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Aetna Up and At It

Shares surge after the insurer puts two shortfalls behind it.



back in shape.

After rattling investors in recent quarters, the giant health insurer on Thursday blew past profit estimates for the third quarter and issued new guidance that topped Wall Street expectations as well. Importantly, the company also brought its crucial medical cost ratio back under control.

Third-quarter revenue climbed 11% to $6.3 billion, matching analyst expectations, due to enrollment gains and premium increases. Net income surged 28% to $476 million, while earnings per share of 78 cents -- or 84 cents counting a favorable reserve development -- beat the 72-cent consensus estimate with ease.

"Aetna reported what we view as nearly a flawless quarter," declared UBS analyst Justin Lake. "Expect a significant relief rally for Aetna and the group."

Lake, who has a buy recommendation and a $49 price target on Aetna's stock, was right about that. Aetna shares soared $2.62 to $41.15.

The company's third-quarter metrics looked solid across the board. Total memberships rose 5% to 15.4 million. Expenses, as a percentage of revenue, declined. Meanwhile, the all-important MCR came in at 79.3%, up slightly from last year, but far better than last quarter's sudden spike. Margins improved as well.

By now, Aetna itself has hinted at favorable developments. Notably, the company suggested weeks ago that its past MCR wasn't as bad as it had originally seemed.

Still, analysts seemed relieved to have actual proof.

"After two quarters in which commercial MCR rose more than expected, today's report will be greeted enthusiastically," Bear Stearns analyst John Rex announced on Thursday. "Recall that beginning about six weeks ago the company had announced that, with the benefit of additional data, the cost issues that it had identified in the second quarter (and impacted the accruals taken) were now viewed as considerably more modest.

"Today's report confirms that view and should lead to a considerable positive move in the stock -- and, for that matter, the entire group."

Rex has a peer-perform rating on Aetna's stock. His firm has provided noninvestment banking services to the company over the past 12 months.

Aetna's stock surged 7%, while rivals


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inched up slightly.

For its part, Aetna believes the positive trends will continue. The company now expects to report full-year earnings of $2.83 a share -- 4 cents higher than the top end of its previous guidance. Analysts have been forecasting 2006 profits of $2.76 a share instead. The company's new 2007 profit forecast of $3.26 a share tops the $3.15 consensus estimate as well.

"Our focus for the future is to meet customer needs with a broad range of innovative products and best-in-class service," Aetna CEO Ronald Williams stated. "We continue to improve our organization with an emphasis on efficiency and flexibility, so that we can be well-positioned to increase affordability and access in a dynamic health care marketplace."

Of course, analysts felt understandably nervous ahead of Aetna's report.

After all, Aetna had blindsided them with bad news two quarters in a row. Still, some experts expected better news this time around.

"We maintain our neutral rating on Aetna while we wait to see evidence that cost trend issues are not systemic," JPMorgan analyst William Georges wrote earlier this week. "However, we believe the stock could react favorably coming into the quarter based on lower (medical-loss ratio) and share repurchases, which could drive a meaningful beat relative to consensus."

Aetna clearly delivered. The company's much-improved MLR generated most of the-third-quarter upside, with share repurchases adding the finishing touch.

"To its credit," Georges admitted on Thursday, "Aetna has been able to address the troubled portions of its risk book quicker than market expectations."

Georges had predicted that Aetna would, in fact, top Wall Street expectations for the recent quarter. But he remained cautious ahead of the update nonetheless.

His firm has an investment banking relationship with the company.

Meanwhile, Cowen analyst Edmund Kroll has cooled on Aetna's stock considerably in recent months. Troubled by the company's second-quarter results, Kroll responded by dropping Aetna from the "Cowen Focus List" and downgrading the stock from outperform to neutral.

In a research note published earlier this month, Kroll suggested that further disappointments could still be on the way. Notably, he predicted that Aetna would miss third-quarter profit estimates by a full nickel. He acknowledged that Aetna had managed to hit second-quarter profit targets despite its rising medical costs. However, he questioned whether the company could pull off that same feat -- which required cuts in selling, general and administrative expenses -- once again.

"Although we are monitoring the situation very closely, management's cloudy outlook on MLR trend going forward causes us to remain cautious on the stock in the near term," Kroll wrote. Importantly, "Aetna no longer fits the profile of an HMO with a steady to improving MLR."

Kroll has been steering investors elsewhere as a result.

"Our large-cap favorites, outperform-rated WellPoint and UnitedHealth, are both well positioned to gain market share, manage medical costs, achieve SG&A leverage and deploy capital for shareholders' benefit," wrote Kroll, whose firm seeks to do business with the companies it covers. Meanwhile, "firm pricing and a benign medical cost environment make our EPS forecasts achievable for 2006-07 -- with modest upside possible from our favorites."