Description

AET long:  6X 08 EPS for best in class HMO, double digit EPS growth and robust buyback

AET, the best in class HMO, is too cheap trading at 6X 08 EPS given double digit operating EPS growth, a robust buyback ($1.8bn YTD) and a great CEO. The stock has been unfairly punished, down ~50% in 2008 on competitor misses and misplaced fears surrounding its balance sheet, which is strong. AET is the only HMO to essentially deliver on its 08 outlook (ex 5-10c lower investment income), and continues to take market share as we enter 2009.  AET is guiding to operating EPS growth of 12-14% in 2009, although on a reported basis EPS will be slightly down vs. 2008 due to a 54c headwind from non-cash incremental pension expense.

Applying an 11X multiple to 2009 street EPS of $4.03, which includes non-cash pension expense, yields a $44 price target vs. AET's current price of $25.

AET continues to execute, consistently growing operating EPS double digits, while its peers have faltered. AET will grow 2008 operating EPS by 13% y/y while UNH will be down 15% and WLP down 1%.

Similarly, in 2009 AET is expected to grow operating EPS (ex the 54c non-cash incremental pension expense) by 12-14%, while UNH and WLP are expected to grow a modest 2% and 6%, respectfully.     

Cheap on absolute and relative basis, at  6.6X 08 and 6.3X 09 EPS, a discount to UNH (8X)and WLP (6X) 09 who missed big in 2008, while AET has superior mgmt, earnings quality and growth. EV/08 EBITDA of 4X. FCF>NI

Momentum in the marketplace and outgrowing its peers, with expected enrollment adds of 750-800k lives in 08 (+5%), and +1,000k in 1Q09, vs. peers that are losing lives. Channel checks confirm that AET is winning on its superior offering, technology, service and cost control, NOT on aggressive pricing. 

Great CEO. Ron Williams had an excellent track record of execution at WellPoint Health Networks, where its medical cost ratio (medical costs/premiums) stayed in a tight band, never rising above 81.2%. He successfully turned AET around when he arrived in 2001, pulling out of unprofitable markets and re-pricing the book. He took AET's medical cost ratio from 90.0% in 2001 to 80.6% in 2007, pre-tax margin from -1.4% to 10.5%, EPS from -$0.49 to $3.50 and the stock from $7 to $59, before the 2008 sell off. He is shareholder-friendly and has upside on ~7m shares (250k shares and ~6.75m options).

Management views shares as undervalued and has repurchased $1.8bn YTD, and expects to repurchase $1bn in 2009 vs. current market cap of $11bn, and we think they likely do more.

2008 was a tough year for HMOs, it gets better from here. AET's peers missed earnings on higher medical cost ratios (medical costs/premiums) in 2008 leading to fears over increased price competition in the commercial risk business, potentially signaling an onset of a multi year down cycle. We see these fears as misplaced and see the operating environment improving in 2009.

• 1. Nearly 50% of the sector misses were related to actuarial mistakes on new Medicare (i.e., NOT commercial) products that have already been re-priced for 2009.
• 2. Company specific elements were a big part of the misses: management at the troubled companies is lacking, note for example:
• o UNH has underperformed operationally since former CEO McGuire was pushed out in 11/06 options backdating scandal.
• o WLP has lost nearly all top management including CEO (retired) and CFO (personal scandal). 9 of 14 regional health plan CEOs are new in their positions. New CEO has no P&L experience and this is the CFO's first public CFO job.
• 3. Public HMO pricing is strengthening in 2009, not weakening as bears had extrapolated. WLP, UNH and CVH (~1/3 of the mkt) have publicly committed to taking corrective pricing actions
• 4. Not-for-profit Blues pricing is firming too, as it has historically in years following a depletion of their capital levels. NFP Blues have been particularly hard hit by lower investment income (down ~70% y/y in 3Q in aggregate), given higher equity allocations.

AET's conservative pricing for 2009. AET is pricing to a medical cost trend assumption of +50bp from current trend, while cost trends are running flat/down, as corroborated by slowing hospital admissions, weak RX trends, and slowing sales at med tech companies. 

Strong balance sheet. AET gave a positive update on its investment portfolio on 12/16/08. As of 11/30/08 it had unrealized losses of only ~$500m, and credit losses that were "diminimus" since the end of 3Q08. We estimate GAAP realized losses of less than $150m(on its continuing operations portfolio, note P&L on ~30% of its portfolio passes thru to policy holders) and significantly less on a Statutory basis (which is the relevant metric for risk based capital levels), given more forgiving accounting.  AET can easily absorb these levels of Stat realized losses, given the generation of $1bn of excess capital in both 2008 and 2009. Moreover, note the strong quality of its "riskier" assets that have attracted much attention:

• CMBS portfolio of $747m ($515m in the continuing AET portfolio) vs. total investments of $17.83bn (AET continuing of $12.7bn). 73% is 2005 and earlier vintage, and 91% is AAA rated.
• Mortgage loan portfolio of $1.7bn($900m continuing AET). 73% is 2005 and earlier vintage. Average LTV is 62%, average debt service coverage of 1.41. No delinquencies.
• Net debt of $3.3bn to $3.5bn 08 EBITDA. No long term debt maturing during 2009 or 2010
• AET will build an additional $7-800m cushion from its $2bn of 09 FCF vs. our projection of <$150m realized GAPP losses and less on STAT basis.

Catalyst

Political risk manageable. Obama's universal healthcare proposals are predicated on the current employer based coverage platform, limiting structural risk (i.e, nobody is proposing a single payer system). AET will be part of the solution in rolling out coverage to the 45m uninsured through the expansion of their Medicaid/SCHIP products.