Cigna Corp. (CI-NYSE, $323.97) Beats on Earnings for Q3, 2022 and wins a $40 billion per annum PBM contract from Centene.

Cigna, like most other major health maintenance organizations, reported a record profit for the third quarter ended September 30th, 2022.

Ongoing revenue was $45.28 billion for the quarter. Drug costs were up, medical expenses were down. Overall, Cigna generated an EPS of $6.04 per share, up from the street average estimates of $5.71 and $.03 shy of the highest estimate of $6.07 in the analytical pool. Overall expense control was fine; there were no unpleasant surprises of note.

Differing from the majority of the large HMO businesses, Cigna is far more a Pharmacy Benefit Manager than it is a health insurer.

The key driver of revenue and profits at Cigna is their Express Scripts division. Pharmacy revenues in Q3 accounted for 72% of consolidated corporate revenues in Q3.

The PBM division is about to get much, much larger in late 2023.

Centene, another HMO, has decided to outsource their pharmacy management to Cigna starting in fiscal 2023. This contract covers more than 20 million new customers and provides an estimated annual topline revenue of about $40 billion. Margin contributions are not disclosed but would likely be consistent with the margins reported by the remainder of the Cigna division, about 3%. Cigna indicates that they will be expensing about $200 million to perform the necessary software and reporting updates to code the contracted orders. There was also likely a significant cost to bid for the contract and finally, some fiscal incentive to persuade Centene to remove such a significant volume of business from their own top line and transfer it to Cigna. All in all, I am doing little more than performing a back of envelope calculation and suggest that the Centene contract will represent an expense drag for about 3 quarters of 2023 and then start generating accretion, to the tune of $400 million-$800 million of operating margin before taxes, starting in 2024.

Despite a relatively low level of profit earned on revenue by Express Scripts, the high revenues to be earned on the Centene contract should provide meaningful accretion to Cigna.

Going forward, the Centene book of business could add anywhere from $1 per share to $2 per share to the bottom line, after tax, all in, annually. That could represent a 4% to an 8% pickup in EPS; but it won’t be evident in 2023. The Centene contract win represents a 2-year story for modeling, with upfront costs compressing profit margins in 2023 and profits expanding rapidly in 2024. Cigna, in their most recent conference call, expressed confidence that the current business book is unlikely to lose any significant number of clients and might even generate a few more PBM wins. Kroger announced their intention of leaving the Cigna PBM earlier this year, unless contract pricing was reviewed. That might, or might not, happen. Were it to occur, this would only shave off a relatively smaller percentage of the accretion to be added from the Centene contract win.

Among the larger HMO companies, Cigna is far more PBM-centric than most.

Cigna is not a huge HMO company. They are rather dominant in commercial health insurance on several east-coast US states and have a reputation for providing excellent coverage to a somewhat less price sensitive corporate and personal clientele. Accordingly, margins are better, customers (once onboarded) tend to be less likely to jump ship, but new client growth vs peers was somewhat harder to achieve.

Cigna purchased Express Scripts in late 2018 for a consideration totaling $67 billions in cash, stock and assumed debt. The significant takeover premium, more than $20 billion at the time, largely eliminated the long thesis regarding CI for some years. This is consistent with most large combinations in the equity marketplace; an acquirer badly overpays, the shares get hit, any modest earnings accretion touted in the proforma is more than offset by balance sheet leverage and the end result is that for several years, even decent purchases represent a drag on the equity valuation. That is almost always the case with large deals, and it was for Cigna. Not owning Cigna back in 2018, I watched and waited for such time until I determined that operating profits had recovered most of the purchase premium paid for Express Scripts.

In 2024, with the Centene contract fully onboarded, an overall revenue mix will be roughly 85% pharmacy revenues and just 15% pure HMO. Express Scripts will then represent the dominant generator of not just revenue, but also earnings, at Cigna. The current peer group assignment might actually be wrong; instead of appraising Cigna to UnitedHealth, Humana, Elevance etc., it could be equally applicable to compare Cigna to pharmacy benefit managers or drug distributors such as McKesson, Amerisource Bergen and Cardinal Health. Investors doing simple screens of Cigna should be aware of the differences in the business model among sector participants. CI intends to steadily grow out its health maintenance operation, which has good ratings, can leverage benefits through the Express Scrips and Evernorth divisions and is set to grow the HMO business by as many as 5% more customers in 2023, but the clear driver of revenues and earnings is via the pharmacy operations.

In any event, good expense control, maintenance of fiscal discipline and the backdrop of a “flight-to-safety” movement of institutional equity capital towards one of the few investment sectors that poses the likelihood of earnings growth keeps Cigna in the mix of companies of interest. Where Cigna has an opportunity to grow, potentially faster than in the past, is due to inflationary pressures repricing commercial HMO offerings at competing companies, resulting in the premium propositions offered by CI then looking relatively more attractive. Full employment favors Cigna as employers use the higher quality health insurance offerings as an incentive for staff.

The portfolio holds Cigna, along with UnitedHealth, as defensively themed secular investments.

HMO businesses as well as pharmacy benefit managers are experiencing an inflow of funds by institutional investors; they deem these sectors to be havens in an uncertain market. Along with consumer staple sellers, such as discount grocers, as well as airport operators that benefit from vacation, and increasingly, business travel; HMO and PBM managers are one of the few market sectors where a secular trend is normalizing to historically generated earnings growth, ex-Covid 19. Cigna seems to fit in the mix.

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