


Aetna has two health care businesses (its Group Insurance and Large Case Pension segments are too small to be material to the investment thesis).  The larger of the two health care businesses, its ‘risk’ business, provides health care insurance.  In the smaller of the two, its ‘self-funded’ business, companies directly cover medical costs themselves but pay Aetna a fee for (a) administering their plan, and (b) helping control their medical costs, chiefly through Aetna’s network of provider discounts.  Large companies that can spread the risk of self-funding across large employee bases have generally self-funded, since it permits the company to capture the underwriting profit for itself and thus reduce expenses.  As healthcare costs have increased, the size of companies willing to self-fund has slowly declined and will likely continue to do so; as a result share across the industry should slowly shift from risk to self-funded.  This shift is undesirable since a self-funded member generates only about 20-30% the annual profit of a risk member.  However, Aetna’s self-funded business deserves a much higher multiple than the risk business.  Its growth in members is greater and the business is less price sensitive, has stickier customers and higher returns on capital since it requires no statutory capital set-aside.


Healthcare payors’ used to underwrite in cycles, like more commoditized parts of the insurance industry. As a result, many investors interpreted slowing member and premium growth across the industry as inaugurating a cycle of pricing competition that would be reflected in higher medical loss ratios (ratio of medical benefits to risk-based premiums) and lower profits.  Aetna’s underwriting stumbles in the first and second quarters aggravated this concern.  While some deterioration in pricing seemed possible then and remains a legitimate concern now, a return of the industry’s previous chaotic and uneconomic behavior is highly unlikely, due to (a) the industry’s consolidation, (b) improved actuarial capacity, (c) more disciplined CEOs explicitly and unanimously committed to pricing discipline (including McGuire/now Hemsley at UNH, Glascock at WLP and Williams at AET) and (d) the brutal treatment equity markets now apply to healthcare insurers that break pricing discipline (witness reaction to Aetna’s Q2 results).  Finally, underwriting profit margins through Q2 06 at major non-profit Blues (available for modest fee online on state by state basis at, indicated that non-profit Blues as a rule were maintaining flat loss ratios as well, i.e., not pricing below cost trend.


Notable attractive business characteristics are recurring revenues and the recession resistance of the product; companies do not eliminate employees’ healthcare coverage to save costs in hard times.  Moreover, Aetna and the other three largest for-profit healthcare insurers benefit from scale.  Doctors and hospitals provide discounts only to insurers with scale in their local markets.  Beyond discounts, companies need data and expertise to help them control their healthcare costs.  This requires healthcare insurance companies to maintain ever more sophisticated information systems.  Large players can amortize the costs of such systems over large customer bases.  As the required level of sophistication has increased, smaller players find it increasingly difficult to compete.  So would new entrants; unlike other segments of the insurance industry, capital cannot flood into healthcare insurance and drive down returns for incumbent companies.  The years 2003-2005 were fat times for healthcare insurers but the high returns and growth provoked no new entrants.


The competitive advantage that accrues to scale in this industry is probably the largest cause of its consolidation over the last five years.  Not coincidentally, returns on capital amongst the large health care insurers have increased significantly over that time period.  After-tax return on incremental invested capital is probably greater than 40% at Aetna and quite high at the other big three for-profit insurers as well.  Though the company grew its risk premium base 9% or better, nearly all organically, in each of the last three years, cash spent on share repurchase 2004-2006E will be slightly more than 100% of net income over that period.


Premium growth is essentially driven by medical innovation, which constantly drives up the average consumer’s dollar-based annual consumption of healthcare.  Cost trend, by which the industry seems to mean the annual increase in the cost of providing a comparable healthcare package increased around 8% in 2006.  Even when Aetna holds its medical loss ratios stable, commercial risk premiums per member have increased less than cost trend, probably because Aetna’s customers were on average buying less expensive medical plans.  Commercial premium per member should increase around 5% in 2006.  Self-funded revenues, which are higher margin but only about 10-12% of healthcare revenues, should increase about 14-15% in 2006.  Assuming continued cost trends at 6-8%, and no membership growth, 5% is a reasonable working assumption for ongoing growth in premium per member.  See Aetna’s presentation (available on website, Nov 7, 2006, Slides 12-15) for its argument that it can in fact grow its membership base.


Expanding margins should permit profit growth to exceed revenue growth.  Increases in premiums per employee means Aetna’s administrative costs do not increase as rapidly as its revenues – it does not need more clerks just to write a bigger reimbursement check; in fact, as it converts paper healthcare claims to digital ones, it needs fewer clerks.  CEO Ron Williams expects the company to reduce the ratio of administrative expenses to revenues from 20% in 2005 to 17% over the next two years. 


As to risks:  Aside from the possibility of pricing indiscipline, already discussed, it is likely that medical cost increases will decelerate from the high single/low double digit levels of the last decade.  More effective cost control measures should gradually dampen growth in medical costs, as would a decline in the pace of medical innovation.  Finally, member growth has been below guidance across the industry in 2006 in the commercial risk business.  A combination of flat or declining membership and/or deceleration of cost trends could push organic profit growth below the 6-7% assumed above.


Scenario unfolds as described above
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