Description

Thesis - Multiple Expansion Story

CI is trading at 7.7x 2013 EPS driven by sector-wide concerns related to Health Care Reform and more near-term concerns related to industry fundamentals. Both of these concerns primarily relate to the commercial risk business, where CI has significantly less exposure than its peers. Accordingly, CI should benefit from sector-wide multiple expansion as we clear 2013 and 2014 guidance hurdles while facing significantly less estimate reduction risk. In addition, CI has a number of potential company specific catalysts that should further support multiple expansion. Finally, a Romney victory would result in significant sector-wide multiple expansion that provides another way to win. With multiple expansion to 10x EPS under the base case scenario, CI is worth $62/share.

Company Description -Business Mix Matters

CI is one of the largest managed care companies in the U.S. It has three ongoing operations business segments: Health Care (~70% of earnings), International (~15% of earnings), and Disability and Life (~15% of earnings). Health Care sells traditional managed care products focused on the commercial space (employers) and boosted exposure to the Medicare space (seniors) following the acquisition of Healthspring in late January. International provides health insurance and other policies to multi-national companies and organizations and also sells directly to individuals. Disability and Life sells disability and life insurance policies to employers.

There are two points worth highlighting in the company description that relate to the investment thesis. First, CI’s exposure to the International and Disability and Life segments (30% of earnings) is unique in the managed care space. Second, over 80% of CI’s Health Care customers are in commercial administrative services only (ASO) fee-based arrangements. The takeaway here is that CI has significantly less exposure than its peers to the commercial risk business, which is the primary driver of low valuations in the managed care space. For perspective, the commercial risk business represents an estimated 25% of CI’s consolidated EBIT (including recurring investment income in EBIT) versus an estimated over 60% for WLP (managed care earnings disclosure by product is limited so estimates are required).

Health Care Reform - Industry Risks Are Real, but CI Less Exposed

Health Care Reform concerns and associated low industry valuations should not be dismissed as unwarranted. Health Care Reform changes, particularly those effective in 2014, are meaningful and could potentially have significantly negative industry earnings consequences. The key point here is that CI is significantly less exposed to these changes than its peers. These changes include:

• Health insurance exchanges for individuals and small groups. Effective in 2014, these exchanges will likely cause margin compression given increased price transparency, product standardization, and state involvement in rate setting. CI has limited exposure here - individual and small group (less than 50 employees), which are almost always risk products, represent 1% of CI’s customers (almost entirely individual). Peers are significantly more exposed to the individual and small group segment (for example, individual and small group represents 35-45% of WLP's commercial customers).
• Industry tax. Beginning in 2014, there will be an $8 billion industry tax that will be phased up to $14 billion by 2018. The tax will be allocated to managed care companies based on health insurance premium market share. Research reports estimate about $700 billion of premiums in 2014, implying that the $8 billion tax in 2014 will represent 1.1% of premiums. Bulls argue that the industry tax will be passed on to commercial customers by insurers simply raising net rates by 7% instead of the historical 5% (the industry tax is not tax deductible so 1.1% would have to be grossed up to 1.8%). Bears argue that insurers won’t be able to pass on the tax and that the tax represents a significant hit to earnings if it falls to the bottom line (38% of risk earnings assuming a 3% net margin). Reality is likely somewhere in between. Importantly, the commercial ASO business, which represents over 80% of CI’s enrollment, will not get taxed (it is fee-based, not premium based). The tax would result in an estimated 10% hit to CI’s 2014 earnings if it completely dropped to the bottom line - in reality, it will likely end up being closer to 5% since at least some of it will be passed on to customers. For perspective, the tax would result in an estimated 30% hit for WLP if it completely dropped to the bottom line.
• Medicare Advantage cuts. Beginning this year, Medicare Advantage reimbursement is being cut in a complicated phase down system through 2017 and a minimum medical loss ratio (MLR) is effective in 2014. Medicare Advantage represents an estimated 15% of EBIT for CI, primarily driven by Healthspring. Importantly, Healthspring’s unique low cost physician partnership model allows it to absorb the cuts while continuing to capitalize on attractive Medicare demographic growth. Healthspring’s acquisition proxy projected stand-alone net income would grow 17% in 2013, decline 2% in 2014, and then grow double digits in the out years.

Industry Fundamentals- Commercial Risk Business Pressured, but once again, CI Less Exposed

Like any competitive business, the commercial risk business has margin cycles. Non-profits, which represent about half of the commercial risk business, amplify these margin cycles (when capital levels grow, non-profits are incentivized to cut prices). For about a year, several companies have been talking about increased competitive pressure, but this took on new meaning when WLP cut guidance in July partially driven by increased competition. WLP also cited higher than expected medical costs, which is the other key component of commercial risk fundamentals. The main issue here is that there is limited visibility into 2013 earnings with only a small percentage of 2013 business priced at this point. How much commercial risk margin compression should we expect? Going into the details of scenario analysis is beyond the scope of this piece, but bear case scenarios can have a significant impact on companies like WLP with more exposure. The key point here is that CI is once again less exposed. A reasonable bear case scenario of 200 basis points of margin compression would be worth 5% to CI’s EPS.

Company Specific Catalysts – Run-off Reinsurance Divestiture and PBM Monetization

CI has two company specific potential catalysts that should further support multiple expansion:

• Run-off Reinsurance segment divestiture. CI management has made clear that divesting its run-off reinsurance segment is a high priority. The key issue of relevance for shareholders is that these businesses have complicated exposures (including interest rates, market price levels, and volatility) that have historically driven part of CI's valuation discount to peers (the other main driver has been CI’s pension liability). CI has taken steps in the past two years to provide a capital cushion for these businesses and statutorily isolate them, but as long as they are on the balance sheet, CI's valuation will be negatively impacted. To be clear, the exposures are complicated, but the disclosures are transparent enough that one can get comfortable that tail risk is not an issue should a divestiture not materialize. CI has not quantified how much it will have to pay to divest the segment (a reinsurance company would be the most likely acquirer), but it has repeatedly emphasized that it has the balance sheet to do it. Analysts estimates suggest that a divestiture could be worth at least a half turn of multiple expansion (worth 7% to stock price) with essentially no run rate earnings impact (the Run-off Reinsurance businesses are modeled to breakeven).
• PBM monetization. Management has also stated that monetizing its Pharmacy Benefit Manager (PBM) is a top priority. Precedent for managed care companies monetizing PBMs included WLP in 2009 (sale to ESRX) and AET in 2010 (outsourcing to CVS with a long term contract at favorable terms resulting in EPS accretion). Management has suggested that an AET/CVS type of transaction is more likely (CTRX is a logical partner for CI since Healthspring outsources to it already in a contract expiring at the end of 2013). Analyst estimates indicate that CI could realize mid single digit EPS accretion here.

Catalysts: Elections, 2013 guidance, Run-off Divestiture, PBM Monetization, 2014 guidance

There a number of events over the next 12-18 months that can drive multiple expansion:

• Elections (November 2012). A Romney victory would result in significant sector-wide multiple expansion since he could dismantle a significant portion of Health Care Reform through the Reconciliation process (only requires 50 votes in the Senate). More generally, Republicans have historically approached the managed care business markedly more positively than Democrats. An Obama victory, which appears to be the more likely outcome, is already priced in – that’s why managed care valuations are low.     
• 2013 guidance (October 2012 – January 2013). 2013 guidance should drive sector-wide multiple expansion as uncertainty related to industry fundamentals is lifted. Importantly, CI has significantly less estimate reduction risk than peers.
• Run-off Divestiture (next 12 months?).
• PBM Monetization (next 12 months?).
• 2014 guidance (October 2013 – January 2014). 2014 guidance should drive sector-wide multiple expansion as uncertainty related to Health Care Reform is lifted. Importantly, CI has significantly less estimate reduction risk than peers.

Valuation - CI is worth $61/share using weighted scenarios

CI is currently trading at 7.7x 2013 consensus EPS of $6.16. The thesis is that there will be multiple expansion over the next 12 to 18 months to 10x, which would be inline with CI's historical average (despite the likely elimination of the Run-off business) and modest relative to long-term normalized annual EPS growth of 10-13%. This implies a $62 value, assuming the base case scenario that 2014 EPS is flattish with the current 2013 consensus. In the bear case scenario, 2014 EPS is 20% lower than current 2013 consensus (Reform and fundamental pressures result in 2014 EPS of $4.93), implying a $44 value at 9x EPS. It is worth highlighting that it is difficult to get to the bear case scenario after considering that consensus estimates assume no capital deployment.  Finally, the bull case is that CI hits the current 2014 consensus ($6.90), implying a $76 value at 11x EPS.  An equal weighting of these scenarios yields a $61/share value.   

Catalyst

There a number of events over the next 12-18 months that can drive multiple expansion:

• Elections (November 2012).
• 2013 guidance (October 2012 – January 2013).
• Run-off Divestiture (next 12 months?).
• PBM Monetization (next 12 months?).
• 2014 guidance (October 2013 – January 2014).