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An opportunity in long dated Aetna bonds

| April 17, 2020

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.

Since CVS Health Corp.’s (CVS – Baa2 (n)/BBB) acquisition of Aetna Inc.  (AET – Baa2(n)/BBB/BBB) in late 2018, AET bonds have traded flat to through CVS paper, but pandemic concerns have moved some health insurance paper wider, including AET. UnitedHealth Group’s (UNH – A3/A+/A) recent results and reaffirmation of guidance could quell some fears surrounding certain HMO’s. Additionally, while AET’s ratings are equalized with those of CVS, AET’s stand-alone capital structure is stronger than its parent and set to further improve over time. A reversion to the historical trading relationship could provide an attractive entry point in AET bonds.

The relationship between AET 4.75% 2044 bonds versus CVS 5.05% 2048 bonds in highlighted in Exhibit 1.

Exhibit 1. AET 4.75% 2044 vs. CVS 5.05% 2048 Spread Comparison

Source: Bloomberg TRACE

AET a Strong Operator

Prior to linking up with CVS, AET was considered a strong operator in the HMO sector, benefitting 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%.  As such, AET had a single A rating by S&P and an A- rating by Fitch prior to the acquisition.  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 as we note that 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 Well Positioned in a Time of COVID

 Following UNH’s 1Q20 beat earlier this week and management’s reaffirmation of full year guidance, we are more confident in AET’s ability to perform during the pandemic given how similar their business segment breakdown is to UNH.  From a risk perspective, both credits are exposed to the Medicare segment, which may prove to be costly during the pandemic given that those above 65 are more greatly affected by the virus.  Medicare only represents 14% of enrollment for AET.  While UNH’s Medicare exposure is low as well, we note that it is higher at 22%, giving AET a slight advantage over UNH from a Medicare exposure standpoint.

Additionally both may stand to benefit from having large enrollment in the ASO (Administrative Service Only) segment.  Under the ASO model, the insurer acts as plan administrator for a company that funds their employee benefit plan.  That said, the healthcare costs actually fall with sponsoring employer.  The majority of AET’s enrollment is in the ASO segment (62%) while UNH’s is a bit lower at 44%.  This could prove beneficial from a cost perspective for AET during the pandemic.  For full year 2019, we note that AET’s Medical Benefit Ratio (MBR) was a solid 84.2%.  MBR is a type of loss ratio and measures the percentage of premiums paid out in claims.  As a general rule of thumb, an MBR of 85% or less is desirable.

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, we believe the debt reduction targets are attainable. As of the most recent quarter, CVS has repaid roughly $8bn of debt since the close of AET, above its $7.5bn Investor Day target.

We note that 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 $500mm of debt comes due.

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