Description

I have been involved in managed care stocks for the better part of the past decade.  Cigna is currently my favorite risk/reward in the group primarily due to valuation.  CI trades at only 11x ’22 earnings despite an improving fundamental backdrop and relatively benign political risk. 

Company description:

Cigna is a global health services company with three divisions:

Evernorth (54% of ’21E earnings): 

-          A comprehensive suite of pharmacy solutions. 

-          One of three scaled PBMs.

-          Key solutions include retail networks, mail-order pharmacy, specialty pharmacy, and formulary management. 

-          Also includes eviCore, a medical benefits management provider.

-          Processes ~1.5b adj. scripts per year.

U.S. Medical (37% of ‘21E earnings):

-          Fourth largest managed care company by members.

-          Particularly strong in middle market commercial. 

-          84% of commercial members are administrative services only.

International:

-          Leading provider of health insurance and administrative services for multinational employers and organizations. 

-          Offers supplemental health, life and accident insurance.

Investment case:

Cigna is a well-managed company with a good track record of capital allocation.  I am a big fan of David Cordani.  Since he took the helm in late 2009, CI stock has compounded at 18.7%.  This has nicely outpaced the S&P500. 

Cigna’s valuation compares favorably to its peers.   CI trades like CVS despite having less leverage and a superior business mix (no secularly challenged retail pharmacy).  If the valuations were all the same, I’d rather own UNH, Humana, and to a lesser extent Anthem, but the gap is far too wide. 

While there will always be political noise, the policy risk is lower now than it has been in a while.  The Biden administration is focused on other priorities and the democratic senate majority is too narrow to get anything meaningful done.  

While that could all change the next election cycle, my experience is that investors underestimate how entrenched our health care industry is. 

One thing that tends to weigh on CI’s multiple is the PBM exposure.  I view Express Scripts (ESRX) more favorably.  I view it as an asset-light toll taker on a growing TAM.  The value proposition is based on scale.  And ESRX is one of three scaled players. 

As evidence of this, in 2019 Prime Therapeutics, a PBM competitor representing 30mm lives across 23 Blues plans, decided to outsource its retail network and pharmaceutical contract negotiation to ESRX.  A year later, Prime outsourced its mail order and specialty pharmacy functions to ESRX.  Basically, Prime’s owners (18 BCBS plans) realized they were better off financially if they just let ESRX do everything. 

Before acquiring ESRX, CI had a sub-scale PBM (partially outsourced to Catamaran, which was acquired by Optum, which is owned by UNH).  CI would often lose national account business because of an inferior pharmacy option.  And employers that chose CI would often carve out the pharmacy benefit and award it to a larger PBM.  Cordani recognized this and pounced when ESRX was out of favor with investors.  I view the merger as highly strategic.  The value of integrating the medical benefit and the pharmacy benefit is likely to increase over time, particularly as specialty drug spend continues to grow (and biosimilars emerge as viable alternatives to off patent biologics). It also opens meaningful cross selling opportunities (CI’s core competency) between the two client bases.

So far, the deal is working out well.  Cigna has now owned ESRX for two full years.  Segment earnings grew 5.3% in 2020 and are projected to grow another 4.4% next year.  Client retention rates have been strong ~98% and script growth has been excellent.    

All the key profit drivers of ESRX (below) are doing well. 

-          PBM (retail networks, formulary management, administration, etc.)

-          Mail order pharmacy

-          Accredo (specialty pharmacy)

-          EviCore (medical management, acquired by ESRX for $3.6b in 10/17)

Here are the financial metrics:

Cigna’s medical business also has favorable attributes. Cigna goes to market with a consultative approach and leads the industry in product uptake by clients.  It helps that CI has especially strong mental health and dental networks.  In the past, competitors with large risk books (~4x more profitable per client) often faced an innovator’s dilemma with their go to market strategies.  This gave CI the opportunity to pick off middle market clients by offering a better value proposition (self-funding).  Not surprisingly, CI clients consistently show best-in-class medical cost trend. 

As a result, CI’s book of business is more weighted towards fee-only ASO clients which I think should be worth a higher multiple since it does not have underwriting risk and requires minimal capital to service.  I also like that CI is not trying to vertically integrate by owning providers (I prefer the partner model).

A key concern with CI medical’s business mix is the relatively small exposure to government business vs. peers.  The thinking is that the commercial market is mature and could potentially be vulnerable if/when policy creeps towards more socialized medicine.  In addition, there is more membership growth on the government side, particularly with Medicare Advantage (why Humana trades at such a healthy multiple). 

CI is aware of these trends and has a plan in place to grow its government business.  In mid ’19 CI pledged to grow its Medicare Advantage membership by 10-15% per year over the next 5 years.  This involved investing in the product and expanding the geographic availability from 18-19% of available MA lives in 2019 to 50% over 5 years.  In 2020, CI grew its MA membership by 18% and expanded its geographic footprint by ~50%.  CI continues to score well on quality metrics.  The MA plan has a 74% net promoter score, the 4th consecutive year of increase, and 80% of its MA and PDP customers are members of 4-star plans.  This leads to better retention and reimbursement. 

CI is also growing its ACA exchange business now that the market has stabilized.  CI has increased its geographic footprint by over 50% in the past couple years to 20% of the market and has further plans to double its coverage to 40% of the market by 2025. 

Management has also expressed that government business is high on the M&A priority list. 

Valuation:

With the recent sale of the disability and life division, CI has a reloaded balance sheet and no longer needs to delever.  This gives them the flexibility to buy back a lot of shares ($8b of FCF).  I think it is worth noting that CI recently instituted a ~2% dividend (~20% payout ratio) yet management maintained its LT EPS growth algorithm of 10-13%.   

CI has guided to “at least $20.20/shr” in 2021.  Management claims that earnings are negatively impacted by ~$1.25/shr due to the pandemic.  This is due to a higher MLR and some membership losses in commercial.  Trends have recently improved a bit so I estimate CI will earn ~$20.50 this year and ~$23 next year.  This is consistent with management commentary that ’22 earnings will grow at the high end or better of CI’s 10-13% annual EPS growth goal (due to a recapture of some of the COVID headwinds).  

Despite the recent move, CI is still trading at a historically low relative valuation vs. the market.  Therefore, I do not find it unreasonable that CI could trade at ~$300 at year end (13x 2022 earnings of $23/share).  This represents upside of 17% in just 6 months. 

Catalyst

cash flow