Cigna: Sport Over For PBMs? (NYSE:CI)

Introduction

On July 9, the Federal Commerce Fee (FTC) launched its “interim employees report on prescription drug middlemen“, detailing how Pharmacy Profit Managers (PBMs) revenue on each side of the commerce – by driving up drug costs and placing stress on smaller, non-chain pharmacies. In fact, that is nothing new to anybody who has studied the enterprise mannequin of PBMs like Categorical Scripts, which is owned by The Cigna Group (NYSE:CI), however regulatory and media consideration is clearly rising.

The New York Occasions, for instance, printed a relatively detailed article on the topic three weeks in the past, referring to PBMs as “The Opaque Business Secretly Inflating Costs for Prescription Medication“.

Equally, OptumRx (owned by UnitedHealth Group Inc., UNH), Caremark (owned by CVS Well being Corp., CVS) and Categorical Scripts are going through lawsuits associated to their position in negotiating insulin costs.

As well as, Categorical Scripts – together with OptumRx – is going through a lawsuit in reference to the opioid disaster in Arkansas, alleging that the PBMs knowingly contributed to the precarious state of affairs. In spite of everything, Arkansas had the nationwide second-highest opioid prescription fee in 2016.

Fairly clearly, PBMs are coming underneath rising scrutiny and as a shareholder of The Cigna Group, I naturally have an curiosity on this matter. Due to this fact, on this replace, I’ll share my perspective and clarify how I see the potential affect on CI inventory.

Nevertheless, I wish to make it clear that this text shouldn’t be misconstrued as taking sides in favor of inflated drug costs and ripping off employers, sufferers and taxpayers. I merely need to supply my opinion on the potential affect of this clearly altering setting on Cigna normally and its PBM Categorical Scripts specifically.

How The Altering Atmosphere May Impression Cigna’s Earnings And Dividend

In keeping with the NYT article, not many individuals even know that PBMs exist, not to mention perceive the position they play within the American healthcare system. In lots of circumstances, the existence of PBMs solely turns into obvious when critical points come up. Accordingly, PBMs are unlikely to face a major threat of contract cancellation from particular person sufferers. It’s clear that people even have the least leverage.

Employers and authorities businesses that negotiate agreements with PBMs don’t essentially have an incentive to terminate their contract with a specific PBM attributable to, amongst different issues, lock-in results – a side that I consider is a vital contributor to the financial moat of PBMs. I do not assume it is a stretch to conclude that OptumRx, Categorical Scripts, and Caremark function in a extremely consolidated oligopoly – managing prescriptions for greater than 200 million People.

Nevertheless, it’s nicely doable that the federal government will more and more intervene to restrict the profitability and progress of PBMs. Under, I’ll try to mannequin the potential affect of a decline in PBM revenues on phase and consolidated earnings, in addition to on the dividend payout ratio and valuation of CI inventory.

As talked about above, Categorical Scripts is Cigna’s PBM enterprise, which in flip is a part of the Evernorth Well being Providers phase. The opposite reportable phase is Cigna Healthcare (see my earlier articles for extra particulars on the corporate’s operations).

In 2023, Evernorth Well being Providers was accountable for roughly 75% of Cigna’s income earlier than unfavourable company gross sales and intersegment eliminations (Determine 1), having generated greater than $153 billion and as soon as once more delivered strong progress (9% year-over-year). Final 12 months, Evernorth generated gross revenue and adjusted pre-tax working earnings of $9.9 billion and $6.4 billion, representing gross and working margins of 6.5% and 4.2%, respectively.

CI): Adjusted revenues by phase, earlier than unfavourable company revenues” width=”640″ peak=”377″ contenteditable=”true” data-width=”640″ data-height=”377″ loading=”lazy”>

The margin profile, which clearly illustrates the high-volume nature of the PBM enterprise, is proven in Determine 2 (blue bars). Nevertheless, it must be famous that the lack of $1.7 bn (company) shouldn’t be included in these margins. Due to this fact, and understanding the dimensions of the PBM enterprise, Evernorth’s precise pre-tax working margin might be nearer to three.5% (pink bars in Determine 2). Intersegment gross sales of round $5.7 billion (3.7% of Evernorth phase gross sales) would tilt the equation once more to a barely larger margin, however for the sake of brevity, I can’t elaborate on this facet right here.

CI): Pre-tax adjusted working margin, earlier than and after together with the estimated contribution from the corporate-related loss” width=”640″ peak=”377″ contenteditable=”true” data-width=”640″ data-height=”377″ loading=”lazy”>

In fact, Evernorth additionally consists of companies that aren’t straight associated to PBM companies, comparable to eviCore Well being and quite a lot of digital options like Evernorth Behavioral Well being and MDLIVE. Nevertheless, contemplating that pharmacy income accounts for practically 93% of phase income, I would not over-interpret their contribution – particularly from a backside line perspective. Seen otherwise, contemplating Evernorth Well being Providers as a pure PBM, the following sensitivity evaluation has a built-in conservative bias.

Determine 3 reveals how Evernorth’s pre-tax working revenue and Cigna’s consolidated internet earnings could be impacted by a decline in income within the Evernorth phase and after accounting for a decline in phase margin.

Particularly, I modeled situations with income declines between 5% and 35% from 2023 ranges and assumed a phase margin compression between 10 foundation factors (5% income decline) and 70 foundation factors (35% income decline). Though it might be extra sensible to mannequin some decline with a contraction of the enterprise, I’ve conservatively assumed that the corporate’s overheads attributable to Evernorth stay unchanged. We see that Evernorth’s phase revenue declines between 7% and 46% when the corporate’s overhead is excluded (blue bars), whereas the decline is as much as 57% when the corporate’s overhead is included (pink bars).

Nevertheless, because of the Cigna Healthcare phase, which makes a major contribution to earnings, consolidated internet revenue would fall much less sharply than the Evernorth phase’s earnings. Within the worst-case situation – which I take into account to be extraordinarily bearish – Cigna’s internet revenue would fall by 32%.

CI): Estimated decline in pre-tax working revenue and internet earnings upon discount of Evernorth revenues” width=”640″ peak=”377″ contenteditable=”true” data-width=”640″ data-height=”377″ loading=”lazy”>

If we now have a look at Cigna’s dividend payout ratio (blue bars in Determine 4), it’s clear that the dividend stays very secure even within the worst-case situation and there’s nonetheless loads of room for progress. In fact, the scope for debt discount and share buybacks, which have performed their half in EPS progress lately (see my earlier articles), is more and more restricted.

Cigna inventory at the moment trades at lower than 13 instances 2023 adjusted earnings, or a blended price-to-earnings ratio of 12.4, in keeping with FAST Graphs. In a worst-case situation, the ratio would rise to 18.7 instances earnings (pink line in Determine 4).

For my part, the chance of presidency intervention in Cigna’s PBM enterprise is the principle cause for the present valuation. How else may a P/E ratio of 12.8 be thought-about cheap for an organization that has grown its income by virtually 14% yearly over the long run (Determine 5)? There may be undoubtedly one thing to the saying “the market is all the time proper”.

CI): Estimated affect of the hypothetical Evernorth income decline on dividend payout ratio and P/E ratio” width=”640″ peak=”376″ contenteditable=”false” data-width=”640″ data-height=”376″ loading=”lazy”>

CI), based mostly on adjusted working earnings per share” width=”640″ peak=”387″ contenteditable=”false” data-width=”640″ data-height=”387″ loading=”lazy”>

Taken collectively, and on condition that the situations modeled are most actually manner too conservative, I can perceive why the market has not reacted to the latest information. The affect on Cigna’s earnings is important, notably within the excessive income decline situations, however decrease than anticipated because of the comparatively low margin nature of the PBM enterprise and good diversification. Given the extraordinarily robust money move conversion (see my earlier articles and Determine 6), I consider the conclusions are straight transferable.

CI): Free money move after stock-based compensation, excluding and together with working capital changes based mostly on a four-year rolling common” width=”640″ peak=”376″ contenteditable=”false” data-width=”640″ data-height=”376″ loading=”lazy”>

Entertaining The Risk Of A Drastically Altering Atmosphere For PBMs – One other Motive Why I Favor Cigna

Having already mentioned what I consider could be a manageable affect on Cigna’s earnings even within the extremely unlikely occasion of a double-digit decline in Evernorth’s revenues, I wish to spotlight one more reason why I’m a satisfied Cigna shareholder.

As readers of my earlier protection of Cigna know, I believed lengthy and arduous about which of the three corporations working a PBM I needed in my portfolio. In the long run, I selected Cigna, primarily as a result of it represents one of the best compromise of operational high quality and valuation.

In fact, UnitedHealth is a really high-quality firm, however I all the time discovered it too costly for my style – regardless of its barely higher fundamentals.

In comparison with CVS, I discovered Cigna to be operationally a lot stronger and higher managed, however after all CVS is in a relatively tough state of affairs, having advanced from a retail pharmacy chain. On a aspect observe, with that in thoughts, administration (particularly former CEO Larry Merlo) undoubtedly deserves credit score for diversifying early into the insurance coverage and PBM enterprise, thereby leveraging its robust retail presence.

Valuation apart – which I see as far more compelling in CI’s case in comparison with UNH – I believe this probably altering setting requires a powerful basis to adapt. Ought to the federal government get entangled within the PBMs’ enterprise, at the very least non permanent stress on margins is probably going (see above), and with it weaker debt servicing capability and finally much less scope for money returns to shareholders (buybacks and dividends). The present rate of interest setting can be taking part in its half on this context.

I’ve mentioned Cigna’s steadiness sheet in my earlier articles and in addition took a very good look on the firm’s funding portfolio throughout the 2023 banking disaster. So, for the sake of brevity, I’ll solely present a quick replace right here.

The self-discipline to give attention to debt discount might be seen within the growth of internet debt, which fell from virtually $32 billion on the finish of 2019 to $22 billion on the finish of 2023 (Determine 7), regardless of share buybacks of virtually $18 billion within the final three years. No marvel that ranking company Moody’s upgraded Cigna’s long-term credit standing by one notch to Baa1 in April 2021 and has maintained the steady outlook ever since.

CI): Web debt at year-end” width=”640″ peak=”377″ contenteditable=”false” data-width=”640″ data-height=”377″ loading=”lazy”>

Primarily based on the steadiness sheet for the primary quarter of 2024, Cigna’s internet debt in relation to free money move (three-year common) is barely round 2.6 instances. The curiosity protection of virtually eight instances pre-interest free money move is equally reassuring. I’ve already referred to the low dividend payout ratio – based mostly on internet earnings – above. By way of free money move, nonetheless, issues look even higher – in 2023, Cigna paid out lower than 15% of its free money move after stock-based compensation and dealing capital changes.

Lastly, Cigna has a well-spread debt maturity profile (Determine 8), and its present weighted-average rate of interest is barely round 4.2%. Given the same rates of interest for the buckets coming due over the following years, it might be unreasonable to count on a major weakening of debt serviceability – even when rates of interest stay at present ranges.

CI): Debt maturity profile as of March 31, 2024″ width=”640″ peak=”377″ contenteditable=”true” data-width=”640″ data-height=”377″ loading=”lazy”>

Gauging The Impression Of Opioid Litigation On Cigna

For my part, Cigna’s robust money move and strong steadiness sheet will assist it navigate this altering setting very nicely, so robust dividend progress and share buybacks are prone to proceed. For a similar cause, I might not over-interpret the opioid lawsuit in Arkansas.

Thus far, Cigna has not explicitly listed opioid-related litigation within the threat part of its 10-Okay report, nor has it made any provisions for it. Whereas that is excellent news in itself, I nonetheless needed to gauge the potential affect of opioid litigation on Cigna.

To that finish, I took a have a look at the newest 10-Ks of pharmaceutical distributors McKesson Corp. (MCK) and Cardinal Well being, Inc. (CAH) – recall the settlement along with Cencora, Inc. (COR, previously AmerisourceBergen Corp.) and Johnson & Johnson (JNJ) to pay $26 billion to resolve opioid-related lawsuits.

McKesson estimated in its fiscal 2024 10-Okay (p. 34) its complete legal responsibility for opioid-related claims at $6.8 billion, of which $665 million was anticipated to be paid in fiscal 2025. McKesson at the moment generates greater than $4 billion in free money move yearly. Cardinal Well being’s fiscal 2023 10-Okay reveals $5.9 billion in accrued liabilities, that are detailed on p. 68 of the report. The corporate at the moment generates round $2.5 billion in free money move.

In view of the truth that the settlements are paid over a number of years, limiting the affect on annual earnings and money move, and given the manageable ratio between the opioid legal responsibility and annual free money move (1.7x for MCK and a couple of.4x for CAH), I do not assume the chance to Cigna is materials.

In fact, there isn’t a method to precisely decide the potential legal responsibility, however even when we assume that Cigna must pay $5 billion – which might signify an unrealistically excessive share of the mixed settlement of CAH, COR, JNJ and MCK – the affect appears very manageable. I consider it’s sensible to count on the settlement to be paid over a ten-year interval, which might solely scale back annual free money move by roughly $500 million (<5% of 2023 free money move after changes) – an immaterial affect on Cigna’s steadiness sheet and earnings energy.

Conclusion

The latest FTC report, in addition to the New York Occasions article on PBMs, counsel that the regulatory setting for PBMs is prone to turn out to be more and more difficult. Cigna, which acquired Categorical Scripts in 2018, could be considerably impacted by the brand new laws, as would rivals UnitedHealth (OptumRx) and CVS Well being (Caremark).

At first look, the 75% income share of Cigna’s Evernorth Well being Providers (which primarily consists of PBM-related income) suggests a big draw back threat. Nevertheless, given the comparatively low profitability of the phase and even with some very conservative assumptions, the affect of margin and income decreasing laws appears manageable. Even when we assume that Evernorth’s revenues decline by 35% – which is an unrealistically pessimistic assumption – the implied valuation of CI shares would solely enhance from the present 12.8x to 18.7x earnings. For my part, the market priced in elevated regulatory stress on PBMs a very long time in the past – how else may a present P/E of lower than 13 be justified for an organization that has grown its earnings by virtually 14% yearly over the past 20 years?

Importantly, the dividend payout ratio in relation to internet earnings would possible stay beneath 30% even within the worst-case situation. Given Cigna’s glorious money move conversion, the cash-related affect would possible be even decrease.

As well as, and in mild of the latest information that Cigna may now even be held accountable in reference to opioid litigation, I take into account the strong steadiness sheet, balanced maturity profile, and low-interest fee sensitivity to be additional components that make me to sleep very nicely as a CI stockholder. The affect of impending opioid-related litigation was discovered to be very manageable – even within the occasion that Cigna was ordered to pay a disproportionately excessive fee – when it comes to the 2021 settlement of CAH, COR, JNJ, and MCK.

Thanks very a lot for studying my newest article. Whether or not you agree or disagree with my conclusions, I all the time welcome your opinion and suggestions within the feedback beneath. And if there’s something I ought to enhance or increase on in future articles, drop me a line as nicely. As all the time, please take into account this text solely as a primary step in your individual due diligence.