RiverPark recently published its Focused Value Fund’s Q2 Investor Letter to discuss the performance of the fund’s during the second quarter of 2018 – you can download a copy of the letter here. According to the letter, the fund opened a new position in CIGNA Corporation (NYSE: CI) during the second quarter. The fund is bullish on CIGNA and in this article we’re going to take a look at the comments made by portfolio manager David Berkowitz about CIGNA in the letter.
Here are the comments:
This quarter, we initiated a position in CI, one of the largest and best managed health insurers in the US. CI generates about 80% of its operating profit from US health insurance and the remaining 20% is evenly split between international benefits management and group disability/life insurance. Within US health insurance, Cigna has historically been stronger in the commercial segment (as opposed to government programs), especially in administrative service contracts, where CI leverages its systems and expertise to help large companies manage self-insurance programs. We are particularly attracted to this service business as it requires far less capital than traditional health insurance and has less volatile earnings because the risk of loss remains with the self-insured employer. Cigna’s government operations, Medicare and Medicaid, have experienced slower growth than some of its competitors, and analysts expected Cigna to make a meaningful acquisition that would increase its exposure to this growth area. Instead, on March 8, Cigna announced an agreement to acquire Express Scripts Holding Co. (ESRX), a pharmacy benefit manager (an existing 3.5% position for the Fund) for a combination of cash and CI stock at a 30% premium to the ESRX share price prior to the merger announcement.
The investment community seemed disappointed with the strategic rationale for the ESRX acquisition and was concerned that the proposed merger could be delayed or blocked due to anti-trust concerns, leading to a decline in Cigna’s share price from $195 to $170 and a relatively wide spread between ESRX’s share price and the implied value of the merger consideration. At the current CI price of $170, the combination of cash and stock consideration would be worth greater than $90 per share versus the current ESRX share price of $77, a spread of more than 16%. With the transaction expected to close within the next six months, this spread would generate an annualized return of approximately 35%, a compelling return for shareholders of ESRX.
Post-merger, our base case estimate is that the new CI will generate EPS of $20.50 in 2021. Based on blended multiples for health insurers, like CI, and pharmacy benefit managers, like ESRX, the combined company will likely trade at greater than 13 times earnings, implying a 2021 share price of at least $266 and a compound return of 16% over the next three years. Our more pessimistic estimate, which factors in no growth for the ESRX business yields EPS of $19 in 2021, a more modest 12 times multiple, and a $228 price per CI share, which would still deliver a 10% compound return over the next three years.
If the deal is not consummated, Cigna would owe Express Scripts a $2.1 billion breakup fee. ESRX, which we thought was an interesting investment at around $75, before the deal was announced, would receive nearly $4 per share in cash and would presumably use this cash along with operating cash flow to resume its share repurchase program, which has already reduced its shares outstanding from 821 million at year-end 2013 to 567 million at end of Q1 (a greater than 30% reduction in share count). CI, having paid the break-up fee of about $8 per CI share, would likely resume its own share repurchase program, and continue to grow its core health insurance business. In this scenario, we estimate Cigna would earn about $14.20 per share in 2019 and trade at around 14 times earnings, implying a share price of approximately $200, a return of nearly 18% versus the current price. As a measure of the conservatism in this analysis, CI traded at more than $200 per share at year-end 2017 having earned $10.20 per share, a multiple of greater than 20 times.
In conclusion, we feel that the attractive valuation of ESRX and the market’s dissatisfaction with a merger that we feel is a strategic positive for both companies, has produced a compelling investment opportunity where we can profit from owning both CI and ESRX, whether the merger closes or not.
CIGNA Corporation (NYSE: CI) a global health service company with 95 million customers around the world. The company offers products and services through subsidiaries including Cigna Health and Life Insurance Co., Connecticut General Life Insurance Co., Life Insurance Co. of North America, Cigna Life Insurance Co. of New York and affiliates. The company’s products and services include an integrated suite of health services such as medical, dental, behavioral health, pharmacy, vision, supplemental benefits, and other related products including group life, accident and disability insurance.
CIGNA shares are down 7.09% since the beginning of this year. Over the past three months, CI has moved up 5.19% whereas the stock has gained 5.71% over the past 12 months. CIGNA has a consensus average target price of $221.16 and a consensus average recommendation of ‘OVERWEIGHT’, according to analysts polled by FactSet. On Thursday, the stock was closed at $188.19.
For the second quarter of 2018, CIGNA reported total revenues of $11.5 billion, up 10% year-over-year, led by continued strong business growth in the company’s Global Health Care and Global Supplemental Benefits segments. The company had net income of $806 million, or $3.29 per share, down compared to $813 million, or $3.15 per share, for the same of the last year.
Meanwhile, CIGNA is a popular stock among hedge funds tracked by Insider Monkey. As of the end of the fourth quarter of 2017, there were 49 funds in our database holding shares of the company, including HealthInvest Partners AB, Vernier Capital, and Iguana Healthcare Management.