AET Aetna Inc. (delisted)

We are reiterating our Neutral recommendation on the shares of Aetna Inc. (AET) following the release of second quarter 2011 results. The third largest commercial health insurer Aetna Inc. posted second quarter earnings of $1.35 per share, beating the Zacks Consensus Estimate of $1.07 as well as the year-ago quarter’s earnings of $1.05 per share. Declining utilization and medical cost trends accounted for the earnings upside.

Aetna progressed quite well in its Medicare business in the second quarter. The lifting of CMS sanctions in June and the pending acquisition of Genworth's Medicare supplement business will likely advance Aetna’s Medicare platform. Management is optimistic about its open enrollment season and expects robust membership growth from its Medicare business in the first quarter of 2012.

Aetna is aggressively looking to generate incremental fee revenues by managing the infrastructure necessary for accountable care organizations. To this effect, in the first quarter, Aetna announced an initiative with Carilion Clinic, the largest health care provider in Southwest Virginia, and added 18,000 administrative services contract (ASC) members to its pool. Besides, from the next year, the company also plans to launch new products in the Commercial, Medicare and Medicaid markets jointly with Carilion. Additionally, the company has signed agreements with two other regional health systems – Emory Healthcare in Atlanta and Heartland Health in St. Joseph, Missouri; and in each case, the company has transformed the typical transactional relationship between insurers and health systems.

The company’s collaborative efforts with these health systems will help identify gaps in care and improve outcomes, while introducing collaborative payment models designed to improve health care quality. The company’s current pipeline contains dozens of similar provider opportunities, and it expects the pace of announcements to gain momentum in the coming quarters.

With respect to Aetna’s international business, product launches in China earlier during the year showed initial success. Further in June, the company entered the market in India through the tiny but strategically important acquisition of Indian Health Organization, a fast-growing medical discount card provider, serving approximately 80,000 individuals in 18 major cities. Indian Health Organization is just one of the innovative ventures Aetna is pursuing globally to expand its footprint and develop new business models.

Aetna has made a number of acquisitions in its Commercial business. In the second quarter, it closed the Prodigy transaction, which will cater to the price-focused customers with its low-cost administrative platform. Prodigy's highly-customized offering addresses a portion of the self-funded market sized at approximately 27 million lives.

Besides, the company also announced an agreement to acquire PayFlex, an administrator of FSAs, HSAs and other accounts that support consumer-based health plan designs. PayFlex offers a flexible low-cost solution that serves numerous Fortune 500 companies. PayFlex would significantly strengthen Aetna’s existing HSA administration offerings and provide additional capabilities to support growth within Aetna’s core Commercial business.

Aetna’s balance sheet looks sturdy with $500 million of excess deployable capital for the second half of the year. Its debt-to-capital ratio of 30.3%, as of June 30, 2011, is in sync with management’s target range of 25–30%. Its strong cash generation for the past three years enabled the company to support growth strategies, repurchase stock and contribute to its pension plan. With a fairly strong cash position, it currently concentrates more on making acquisitions, which it believes will be more accretive to operating EPS earnings when they are integrated and synergies are realized, and be financially attractive when compared with repurchasing shares.

However, the current state of the global economy and market conditions are quite challenging with high levels of unemployment, diminished business and consumer confidence. With several job cuts, health membership too has suffered a significant slump. Medical membership during the second quarter declined even more than the preceding quarter. We believe, given the continued employer attrition and the current macro economic situation, membership is likely to decline for the rest of the year, thereby suppressing margins. Management expects 18.2 million medical members for 2011, flat with the second quarter.

Moreover, the low interest rate environment is expected to continue throughout 2011, which would negatively impact investment income. Management's latest guidance forecasts lower yields and less favorable alternative asset returns for the second half of the year. Though the company manages a well diversified investment portfolio, we expect returns from this segment to be suppressed. 

Aetna, competing with UnitedHealth Group Inc. (UNH), CIGNA Corp. (CI), Humana Inc. (HUM), and WellPoint Inc. (WLP), carries a Zacks Rank # 2, implying a short-term (1–3 months) ‘Buy’ rating.

 
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