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Aetna 15-year bonds most attractive part of CVS/AET capital structure
admin | July 19, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Aetna bonds trade through parent CVS with the exception of the 15-year part of the curve, making it the most attractive part of the capital structure. Aetna bonds are structurally senior to those of CVS, the operating companies are well capitalized, and Aetna’s standalone leverage should improve over time.
Background
After highlighting a trade in CVS last week, the AET 6.625% 6/15/36 and 6.75% 12/15/37 bonds are the most attractive part of the CVS/AET capital structure. Across the curve, AET bonds trade through CVS with the exception of the 15-year part of the curve. While Aetna Inc. (AET – Baa2 (n)/BBB) is a wholly owned subsidiary of CVS, the CVS bonds are structurally subordinated to AET bonds as noted in CVS’ debt prospectus supplement (filed 3/6/18), thereby making AET structurally senior despite the equalized ratings. CVS is also committed to AET’s existing financial policies which include keeping AET’s operating companies well capitalized, at a combined risk-based capital ratio of 275% or higher, in order to provide some “insulation” from the parent and maintain strong insurance financial strength (IFS) ratings. Moody’s , Fitch and A.M. Best all currently have a mid-single A IFS rating for AET, while S&P is one notch lower at A-.
Exhibit 1: AET-CVS curve
Source: Bloomberg
AET a strong operator
Prior to linking up with CVS, AET was considered a strong operator in the HMO sector, benefiting from its size and scale as well as the depth of its provider network. AET consistently posted strong profitability primarily due to its disciplined pricing and underwriting approach. For the three fiscal years prior to CVS, AET posted an average return on revenue (ROR) of 8.8%. S&P forecasts an ROR of 7%-8% for 2019-2020, which compares favorably to S&P’s 2%-5% forecast for the industry over the same time period. Furthermore, AET remains very conservative, maintaining an RBC ratio of 275% or higher is both above regulatory requirements, as well as its peers, who look to maintain RBC in the 225%-275% range.
AET leverage to improve over time
CVS has been very vocal about its commitment to reducing adjusted combined leverage from 4.7x at acquisition close, to mid-3.0x leverage by 2021 and low-3.0x by 2022. Based on cash flow estimates and CVS’ track record, the debt reduction targets appear to be attainable. When the acquisition closed, CVS made the decision to centralize the treasury operations for both CVS and AET. With a central treasury, the agencies view AET’s liquidity and financial flexibility to be tied CVS. However, on a go forward basis, any future debt issuance will be done out of CVS. That said, AET’s stand-alone leverage will improve over time as AET debt matures and is either repaid or refinanced out of the CVS parent. AET’s next debt maturity is on 6/1/21 when $500 million of debt comes due.
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