ELV - Humana And Cigna Topple On Rumors Of An Unlikely Union

2023-11-30 07:00:00 ET

Summary

• Humana and Cigna are reportedly in talks to merge, potentially creating one of the largest mergers in the healthcare industry.
• The merger could generate significant cost savings and revenue synergies for the combined company.
• However, past attempts at mergers in the healthcare industry have faced regulatory scrutiny, making the success of this deal uncertain.

November 29th was not a particularly pleasant day for shareholders of insurance giants Humana ( HUM ) and T he Cigna Group ( CI ). Shares of the former dropped 5.5% while shares of the latter declined by 8.1% after news broke that the companies are rumored to currently be in talks to combine in a stock and cash transaction that would represent one of the largest mergers in the history of the healthcare space. Although specifics would ultimately be determined by the structure of the deal, the price, and management’s view of what the future holds, it's almost certain that such a maneuver would have the potential to generate hundreds of millions or even billions of dollars in annual synergies. But given the history of attempted mergers in this industry, it's highly unlikely that such a deal, even if agreed upon by both parties, will be consummated.

An interesting… but pondered… merger

If news of this potential merger gives you a sense of deja vu, it's because this is not the first time that Humana and Cigna have considered combining. Apparently, back in 2015, Humana explored the possibility of selling itself to Cigna, but instead of following through on that initiative, Humana decided to merge with rival Aetna in a deal that was blocked by US courts. Now, however, things are rather different. Both companies are quite a bit larger than they were back then. Prior to shares falling in response to this announcement, Humana boasted a market capitalization of $62.87 billion, while Cigna is even larger with a market capitalization of $83.77 billion.

Any combination of large enterprises offers the potential for significant cost savings, even in the event that there is little overlap from an operational perspective. This is because it is easy to cut fat by getting rid of duplicative operations, such as much of what occurs at the corporate level. Examples would include human relations, investor relations, certain regulatory areas, accounting, high-level executive positions, and more. But there are other ways to generate synergies from a combination. For instance, when you have two companies that have some significant differences in what they do or how they operate, there is the potential to engage in cross-selling or to leverage existing infrastructure in order to make selling or servicing more efficient. While this would have an impact on margins, it would also help generate revenue-related synergies.

Such an opportunity might exist between these particular firms. At a high level, they are both healthcare players in the insurance space. But there are significant differences in how they operate. As an example, Humana’s business is really centered on two primary things. These would be its Insurance unit and CenterWell. The latter of these, CenterWell, is the smallest portion of the company, accounting for only 16.3% of the company's revenue last year. For those who don't know, CenterWell includes the company's pharmacy, provider services, and home solutions operations. It also includes some other miscellaneous items like its strategic partnerships with WCAS to develop and operate senior-focused primary care centers, as well as the company’s minority ownership interest insert in hospice operations.

The rest of the company's revenue comes from its Insurance business. But ‘insurance’ is such a broad term that we must dig into the picture a bit to understand precisely what Humana does within this space. The vast majority of revenue associated with the Insurance segment, about 84.6% of the segment’s revenue in all, involves Medicare programs, with the vast majority of those operations involving both the individual Medicare Advantage program and the group Medicare Advantage program. The company does have some other revenue that comes from the government. For instance, using data from 2022, about $6.38 billion, or 7.2%, of its revenue, came from ‘Medicaid and other’ operations.

By comparison, Cigna is a much more complicated entity. Like Humana, Cigna provides services under the Medicare Advantage program. But this is a part of the company that has actually struggled to do well in recent years. While Humana has seen revenue under this business climb from $59.47 billion in 2020 to $72.89 billion in 2022, Cigna has seen its Medicare Advantage revenue inch up only slightly from $7.57 billion to $7.90 billion. For the first nine months of this year, both companies have seen growth in this space. But once again, Humana has been far more impressive. Revenue associated with Medicare Advantage has grown 16.5% from $55.28 billion to $64.39 billion. By comparison, revenue growth for the program for Cigna has increased only 8.6% from $6.08 billion to $6.61 billion.

While it is true that Cigna is weak on this front, it is strong when it comes to other things in the medical space. The company has largely focused in recent years on operations involving pharmacies. Most specifically, the company generates significant amounts of revenue from its network as a Pharmacy Benefits provider. Under this broader corporate umbrella, the company has many different brands, including PBMs (Pharmacy Benefits Managers) like Express Scripts PBM. Significant amounts of revenue also come from its home delivery pharmacy business. But outside of these two areas, which collectively account for roughly 67.7% of its overall revenue when combined with certain specialty revenues, the company does engage in the health insurance market. I already touched on some of this by talking about its exposure to the Medicare Advantage program. But the company also has some international healthcare operations and it provides its services on the commercial side in the US. In fact, the US commercial side of the enterprise was responsible for $22.08 billion worth of revenue last year. That's about 58% of overall insurance premiums under its Cigna Healthcare segment.

An unlikely merger

For better or worse, there is a massive graveyard filled with failed mergers between major players in the healthcare market. I already mentioned the failed transaction between Humana and Aetna back in 2015. In 2017, courts ended up blocking Elevance Health’s ( ELV ) (formerly known as Anthem) proposed purchase of Cigna for $48 billion. Even smaller transactions have faced tremendous amounts of scrutiny from regulators in recent years for fear that anti-competitive pressures might increase costs for Americans. Earlier this year, for instance, regulators tried to block but were ultimately unsuccessful in doing so, the acquisition of Amedisys by UnitedHealth Group ( UNH ) in a deal valued at only $3.3 billion. That's a rounding error for a company that currently has a market capitalization greater than $500 billion. This came a year after regulators pushed back on UnitedHealth’s acquisition of Change Healthcare in a deal that was ultimately completed at a price of $8 billion.

This is not to say that large transactions in the space cannot occur. Back in 2018, for instance, drugstore chain CVS acquired Aetna in a deal valued at $69 billion that ultimately turned the combined company into CVS Health ( CVS ). That was a merger that had both horizontal and vertical aspects to it. And it may be the vertical nature of this potential transaction that could create some potential for regulators to either approve or to lose throughout the court process. Personally, I would not put a high probability of success on such a transaction. But given how different the two are from one another, there could be one potential avenue for success.

Earlier this month, news began circulating that Cigna might be looking to offload its Medicare Advantage operations. As measured by total enrollment, the company controls only about 2% of that market . However, Humana is a behemoth in that space with a roughly 18% market share. That makes it the second largest player, second only to UnitedHealth’s 29%. What's more, while Cigna has struggled on this front, I already detailed how revenue had grown for Humana when it comes to its Medicare Advantage offerings. This growth has been driven in large part by an increase in total enrollment from 4.576 million back in 2020 to 5.131 million in 2022. By the end of the third quarter of this year, enrollment had grown further to 5.885 million. If Cigna unloads the Medicare Advantage operations, that might ease the concerns that regulators have.

If a merger is possible and if potential cost savings could create value for shareholders, a natural question many might ask is why shares of both companies plunged in response to this news. More likely than not, the decline in price can be attributed to worries that one player or the other may ultimately have to overpay for the transaction to work out. Given that Cigna is much larger, it would make sense for it to absorb Humana. But in all honesty, Humana seems to be the better company between the two. As you can see in the table above, both companies have profit and cash flow margins that are quite similar to one another. But in the chart below that, you can see that revenue has grown much more rapidly for Humana than for Cigna.

Beyond this, there are other reasons why I say that Humana is the better of the two firms. Unlike Cigna, which has net debt of $21.60 billion, Humana actually has cash in excess of debt that totals $18.57 billion. Because of this and the higher quality, investors demand a higher premium on the equity of Humana compared to the equity of Cigna. Using estimates from 2023 and real data from 2022, I showed, in the chart below, just how pricey shares of each company happened to be on a price to earnings basis, a price to adjusted operating cash flow basis, and on an EV to EBITDA basis. As you can see, Humana is more expensive, which may have markets concerned about the potential of Cigna overpaying. That would also explain why shares of its stock fell more than Humana’s did. Though, also included in that chart is valuation data where we instead compare earnings and adjusted operating cash flow to the EBITDA for each enterprise. In this case, the companies look much more in line from a valuation perspective, and Humana is actually cheaper on an EV to EBITDA basis.

Takeaway

To be perfectly clear, I would not be surprised if some announcement of merger is made regarding Humana and Cigna before this year is out. But absent those companies making some significant concessions in response to concerns from regulators, I think the probability of a major deal is quite low. Investors should definitely view this as a speculative scenario. The market clearly thinks that and an announcement is likely to occur, though the perception of the market seems to be that a transaction would hurt shareholder value or that the focus on trying to complete the transaction would do so. I actually think that a combination between the two, if completed, could be very profitable for investors. And that is because the two companies do have such significant operations. But regardless of what I think on the matter, what I do know is that investors would be wise to keep a close eye on the situation to see what developments pop up.

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