Description

Cigna guides to 10%-13% long-term EPS growth, has delivered 15% over the past 11 years, and trades at 12x 2022E and 11x 2023E EPS with a 2% dividend yield. It is largely immune from the big unknowns of inflation and recession risk, and benefits from rising interest rates. It is repurchasing 10% of its shares this year, partly with divestiture proceeds, and can maintain an aggressive pace of buybacks.    

I wrote up Cigna in Feb. 2017, saw it as a trade as the stock was cheap after its broken merger with Elevance Health (fka, Anthem) and the company was in the midst of a large capital return program. I closed out the position a year later with a 32% return  - more luck than brains - and a month later Cigna announced its controversial takeover of Express Scripts which levered its balance sheet and put the stock in the penalty box for a couple of years as the company focused on deleveraging.

Like the market, I didn’t like the deal. Management’s justification of strategic synergies seemed weak at best and slow-growth Express Scripts clipped the company’s overall net income growth rate to 6%-8% from 6%-10%. Cigna maintained its 10%-13% long-term EPS growth target, but it required a modestly heavier lift from share buybacks and M&A.

I recently had two Peter Lynch moments as I now have Cigna health and dental insurance for the first time and, after being on the receiving end of their managed care tactics meant to improve their profitability, a light bulb went off. I  took a look at CI’s long-term performance and it’s been a compounder that’s trounced the S&P 500 and Nasdaq over the past decade, while being the worst performer among its peers. With UNH, ELV and HUM now trading at higher valuations and  offering only slightly better long-term EPS growth, I believe that over the next decade CI stands a good chance of continuing to outperform the S&P 500 and Nasdaq, and possibly being among the Managed Care stocks.

In the following valuation table, note that while CI communicates a 10% - 13% long-term EPS outlook, it has delivered 15% over the past 11 years. Conservative guidance is part of its culture. I listed CVS which owns Aetna and the government players CNC and MOH at the bottom of the table, but I don’t see them as comps of CI. At a 12x P/E, CI could deliver a mid-teens to 20% TSR assuming some multiple expansion and including its nearly 2% dividend yield.   

CI benefits from the tailwind of an aging population, and is largely immunized from economic cycles. In an environment of high uncertainty over inflation, interest rates and recession risk, it is nice to have an investment that can compound EPS largely irrespective of these variables. The 65+ population chart below looks like an S-curve that we are in the sweet spot of. There is an added accelerant in that 60% of the average person’s lifetime healthcare expenditures occur from the age of 65 on. 

Percent of U.S. Population Age 65 and Older

Charlie Munger has talked about the importance of a tailwind, saying that a mediocre person in an industry with a tailwind will outperform a highly talented person in an industry with a headwind. Every single managed care stock (excluding CVS) has significantly outperformed the S&P 500 and the Nasdaq over the past decade, and it comes down to the tailwind of mid-single digit medical cost inflation that the industry passes through.  

Looking out over the next decade, the tailwind is still there but, while UNH and HUM having long captured the imaginations of growth investors who are willing to pay a far higher multiple for not much more growth, and Anthem trying to create the same dynamic through the gimmick of a name change to Elevance (which has partially succeeded), overlooked CI stands out as offering compelling value and meaningful re-rating potential which I believe can happen gimmick-free through its conservative guidance and beat-and-raise model now that it has emerged from its post-merger deleveraging phase. Moreover, the modest hit to growth from the Express Scripts deal goes away over time and CI’s EPS growth will have a rising bias long-term. Cigna has 2 operating segments, Evernorth and Cigna Healthcare, and a Corporate & Other segment.

Evernorth (62% of pre-Corp. EBIT): The largest piece of Evernorth (55% of segment revenues) is Pharmacy Benefit Services (i.e., Express Scripts) which management expect to deliver 2%-4% long-term revenue growth. The other 45% is mostly Specialty Pharmacy (8%-10% long-term revenue growth), and the smaller Care Services (10%-15%+ with above average margins). Overall, management expects 5%-7% revenue and earnings growth from this segment, with an upward bias as the faster growing Specialty Pharmacy and Care Services go from 45% of segment revenues to 55% in 2026. CI expects a pre-tax margin of 4.5%-5.5% for this segment.

Cigna Healthcare (38% of pre-Corp. EBIT): The largest earnings contributor here is the high-margin U.S. Commercial business (6%-8% long-term revenue growth), where CI is the most ASO-heavy (administrative services only) publicly traded managed care company. Under ASO arrangements, self-funded clients bear the risk of medical costs and many purchase stop-loss insurance, often from CI, to limit exposures. CI acts as more of a processor than an insurer in ASO arrangements, earning fee revenue as opposed to premium revenue. About 84% of CI commercial lives are in ASO arrangements (Anthem: 62%, Aetna: 60%, UnitedHealthcare: 45%, Humana: 26%). The ASO revenue mix is far lower as an ASO member generates far less revenue than at at-risk member, but CI’s industry-leading weighting to ASO should give its commercial book greater earnings stability than its peers and a more favorable FCF profile as ASO FCF is not generated in insurance subsidiaries. 

Cigna also has a modest U.S. Government business (10%-15% long-term revenue growth) which comes with low margins, and an International Health business (8%-10% long-term revenue growth) with margins between Commercial and Government. CI expects 8%-10% long-term revenue and earnings growth for this segment, and a 9%-10% pre-tax margin.  

Modestly accelerating growth outlook long-term: At its Investor Day, CI broke out its growth drivers into different buckets to help investors understand the underpinnings of its revenue model. (1) Foundational growth assets (60% of revenues, or $100B) are scaled businesses in mature markets that have predictable but low growth, and very attractive FCF generation outside of insurance subsidiaries. This bucket includes Pharmacy Benefit Services (ESRX), U.S. Commercial and International Health, and is expected to have low-to-mid single-digit revenue growth. (2) Accelerated growth assets (40% of revenues, or $70B) are higher growth businesses in attractive markets aided by secular forces and evolving wins. These businesses include Specialty Pharmaceuticals, Evernorth Care Services and the U.S. Government business, and are expected to grow revenues at LDD. (3) Cross-Enterprise Leverage is cross-selling or deepening the relationships between the Evernorth assets (which are sold to other health plans as well) and Cigna Healthcare. A big initiative, and a key driver of the ESRX deal, is increasingly bringing in Evernorth assets into Cigna’s health plans.

One of my Peter Lynch moments related to CI’s Cross-Enterprise Leverage initiative. When I had a UNH plan, I would have my RXs sent to the local CVS and in the CVS app I’d have them mailed to me. Switching to Cigna seemed to end that set up and I just picked up the first couple of RXs at CVS in person. I tried to set up the mail option in the CVS app again but couldn’t find it, so I went to the store thinking they could simply set it up for me and I’d never have to come to the store again. Turns out Cigna doesn’t allow for mail delivery through CVS. I would need to use Cigna’s mail order pharmacy for that, and I’ve been getting regular emails from Cigna about getting my RXs mailed to me through them. I haven’t caved yet because in this reopening phase I don’t want to eliminate my options to get out of the house (which will feel like Covid lockdown again), but at some point my laziness will kick in and Cigna will have chalked up a win to their Cross-Enterprise Leverage strategy.

In the chart below, they’ve shown the success of this strategy as they’ve consistently raised the long-term earnings growth outlook for Evernorth since the ESRX deal.

The following chart illustrates that there’s more to go, as Evernorth is only 30% penetrated within Cigna Healthcare and CI believes it can get to 50%.

This leads to the mix of the faster-growing Accelerated growth assets increasing from 40% of revenues today to 50% by 2026.

Assuming Foundational grows revenues at 3% and Accelerated grows at 12%, the mix shift from 60/40 to 50/50 means overall revenue growth of 6.6% today will rise to 7.5% in 2026. CI’s overall sustainable revenue growth guidance is 6%-8%, and it appears it goes from the low-end to the high-end over the next 4 years. An extra point of revenue growth should result in an extra 1-2 points of sustainable EPS growth (with operating leverage and share buybacks) which has positive multiple implications.

Capital allocation: In 2020, CI sold its Group Disability & Life business to New York Life for $5.3B in net proceeds. This business grew earnings at ~2% annually and was a big distraction. In July, CI sold about half of its International Health business to Chubb for $5.1 B in after-tax proceeds, designating the proceeds mostly to share repurchase including a $3.5B accelerated repurchase announced in June. In total, CI expects to repurchase at least $7B in shares in 2022, representing 8% of its market cap. CI will return another $1.4B though its dividend, bringing its total capital return to ~10% of its market cap this year. With LTM CFFO of $9.6B and Capex of $1.3B on a growing business, CI can maintain something close to this level of capital return.

The balance sheet freedom to return virtually 100% of FCF to shareholders is a recent phenomenon. After taking on $24B in debt in 2018 for the ESRX deal, over the following 2 years CI repaid $10B in debt, repurchased just $6B in shares and paid no dividends. A real dividend is new to CI as well.  It paid a token annual dividend of $0.04 through 2019, but in 2021 began paying quarterly dividends of $1.00 and raised the dividend by 12% this year to $4.48 annually. Given its aggressive share repurchase, CI’s cash dividend payments will lag its growth in dividends per share, allowing the company to go for Dividend Aristocrat status longer-term with just a modest annual increase in cash dividend payments. I estimate CI’s cash dividend this year will increase by about 5%, while it put through a 12% dividend per share increase.     

10%-13% long-term EPS growth guidance appears conservative: Cigna has a history of guiding conservatively. It has long promised 10%-13% growth, yet delivered 15% over the past 11 years. With revenue growth poised to increase from the mid-6% range to the mid-7% range over the next 4 years, combined with the balance sheet freedom to buyback shares aggressively, CI could continue to deliver above the high-end of its target range. A rising interest rate environment also benefits Cigna as it reinvests its bond portfolio at higher rates. Book value will be hit, but managed care stocks are valued on earnings. CI’s communicated EPS outlook is as follows:

Intrinsic Value of $382: CI can be valued on SOTP based on transactions for PBMs and Managed Care Companies. CI paid just under 10x EBITDA for ESRX, and ESRX acquired Medco for 10.8x. These are the lowest multiples in the table below as ESRX had low growth. ESRX makes up 55% of Evernorth’s revenues with the other 45% being the faster growing Specialty Pharmacy and Care Services business. As a prior chart showed, CI increased Evernorth’s earnings growth rate from 2%-4% pre-merger to 5%-7% today. It’s cross-sell initiative should lead to further upside. I valued Evernorth at 12x EBITDA.

Anthem tried to buy Cigna (pre-ESRX) for 14x EBITDA which is near the high end of transactions, but the largest companies have tended to command premium valuations. The most comparable deals in the following table are Health Net (14x),  WellPoint (12.9x), Pacificare (13.3x) and Trigon (15.8x). I valued Cigna Healthcare at 14x.

Using 2023E EBITDA, I arrive at a 1-year out intrinsic value of $382, which implies a 13x overall EBITDA multiple and 15x the current 2023E consensus EPS (in line with ELV’s P/E). CI offers 37% one-year upside, and trades at 73 cents on the dollar, with the dollar compounding at 10%-13% or better. CI pays a nearly 2% dividend yield.

In a best case in which CI delivers 15% EPS growth and growth investors come into the name, its multiple could re-rate to the high teens. At 18x 2023E, it would be a $455 stock (64% upside) and it would still trade at a discount to UNH and HUM.  

Historic risks have been greatly reduced: Political risk was always the big multiple killer for managed care stocks, but today Bernie Sanders and maybe Elizabeth Warren are the only politicians left still talking about a single payor healthcare system. If such a change did occur, the vast majority of analysts believe that the managed care industry would be a part of the new system. These companies have growth so large and are so entrenched that the government would have to partner with them under a single payor system.

There is an example of a country going to a single payor system, but it required extreme circumstances. England’s healthcare system prior to WWII was seen as unfair. The poor were not able to afford healthcare and were reliant on charities and other support systems to help with medical bills. The Labour Party fought for a single payor system from time to time, but it was not able to gain much traction. Then, England was devastated in WWII and it needed to rebuild itself. It was under those dire conditions that the NHS came into being in 1948. If the U.S. follows a similar model, we’ll have a long lead time and far bigger problems to worry about. 

The JPM/BRK/AMZN healthcare partnership shutting down said a lot about how difficult it is to improve upon the current system. Last month, Amazon announced the end of Amazon Care.   

The remaining risks are (1) a substantially higher unemployment rate leading to falling enrollment, and (2) a surge in healthcare costs post-pandemic. Historically, such issues have not derailed the ability of managed care companies to grow EPS because of (1) the tailwind, and (2) the Big 5 (UNH, CI, ELV, HUM, Aetna) have just 40% share (2015 data) of the fully-insured market. There is still a large share of the market in the hands of smaller, regional insurers which don’t have the scale and technology of the Big 5 and will likely be permanent share donors and/or acquisition targets.  

Catalyst

Continued beat and raise. Aggressive buybacks.