Aetna Inc. Has Bold Ambitions In A Changing Health Insurance World

Not to belabor the point, but the Affordable Care Act (perhaps better known as "ObamaCare") is going to change the health insurance market in some pretty significant ways – even though the actual percentage of uninsured Americans isn't/wasn't as large as many people guess. In any event, Aetna (NYSE: AET  ) is approaching this new environment rather boldly. Not only has Aetna put other insurers like UnitedHealth (NYSE: UNH  ) to shame with its participation in health care exchanges, but the company has openly targeted double-digit top and bottom-line growth on a long-term basis.

I do believe Aetna's reach exceeds its grasp. The good news is that the Street isn't fully buying the story either, and actually seems to be undervaluing even a more modest outlook. I expect plenty of noise and turbulence over the next year or two as the sector adapts to the new operating environment, but Aetna looks intriguing right now.

A Big Splash On the State Exchanges

Aetna has made the biggest commitment to the state health exchanges of all the health insurance companies. Aetna is in 17 states, although even that level of participation covers just 30% of the individual markets and less than half of its existing individual book.

How does that level of participation stack up? Including the District of Columbia, WellPoint (NYSE: WLP  ) is participating in 14 states, as is Humana (NYSE: HUM  ) . UnitedHealth and Cigna (NYSE: CI  ) are talking a much more cautious approach, with five states each, while smaller players run the gamut from Molina (NYSE: MOH  ) at nine states to Health Net (NYSE: HNT  ) at just three.

There is an important "yeah, but" when considering Aetna's level of participation. While Aetna is in 17 states, it is only really competitive on pricing in 10 states (covering about 15% of covered markets). Aetna is cheaper pretty much across the board in catastrophic plans and cheaper in Bronze, but not really so competitively priced at the Silver and Gold levels.

Counting The Costs? Good Luck!

One of the biggest challenges with the ACA is the uncertainty it creates in the sector's earnings for the next year or two. Aetna thinks utilization will rise from about 1% to around 1.5% to 2% in 2014, but nobody knows. What does appear more certain, though, is that taxes and fees will take a sizable bite out of 2014 earnings.

The risk mitigation options are also a sizable question mark today. The risk adjustment mechanism that adjusts for imbalances between high-risk and low-risk enrollments will be a zero-sum game for the sector, while the risk corridors and reinsurance programs help transfer some of the initial risk to the government. All told, these efforts should keep the margin impacts within a single digit band (plus and minus), but that's still quite a lot when you're talking about an industry with high single-digit operating margins.

What Else Ya Got?

There's a lot more to insurance companies like UnitedHealth, WellPoint, and Aetna than the extent of their participation in the state exchanges. Accountable care organizations (ACOs) are getting more and more attention, and Aetna believes its approach can save customers in the neighborhood of 8% to 15%. ACOs are basically collaborative organizations between health care providers and payers, in which they work together to make better use of preventative care and coordination to lower overall costs, with the benefits being shared/split and payments based more on outcomes than procedures or actions.That said, I expect Cigna, UnitedHealth and WellPoint to all fight hard for share in this market.

Aetna has put most of its integrated health care eggs in the ACO basket. Unlike Humana and WellPoint, Aetna really has not prioritized in-house clinics, and Aetna likewise doesn't match UnitedHealth in the health care IT space (though few do).

Last and by no means least, Aetna is going to be working hard over the next couple of years to drive synergies from the Coventry acquisition. Roughly two-thirds of the targeted synergies should be attainable from relatively simple fixed cost leverage and eliminating overlapping corporate expenses, so I like Aetna's chances of hitting their targets and using the benefits of synergies to preserve free cash flow and ROE during the next couple of years.

The Bottom Line

I value companies like Aetna on a dual-model basis, with a DCF model and an excess returns model. On the DCF side, though I don't believe Aetna will hit it's double-digit revenue growth target through 2020, I do look for long-term free cash flow growth of around 10%. On the excess returns side, I am looking for a long-term ROE of 16.5%, about a point below the trailing 10-year average. For those who pay attention to earnings growth, that ROE model implies a five-year growth rate of about 9%.

Both models generate similar fair values -- $86 for the excess return model and $88 for the DCF model. In either case, it would appear that Aetna may well be significantly undervalued even with a trailing return of over 50% and the shares near a 52-week high.

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