Description

Cigna is a deep value stock. It is a classic case when a solid business runs into troubles but not broken. Trading at 10x projected 2004 EPS, this stock is priced to fail. However, my research indicates the situation has stabilized and earnings will improve. With a little patience, you can be rewarded with 40% return in the next 12 month.

Key investment points:

· Managed care industry has high barrier to entry.
Managed care industry is highly regulated. There are four players (United, Aetna, Cigna and the Blue Card) that dominate the national market, meaning that they have the network and the capability to serve the big corporations with multiple locations. A new entry to this industry is virtually impossible.

Right or wrong, the fact is that bad managed care companies never go away. Medical insurance is a very short tail business, so in theory if a company misprice the book, it has opportunity to fix it in the following year. The transition will be painful, but they always survive. It happened to UNH, OHP and AET b, and this time it is CI.

· Cigna has largely fixed the key source of the problems – its medical claim systems.

There is nothing more important to a managed care company than having a fast and reliable medical claim system. That is exactly where Cigna’s trouble started. The company initiated a massive transformation system project in the second half of 2001 to consolidate several old claim systems to two new systems aiming to increase the auto-adjudication capability and cut cost. However, the new systems didn’t perform as planned, which resulted in poor provider relationship and low customer satisfactions. More importantly, Cigna couldn’t get a clear read on its underlining medical cost, which is the prerequisite for right product pricing. All of these led to membership loss (about 11% from 02 to 03) and higher medial loss ratio (MLR in 2Q 03 was 90.4%, which the industry comp was in low 80%).

My research indicates that Cigna has largely fixed the problems with its two claim systems. So far they have loaded about 7 million members (out of the total of 12 million) on the two systems and auto-adjudication rate is 60-70% vs less than 40% on the old systems. Over time, more members will be loaded on the new systems. Going forward, the MLR should improve substantially and the SG&A will go down.

· Customer satisfaction has improved.
Survey from sell-side research and my channel checks with healthcare benefit brokers have all indicated that Cigna’s customer service quality has improved substantially to now in line with the industry average, a big jump from last year. However, it takes longer to change the customer perception and win some new accounts. It always takes two pricing cycle to fix a managed care company. 04-membership loss will still be high, about 10%, since the customers’ decisions to leave were made in spring 03. I expect the loss will abate substantially in 05 and the new win rate will go up.

· Run-off reinsurance business is truly running off now.
Cigna took a $1.1 billion charge in 02 and another $230 million in 2Q 03 for its run-off reinsurance business. The hedging strategy seems to work well. I believe very unlikely we will see another charge from this business.


Valuation:

Cigna will earn about $5.50 EPS in 03. Cigna’s earnings have substantial leverage on its MLR – 100 bp MLR improvement can lead to 80 cents EPS. I believe the new claim systems in place will lead to about 200 bp MLR improvement in 04 and at least another 100 bp in 05. In the meantime, I conservatively estimated that this Cigna’s membership would be down 10% in 04 and another 4% in 05. Higher margin with lower membership base will still lead to significant earnings improvement. EPS in 04 will be close to about $5.60, due to the dilution from sales of its retirement business to Prudential. Continuing MLR improvement and lower SG&AEPS in 05 should be close to $7. At 12 x PE multiple, this stock will worth around $80 per share. My sum of parts valuation supports the same price target.

Sum of parts

Enterprise Value Per share value
Healthcare 11497 $ 82
Employee Benefit 2000 $ 14
International 450 $ 3
Run-off Reinsurance 0 $ -
Other operations 800 $ 6
Corporate -1200 $ (9)
Total 13547 $ 97
LTD -1500 $ (11)
Total Equity value 12047 $ 86

Catalyst

· Earnings improvement: Turnaround of a Managed Care company takes three phases – control medical cost, stem membership loss and lower SG&A. Cigna is still in phase one, and there is a lot of room left for further earnings upside in the next two years.
· Future sell-side upgrade
Many sell-siders (and buyside too) have been burned by this stock in the past. While signs at Cigna is pointing up, sell-side is waiting for the earnings to come through. Only Prudential and Smith Barney have buy ratings on the stock. Many have sells or underweight. With earnings improvement, upgrades that pump the stock higher.