We are cautious presently on the equity markets, and while we have been holding cash and shorting stocks, we have not been implementing many long positions. In addition, we don’t usually like to invest on the premise that a company will be bought, but we believe Aetna (AET) is a special case due to its cheap valuation. We are well aware that Aetna recently reported disappointing earnings, and was also the subject of a recent story in the Wall Street Journal in which it was brought out that health insurance is becoming too expensive for some employers to afford. Yet, we do not think the problems in the health insurance sector are any more problematic than those in the hospital sector, which faces such problems as possible cuts in insurance and Medicare payments, and the trend away from hospitalization in general. Any yet HCA, a major hospital operator, has recently been the subject of a leveraged buyout offer (LBO) by a private equity consortium. Aetna is a relative bargain compared to HCA, as we will explain. It may be that due to the consolidation that has already occurred in the healthcare insurance area, a buyout of Aetna by a strategic, corporate buyer would fail to gain approval by regulators. Yet, we see no reason why a financial, private equity buyer would not be interested in a LBO of Aetna. Let’s step back for a moment and talk about what a LBO is. By analogy, buying a house is very similar in structure to a LBO. Why? Let’s assume you buy a $200,000 house with 10% down, and borrow the rest. Let’s also assume you put a renter in the house whose payments cover all your expenses including the mortgage. Let’s further assume the renter pays off the mortgage. Forgetting about commissions, taxes, and closing costs, if you sell the house for $200,000, what’s your profit? Well, you bought it for $200,000, and sold it for $200,000, so the profit is zero, right? Wrong! You put in equity of only $20,000, and financed the rest, so your profit is $180,000 ($200,000 minus the $20,000 down payment). You have made 9X your money. The concept of LBOing a company is in theory similar. You buy a company, and restructure the balance sheet, putting in a relatively small slither of equity, while financing the company with a lot of debt (similar to buying a house). You really don’t need to sell the company for much more than its purchase price to make alot of money (assuming you have enough cash flow to pay down your debt while you owned the property). Now, let’s talk about the specifics of Aetna, and why it is so attractive as a LBO candidate. For starters, Aetna at a 2007 forward PE of about 10X earnings sells at a considerable discount to the S&P 500, and at a discount to both HCA(estimated forward 2007 PE of 15X) and UnitedHealth Group (UNH) (estimated forward 2007 PE of 14X). Aetna’s estimated enterprise value/2006 revenue of .20 is also cheap compared to those of UNH and HCA, which are estimated, respectively, at .90, and 1.20. What is perhaps most striking is the huge amount of cash Aetna has on its balance sheet ($23.00 per share net of debt as compared to $-26.00 for HCA and $1.90 for United Healthcare), and hence the opportunity Aetna provides to fund a private equity group’s buyout. In fact, given Aetna’s huge amount of cash, a private equity buyer could probably use that cash for most of its "down payment", and borrow the rest. As well, Aetna’s relatively small amount of debt (25% debt/equity) , provides the opportunity to leverage its balance sheet. As an aside, we would mention that given Aetna’s huge cash reserves, and light debt load, it is in a position to execute a massive stock buyback. For example, if it were to buy back $5 billion in stock, it would shrink its shares outstanding by about 28%, which would increase its earnings per share by about 40%, and lower its forward PE from 10 to about 7. Another way of saying this is if you subtract from Aetna’s market capitalization its cash, and add back its debt, value of options outstanding, its unfunded pension obligations, and a reserve for discontinued pension products, we estimate its enterprise value to projected 2006 revenue is .45. That is very cheap indeed. We ran Aetna through our LBO model, and we estimate that assuming debt is leveraged about 5X to EBIT (which we believe is moderate leverage for an LBO), assuming a buyout at a 25% premium to Aetna’s current stock price, assuming 5% growth in annual cash flows, and assuming Aetna is re-sold to the public market’s at 8X earnings, a buyout of Aetna would yield an internal rate of return to a private equity of about 30%. So, we see considerable upside potential to Aetna’s common stock. To put it another way, a private equity buyer would probably have to pay a hefty premium to Aetna’s current price to buy the whole company. This is called a control premium. We believe that Insight has been able to purchase Aetna’s common stock more cheaply, and without the control premium a buyer of the entire company would have to pay. Insight currently holds a long position in Aetna.
Philip Frank, PhD
President and Portfolio Manager,
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net
