Description

In a relatively frothy market, Cigna (CI) is an interesting special situation with decent upside potential and limited downside risk due to the potential for substantial share repurchase. If CI’s takeover by Anthem (ANTM) goes through (a 5% probability, IMO), CI has 29.5% upside to deal value. The deal could close in a couple of months. In the more likely event that the deal is blocked on appeal (95% probability, IMO), CI has substantial dry powder and will conduct a large share repurchase (19% of its outstanding at the current share price). Under this scenario, the shares offer 16% upside in a year, based on applying CI’s median P/E multiple to 2018 EPS. Finally, CI could make an acquisition, resulting in potentially greater accretion to 2018 EPS.    

Cigna is the 4th largest health insurer in the U.S., covering 15 million medical lives. The Company breaks out its results into three segments. I’ve used 2015 operating income percentages in the following paragraphs because one-time issues skewed 2016 results, as explained later.

Global Health Care (76% of 2015 operating income) encompasses CI’s commercial and government (Medicare and Medicaid) health & specialty insurance businesses. The company offers a differentiated set of medical, dental, behavioral health, vision and prescription drug plans globally. CI is a leader in the administrative services only (ASO) market where, on +85% of its U.S. medical lives, it generates fee revenues for providing such non-risk services as claims processing and plan design for self-funded employers. CI is a pioneer with respect to wellness programs and physician partnership arrangements, and as such benefits from the lowest medical cost inflation rate in the industry (5% vs. 6.75% for ANTM in 2015). The Global Health Care segment has historically generated operating income growth in the mid-to-high single-digit range.

Global Supplemental Benefits (11% of 2015 operating income) offers supplemental health, life and accident insurance in the U.S. and select international markets. This segment has historically had high single-digit operating income growth.

Group Disability and Life (13% of 2015 operating income) is the company’s “cash cow” with historic earnings growth in the low single-digits.

CI has the largest overseas presence of any U.S. health insurer. EPS grew at a 13% CAGR over the last 6 years, coming in at the high-end of management’s 10%-13% long-term target and outperforming its peers (10% EPS growth on average for ANTM, AET, UNH and HUM).    

2015 was a record year for proposed health insurance consolidation, with three large transactions announced including the potential acquisition of CI by ANTM (the other two deals were Aetna/Humana [blocked] and Centene/Health Net [closed]). A federal court recently blocked ANTM’s acquisition of CI. While ANTM has the unilateral right to extend the merger agreement to April 30th and seek an appeal, CI recently stated it will pull out of the merger and sued for the $1.85 billion breakup fee plus $13 billion in damages. ANTM countersued to hold CI to the terms of the deal, and a judge issued a temporary order blocking CI from backing out until an April 10th hearing. In my view, there is a 5% chance that the deal goes through on an appeal. If the transaction closes, CI offers 29.5% upside to deal value in the next couple of months (the deal terms are $103.40 in cash per CI share plus 0.5152 ANTM shares, for total consideration of $185.96). Given the low probability of the deal going through, I believe it’s more relevant to look at CI on a stand-alone basis.

CI negatively surprised the market when it reported 2Q 2016 results, slashing midpoint 2016 EPS guidance by 13% to $7.93 after slightly raising guidance to $9.15 when it reported 1Q 2016 results. CI recently reported that 2016 EPS came in at $8.10, down from $8.66 in 2015. The weakness was isolated to the Group Disability and Life segment, where operating earnings fell by 62% in 2016. CI made modifications to the disability claims process in 1Q, resulting in longer cycle times and therefore higher disability durations and claims inventory. In addition, life insurance claims spiked, which happens from time to time, virtually always reverting to the mean. Management strengthened operational processes in disability, took pricing actions in life, and expects the segment to show significant improvement throughout 2017, with a full recovery by the end of the year.

Two factors should limit the downside risk in CI in the likely event that the ANTM deal is blocked on appeal. First, CI management stated that it would implement a large share buyback if the deal does not go through. CI currently has $2.5 billion in free cash at the parent.
With the breakup fee (~$1.1 billion after-tax) and another year of FCF, the Company will have +$5 billion in cash at the parent by the end of this year. In addition, the Company will increase its 27% debt-to-capital ratio by another 10 percentage points via share repurchases (and 15 percentage points in the event M&A opportunities arise). Management pointed to $7 billion to $14 billion in deployable capital by the end of 2017, with the low-end applying to share repurchases and the high-end applying to acquisitions. Second, the Group Disability and Life segment, which earned $125 million in 2016, should fully recover back to 2015 levels ($324 million) by 2018. CI’s other two segments should continue their historic mid-to-high single-digit rates of growth.

Conservatively modeling 5% operating income growth for Global Health Care and 6% for Global Supplemental Benefits out to 2018 and assuming CI completes a $7 billion share repurchase at the current share price by the end of 2017 (18.8% of its market cap) I arrive at 2018 EPS of $11.92. Trading at just 12.0x 2018 earnings and offering 10%-13% long-term EPS growth potential, CI is modestly undervalued. Applying a 14x forward multiple (in line with CI’s long-term median P/E) to 2018 EPS yields a fair value of $167 in a year, for upside of 16%. The shares should then compound in line with the company’s 10%-13% long-term EPS growth target.

Lastly, CI could create more value through M&A. The “Background of the Merger” section of the ANTM/CI merger proxy states that CI held discussions and made a preliminary bid for “Company B,” which I believe is Humana. CI may try to combine with HUM, now that both companies had their respective mergers blocked, or pursue other transactions. I do not have an opinion as to the likelihood that a CI/HUM merger would gain regulatory approval. Health insurer mergers are typically quite accretive due to substantial cost synergies.

In the near-term, CI has limited share repurchases to $250 million per quarter (the amount permitted if the merger agreement were still in effect) until there is more clarity with respect to the litigation with ANTM, as it does not want to jeopardize its break up fee.           

Catalyst

The takeover by ANTM goes through, or CI utililzes its $7 billion/$14 billion in deployable capital for share repurchases/M&A.