Description

Investment Thesis

CIGNA Corporation (CI) looks like a compelling event-driven long opportunity with at least 20% upside and potentially 40% upside from current levels.  The Company is currently evaluating the sale of its pharmacy benefit manager (PBM) unit which would be a value unlocking transaction as PBMs currently trade at a mean valuation of 17.6x 2009 EPS where as CI currently trades at 6.5x 2009E EPS.  Further, the Company has significant incentive to sell the business as proceeds from the transaction would be used to address the Company's balance sheet issues (variable annuity exposure, underfunded pension, and commercial real estate holdings).  These issues have been an overhang on the Company's stock as the market is concerned the Company could need to issue equity.  Of note and as expanded upon below, CI is minimally exposed to any changes in health care brought about by the Obama administration.

Based on its 30-day average trading volume, the stock trades approximately $130 million / day so it's very liquid and easy to take a position in.

Company Description

CIGNA Corporation is one of the largest investor-owned health service organizations in the United States. Its provides health care and related benefits, the majority of which are offered through the workplace, including: health care products and services; group disability, life and accident insurance; and workers' compensation case management and related services.  CIGNA's revenues are derived principally from premiums, fees, mail order pharmacy, other revenues and investment income. CIGNA's businesses are divided into the following segments:

• Health Care (70% of revenues)- offers insured and self-funded medical, dental, behavioral health, vision, and prescription drug benefit plans, health advocacy programs and other products and services that may be integrated to provide individuals with comprehensive health care benefit programs.
• Disability and Life (15% of revenues) - markets group long-term and short-term disability insurance products and services in all 50 states and statutorily required disability insurance plans in certain states. These products and services generally provide a fixed level of income to replace a portion of wages lost because of disability.
• International (10% of revenues) - consist of products and services to meet the needs of multinational companies and their expatriate employees and dependents. These benefits include medical, dental, vision, life, accidental death and dismemberment and disability products.
• Run-off Reinsurance (2.5% of revenues) - Until 2000, CIGNA offered reinsurance coverage for part or all of the risks written by other insurance companies (or "ceding companies") under life and annuity policies (both group and individual); accident policies (workers' compensation, personal accident, and catastrophe coverages); and health policies. The products and services related to these operations were offered by subsidiaries of CIGNA Corporation.  In 2000, CIGNA sold its U.S. individual life, group life and accidental death reinsurance businesses. CIGNA placed its remaining reinsurance businesses (including its accident, domestic health, international life and health, and annuity reinsurance businesses) into run-off as of June 1, 2000 and stopped underwriting new reinsurance business. CIGNA's exposures stem primarily from its annuity reinsurance business, including its reinsurance of guaranteed minimum death benefits ("GMDB") and guaranteed minimum income benefits ("GMIB") contracts. Additional exposures arise from its reinsurance of workers' compensation and other personal accident and catastrophic risks.
• Other Operations (2.5% of revenues) - consists of: (i) non-leveraged and leveraged corporate-owned life insurance, (ii) deferred gains recognized from the 1998 sale of the individual life insurance and annuity business and the 2004 sale of the retirement benefits business, and (iii) run-off settlement annuity business.

Potential Sale of PBM Unit

On June 9^th, 2009, CI hosted an investor day during which management commented that they were reviewing a potential sale of the Company's PBM unit.  This is close on the heels of Express Scripts' (ESRX) recently announced acquisition of WellPoint's (WLP) PBM business (NextRx) on April 13, 2009.  Key points to note are as follows:

• Medco Health Solutions, Inc. (MHS) the Most Likely Buyer - It appears most likely that Medco would emerge as the lead bidder for CI's PBM unit.  Medco has commented in the past that they expect to see consolidation in the PBM space (greater purchasing synergies, revenue scale vs. overhead) and that they, themselves, would be "opportunistic" on pursuing PBM deals.  ESRX and CVS Caremark (CVS) could also emerge as a bidders but this is unlikely as ESRX is currently engaged in the NextRx deal and CVS is in the process of integrating Longs.
• Sale Value of $1.3-1.5 Billion - Unfortunately CI does not disclose the financial results of its PBM business.  A number of sell-side analysts cover the stock and estimate the unit's financial performance through a variety of methodologies.  Rather that recreate the wheel here, I'll just note that the consensus among analysts is that the unit generates approximately $4.2 billion in revenue, $125 million in EBITDA, and approximately $80-85 million in earnings ($0.30 in EPS to CI).  As shown in the comp analysis below, PBM's currently trade at mean valuations of 11.0x 2009E EBITDA and 17.6x 2009E earnings.  Applying each of these multiple to CI's PBM unit implies a value of around $1.4-1.5 billion.  Of note, ESRX is purchasing NextRx for $4.7 billion or approximately 12.7x EBITDA.  However, CI's PBM unit should not be as highly valued as NextRx for several reasons: (i) it is a lot smaller, so it doesn't offer the same type of leverage that NextRx can, (ii) the mail order penetration of CI's PBM is currently in the 25-30% range (per management's guidance) vs. the 10% penetration rate of NextRx, so there is less opportunity for the buyer to improve penetration and drive higher margins, and (iii) CI's PBM membership has been in a recent decline which could also negatively impact the valuation of the business.  Applying a discount for these factors appears appropriate, suggesting a sale price of $1.3 billion.  Still, significant synergies could be gleaned by an acquirer, so a $1.5 billion price is possible.   
• HSR Waiting Period for the ESRX/NextRx Deal Passed without Second Review - A couple of weeks ago, the HSR waiting period for ESRX's acquisition of WellPoint's PBM unit, NextRx, passed without a second review and essentially clears the way for the transaction.  That it passed uneventfully suggests that future PBM transactions will not meet with significant regulatory resistance.

Rationale for Sale

There are two main incentives for CI to sell its PBM unit:

• Unlock Value - as shown in the attached comp analysis, publicly traded PBM's currently trade at an average multiple of 17.6x 2009E EPS.  This is in contrast to CI which currently trades at 6.5x 2009E EPS.  As sale of the unit would be significantly "value unlocking" for CI.
• Address Balance Sheet Issues - CI has several balance sheet issues for which it's stock is trading at a discount to its peers (CI is trading at 6.5x 2009E EPS versus Aetna (AET), UnitedHealth (UNH), WellPoint (WLP), and Coventry (CVH) are trading at a mean multiple of 8.6x 2009E EPS - see comp analysis below).  The sale of CI's PBM unit ($850-900 million in after-tax proceeds) will not fully ameliorate CI's balance sheet issues but will be a large step in the right direction.  Market fears of an equity offering should be put to rest and CI's stock should trade at a much higher valuation multiple.  CI's main balance sheet issues are:
  • Variable Annuity Exposure - Part of CI's Run-off Reinsurance business, which has been in run-off mode since 2000, provided guaranteed minimum death benefits (known as VADBe).  These products are essentially investments in mutual funds coupled with a death benefit.  There is equity exposure associated with these products as the value of the underlying assets rises and shrinks with the equity markets but the death benefit remains intact.  So, the funding status of these products is highly dependent upon the performance of the equity markets.  Under current market conditions, VADBe future asset values (account values plus CI's reserves) exceed liabilities by about $800 million.  However, if the equity markets continue to fall, liabilities could exceed assets rather quickly.  A significant downdraft in the equity markets present one of the largest risks to CI going forward.
  • Exposure to Commercial Mortgages - CI currently holds $3.6 billion in commercial mortgages as part of its investment portfolio.  Although the portfolio has not been significantly impacted yet, losses in the portfolio could be more significant than management has reserved for as the current economic environment persists.
  • Underfunded Pension - As of Dec 31, 2008, CI's pension was underfunded by $1.9 billion.  This was largely due to the difference between expected and actual returns on pension plan assets in 2008.  An increasing level of the Company's cash flow will have to be directed to the Company's pension plan in order to shore up plan assets.  CI expects contributions to the pension plan to be approximately $410 million in 2009.

Minimal Exposure to Health Care Reform

CI's business should be minimally affected, if at all, by health care changes being proposed by the Obama administration.  75% of CI's revenues and approximately 60% of its operating earnings come from its Health Care segment.  Within that, CI's medical membership is very heavily weighted (70%) toward the Commercial self-insured / Administrative Service Orientation (ASO) marketplace.  Only 1% of CI's membership comes from the "individual and small group" market, the main target for government health care reform.  Further, the Company derives minimal revenues from Medicare and is the least exposed of all the managed care companies to Medicare.  Accordingly, recently proposed legislation (HR6331), which will cut revenues from Medicare, won't have much, if any, affect on the Company's financial performance.

There is, however, the risk that if the government enacts sweeping health care reform, all of the companies in the space will likely trade down, CI as well, even though it shouldn't.  One may wish to hedge a long position in CI against a basket of other market participants (AET, UNH, etc. to hedge out some of this risk).

Valuation / Price Target

As shown in the comp analysis above, CI is trading at a 24% discount to its peers - 6.5x 2009E EPS for CI whereas Aetna (AET), UnitedHealth (UNH), WellPoint (WLP), and Coventry (CVH) are trading at a mean multiple of 8.6x 2009E EPS.

During the Company's June 9, 2009 investor meeting, management reiterated earnings guidance of $3.70-3.90 for 2009.  The consensus sell-side EPS estimate for CI for 2009 is currently $3.72.  Assuming that CI sells its PBM unit which contributes approximately $0.30 to CI's earnings, EPS should be approximately $3.40.  Applying the peer multiple of 8.6x EPS to this $3.40 in EPS generates a per share value of $29.24, ~20% higher than current levels.

Of note, CI has historically traded at over 10x earnings.  Applying this multiple to $3.40 generates a per share value of $34.00, ~40% higher than current levels.

Catalyst

The main catalyst for CI would be the sale of its PBM unit which management is currently evaluating.  The Company has significant incentive to sell the business as proceeds from the transaction would be used to address the Company's balance sheet issues (variable annuity exposure, underfunded pension, and commercial real estate holdings).  These issues have been an overhang on the Company's stock as the market is concerned the Company could need to issue equity.