UNH - Cigna's Merger Fumble: A Festive Financial Rebound

2023-12-11 11:16:21 ET

Summary

• The Cigna Group's decision to end merger talks with Humana Inc. is expected to positively impact its stock and prioritize shareholder returns.
• Cigna's historical financial performance shows a solid underlying business performance and strong growth in core segments.
• Cigna's strategy of share buybacks has been successful in creating value, and its valuation is competitive compared to peers.

Investment Thesis

The decision by The Cigna Group ( CI ) to discontinue merger discussions with Humana Inc. ( HUM ) is likely to positively impact its stock, alleviating investor concerns that the merger would distract management from prioritizing shareholder returns. This year, the stock has experienced a 22% decline as investors reacted to a significant slowdown in share repurchases, which fell by approximately 50% compared to 2022 and 2021, despite record cash flows. In hindsight, the secretive merger talks, which only came to light ten days ago, may have influenced the decline in the pace of share buybacks.

With Cigna holding close to $30 billion in cash, marketable securities, and investments, coupled with strong annual cash flow, there's a strong indication of a potential revival and acceleration of its share repurchase program. Given the stock's current dip, robust cash flows and earnings, and the potential acceleration of the share repurchase program, I am optimistic that 2024 will mark a turnaround for Cigna.

Historical Financial Performance Better Than It Looks

Cigna's core operational growth appears more robust when adjusting for non-recurring items, revealing a solid underlying business performance that's not immediately apparent from the GAAP financial results. The sale of its non-core businesses, including its Asia-Pacific life insurance operations in 2022 (the Chubb transaction) and the Disability and Life Insurance in 2021, has resulted in earnings fluctuations due to realized gains in the sales of businesses.

However, when adjusting earnings to these capital gains and losses, we see an upward trend in adjusted earnings in the past three years and the nine months ended September 2023. Moreover, when looking at sales figures, we see that growth in core segments has "powered through" the loss of revenue from the sale of non-core assets.

These strong results lend confidence in Cigna's future outlook. Looking ahead to 2024, the company anticipates another strong year of performance, building on its current momentum, with expected EPS of $28 per share, up 12% from the $24.75 per share trajectory for the full year 2023, which has also been revised upwards in October. This positive momentum is partly due to the new contract with Centene Corporation ( CNC ), which will see the company becoming the Pharmacy Benefit Manager for CNC's 20 million customer base. This deal involved a significant initial investment by Cigna summing to $200 million, or $0.5 per share in Q3 23, an amount poised for normalization going forward.

Additionally, the patent expiry of Humira, AbbVie Inc.'s ( ABBV ) high-cost cancer drug, is a positive tailwind, as it is one of the costliest drugs in terms of total sales, as more affordable new biosimilars gain a foothold in the market, positively impacting Cigna's Medical Cost Ratios. Complementing these developments is the expected growth of Cigna's Pathwell program launched in Q4 2022, which targets patients with complex diseases, who, despite being fewer in number, account for a major share of healthcare expenditures. These combined factors position Cigna for continued success and financial growth in the coming year.

Accretive Share Buybacks

Cigna's strategy of repurchasing its stock has been a key element in its value creation strategy, especially following its landmark acquisition of Express Scripts in 2018 for $67 billion in a cash and stock deal. From 2014 to 2017, Cigna invested $5.2 billion in share buybacks, reducing outstanding shares by 5.5% in three years. This trend accelerated from 2018 to 2023, with the company spending $23 billion on repurchases, reducing outstanding shares by 23%.

Cigna's focus on the healthcare sector provides a degree of economic resilience. Healthcare service is an essential commodity, with individuals likely to prioritize healthcare expenses even during economic downturns, potentially borrowing if needed. This essential nature of healthcare, combined with Cigna's increased sales and operational efficiencies, has led to a positive trend in its Free Cash Flows. This year, Cigna's FCF reached $11 billion, marking the highest level on record, reflecting a picture of a vibrant company that isn't yet priced on the public markets.

Attractive Valuation

Cigna's valuation, with a Price-to-Earnings ("P/E") ratio of 10x, is competitively prices compared to other peers in the managed care market like Humana and UnitedHealth Group Incorporated ( UNH ), who have higher P/E ratios almost double that of Cigna. This valuation places Cigna in a category similar to CVS Health Corporation ( CVS ) and Walgreens Boots Alliance, Inc. ( WBA ), which are also modestly valued. However, the reasoning behind these valuation discrepancies is not clear, and the gap is too wide to be explained by differences in the revenue streams; Humana and UnitedHealth derive the majority of their earnings from health insurance premiums, including stable income from Medicare and Medicaid, whereas Cigna and CVS rely more on drug sales and pharmacy benefit plans. Still, with a 43% earnings exposure to health plan premiums, resilient demand, and growing and vibrant operations, I don't believe Cigna deserves to be placed in the same category as struggling peers such as Walgreens and CVS.

Cigna's current price at 11x its TTM Free Cash Flow further highlights its value proposition. The company's commitment to shareholder returns, growing earnings, and revenue enhances its appeal as a value investment.

Risks

Healthcare policy political discussions have shifted focus from the comprehensive reforms of the Obama era, particularly those impacting Medicare and Medicaid, to the role and regulation of Pharmacy Benefit Managers in the U.S. healthcare system. Political views on this matter vary widely, creating uncertainty regarding the passage of proposed bills to regulate the PBM market. These bills, many of which propose gross margins and profitability limitations, could significantly impact Cigna's PBM segment under its Evernorth Health Service brand. If legislation perceived as harmful to Cigna's already thin Evernorth margins is passed, it could lead to a decline in the company's share price, contradicting our positive outlook for 2024.

Summary

Cigna's decision to end merger talks with Humana and its strong financial performance signal a robust 2024 outlook. Key drivers include the Centene contract and Humira's patent expiry, boosting its market position in the PBM market and enhancing its ability to deliver on value care Medical Cost Ratio metrics, respectively. Despite potential regulatory challenges in the PBM sector, Cigna's attractive valuation and solid cash flow make it an attractive investment contender in the healthcare industry.

For further details see: