Portfolio Review

7/13/2015


Aetna downgraded on Humana deal

We are downgrading Aetna ($113; AET) after the insurer agreed to purchase rival Humana ($186; HUM) for roughly $37 billion. The deal will improve Aetna's leverage in negotiating prices with hospitals and triple its Medicare Advantage business. But it also comes with the hefty announced price tag of $230 per share, a 23% premium to Humana's price before the deal was announced and 29% above where shares traded before reports surfaced that management was exploring a sale. Making matters worse, Humana slashed its 2015 earnings guidance after announcing the deal, citing higher medical utilization among elderly members.

For every share of Humana, investors will receive $125 in cash and 0.8375 shares of Aetna. The resulting company could serve upwards of 33 million medical members, ranking third behind Anthem's ($159; ANTM) 38.5 million members and UnitedHealth's ($119; UNH) 45.8 million members. It will have the leading share of members in the fast-growing Medicare Advantage market. But Aetna and Humana both offer Medicare Advantage plans in nine of the same states. Together they would have more than 50% of the Medicare Advantage market in four states, which will surely invite close scrutiny from regulators.

Aetna says it expects to divest parts of its business to clear regulatory hurdles. But U.S. antitrust officials are taking a more aggressive stance on acquisitions, already nixing three deals in 2015. Earlier this month, the U.S. filed a lawsuit to block the $3.3 billion sale of General Electric's ($26; GE) appliance business to Electrolux on grounds the deal could trigger higher prices for consumers. Humana shares trade at a 15% discount to the current value of Aetna's offer, reflecting antitrust concerns. Aetna must pay Humana a $1 billion breakup fee if regulators block the deal.

The deal's terms also include a break-up fee of about $1.4 billion should either company accept another takeover offer. UnitedHealth has reportedly expressed interest in Aetna, while Cigna ($150; CI) has entertained bidding for Humana. Aetna's deal may also put more pressure on Cignato accept Anthem's overtures. Cigna had rejected Anthem's $47 billion offer last month, though the two companies have reportedly resumed talks. Cigna and Anthem would have a combined 53 million members.

There may still be a remote chance UnitedHealth rekindles its efforts to acquire Aetna. But Aetna's Overall score has fallen to 66, hurt by a middling Value rank of 53 and below-average scores for Momentum and Earnings Estimates. The stock's weakness in Quadrix, combined with the deal's big price tag and regulatory overhang, lead us to remove Aetna from the Buy and a Long-Term Buylists. The stock should be sold. Anthem and UnitedHealth are rated A (above average). Aetna and Cigna are now rated B (average). GE is also rated B (average).

More takeover talk

Teva Pharmaceutical Industries ($61; TEVA) reportedly plans to increase its offer for Mylan ($69; MYL). Teva's new bid could approach $43 billion ($88 per share), up from its April bid of $40.1 billion ($82 per share). In rejecting Teva's original offer, Mylan claimed its stock was worth "significantly in excess" of $100. Teva has acquired a 4.6% stake in Mylan in the hope of thwarting its rival's attempt to block the deal in Dutch courts. Mylan remains a Buy and a Long-Term Buy.


Chatter swirls that Nvidia ($20; NVDA) may try to merge or partner with MediaTek, a semiconductor company based in Taiwan. MediaTek, struggling to defend its semiconductor profits in the increasingly competitive smartphone market, reportedly seeks to gain entry in the automobile industry. Nvidia is a Long-Term Buy.

Airlines update

In recent months shares of U.S. airlines have wavered on capacity concerns, fluctuations in oil prices, and now an antitrust probe into possible collusion. S&P 1500 airline stocks are down an average of 9% since May 1. Southwest Airlines ($32; LUV) shares have fallen 22% in that time, while Alaska Air Group ($66; ALK) shares are up 1%.

But the industry appears to be gaining more pricing power as the four largest U.S. airlines — American Airlines Group ($39; AAL), United Continental, ($53; UAL), Delta Air Lines ($40; DAL), and Southwest — now control 80% of the domestic air market. Moreover, the airline industry has improved efficiency by employing bigger planes. U.S. airlines have increased seats by 12% over the past two years, while offering 4% fewer flights, according to The Wall Street Journal.

Alaska Air said both traffic and capacity rose 7% in June. The airline's load factor slipped to 86.7% from 86.9%. Southwest also reported nearly 7% traffic and capacity growth in June, while its load factor rose to a record for June of 86.2%. Southwest declined to report monthly passenger revenue per available mile (PRASM). Last month Southwest lowered its June-quarter guidance for PRASM to a decline of 4% to 5%. In other news, Southwest reached a tentative agreement with its flight attendants. Terms were not announced, though Southwest said the deal includes wage increases. Alaska Air is a Focus List Buy and a Long-Term Buy. Southwest Airlines is a Long-Term Buy.

Corporate roundup

Production has begun on Apple's ($123; AAPL) next iPhone, according to DigiTimes. Suppliers reportedly expect total iPhone shipments of 230 million to 240 million units this year, up 20% to 25%. In a separate report by The Wall Street Journal, Apple has asked manufacturers to build an initial 85 million to 90 million units of its forthcoming iPhone, up from its initial 2014 order of 70 million to 80 million units. Both reports will likely keep profit estimates for Apple moving higher. Separately, daily sales of the Apple Watch have slowed to as few as 10,000 units from 200,000 in the first days of the device's launch, reported researcher Slice Intelligence.  Apple, reasonably valued at 14 times expected fiscal 2015 earnings, is a Focus List Buy and a Long-Term Buy.


BP ($39; BP) agreed to pay $18.7 billion in penalties to resolve all state and federal claims from the April 2010 oil spill in the Gulf of Mexico. BP's bill from the disaster now stands at roughly $54 billion — more than half of its profits since the oil spill occurred. BP is rated C (below average).


Heinz and Kraft Foods Group completed their $45 billion merger, resulting in a company called Kraft Heinz ($75; KHC). Berkshire Hathaway ($137; BRKb) and investment firm 3G Capital own a 51% stake in Kraft Heinz, which becomes the fifth-largest food and beverage company in the world. On our Monitored List, Kraft Foods is being replaced by Kraft Heinz, rated C (below average). Berkshire is rated A (above average).


Rank Changes

Aetna ($113; AET) is being dropped from the Buy List and Long-Term Buy List. As a result, the Focus List and Buy List now have 17.5% in the Vanguard Short-Term Corporate Bond ($80; VCSH) exchange-traded fund, while the Long-Term Buy List has 16.9% in this low-risk bond fund.


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