The Cigna Group (CI-NYSE, $262.87) Contemplates Blowing the Last Three Years of Progress on a Highly Dilutive Acquisition of Humana Inc. (HUM-NYSE, $482.41).

Cigna Group and Humana Inc. shares both fell sharply today on a leaked rumor of a potential combination.

Shareholders of Cigna and Humana were both flummoxed by the simultaneous decline; typically a takeover candidate rises in price on merger news, while the suitor often declines in price due to the takeover premium paid on a deal. The simultaneous decline of both companies is indicative of a transaction that will be done mostly with stock rather than cash.

There are two likely financial reasons for the decline as well as a timing issue.

1.Cigna, based upon 2024 forecasts. is assumed to be capable of generating more than 2X the dollar profit of Humana, but sells for just about 1/2 the P/E of Humana. This wreaks havoc with a stock swap, because in order to provide a takeover premium to Humana shareholders, Cigna must break the bank, insofar as dilution is concerned.

If the markets are envisioning a standard 20% premium on Humana price, to be paid for with Cigna shares, in an all stock deal, then about 2 shares of Cigna will have to be delivered for each Humana share and that increases the total outstanding count on Cigna to almost 540 million shares, up from the current 292.6 million now on the market.

Unfortunately, Humana doesn’t have the profit to justify such a premium, so 2024 earnings per share at the “new” Cigna-Humana would decline by about 24%. That comes about by taking the 2024 forecast numbers by both companies, adding them up and dividing it into the total number of shares post merger. Yes, the new company is larger, as are the earnings, but not even remotely close to the massive increase in shares needed to complete the merger.

2. Cost savings at Humana, to make the deal work in the near tern for Cigna, is almost impossible to model. Cigna does a great business in commercial health insurance and a roaring business in the PBM but is a puny player in government payor insurance and government payor accounts carry low margins. Humana is overwhelmingly weighted towards government payor insurance plans and those margins just cannot be doubled, which is what needs to be modeled for a stock swap to not be dilutive for Cigna.

There is potential for synergies. Cigna could cede its small government payor business to Humana and Humana could shift its small commercial book to Cigna, which would help somewhat. Cigna can greatly improve the PBM volumes on the Humana accounts, as Express Scripts benefits immediately from scale. But to double the profits of Humana? In a single year? It ain’t happening, no way, no how.

3. This transaction is being contemplated prior to a US presidential election, with a potential closing date smack dab in the middle of a debate cycle, and those optics are as bad as may be envisioned. The combined company would be the #1 PBM in the United States, would jump to #1 in the US on commercial accounts and would also be a major player in government payor programs. Again, there is no way that such a takeover/merger would not be front and center for media to lob grenades, for voters to pick up pitchforks, for the government to drag through the mud.

If one were to write a textbook about how NOT to conduct a merger, this would be an ideal candidate for chapter 1.

Low P/E stocks always get punished when buying high P/E companies using mostly or all stock, rather than cash. High interest rate cycles are not the time when one borrows money to buy companies with low profit margins. Doing a large deal that is of concern to both the public and politicians, front and center in an election cycle, with an incumbent government that can make political hay by rejecting a merger, that is almost suicidal.

Should this merger actually proceed, it will take some years for Cigna to restore its earnings to a level previously forecast as a standalone entity

There is no possible avenue for the executive at Cigna to spin a possible 24% EPS decline in the first year, on a post merger basis, as a good deal for existing Cigna shareholders. They can introduce as many pie charts and graphs as they like, all at the behest of the M&A firms that will make billions, even if the deal falls through on regulatory or other points; it is still highly dilutive and that’s what drives stock prices.

There is no possible way to immediately double the earnings from Humana in year one to make a case for such massive dilution in a stock swap.

There is no possible way to borrow $30 billion at a rate low enough to provide a high cash payment to minimize the dilution that comes from offering low P/E stock for high P/E stock. All of the hard work done by Cigna in the past 36 months to simplify the corporate structure, to grow organically without dilutive acquisitions, to offer up a corporate mantra of organic growth rather than acquisitive growth, is apparently for naught.

What management of Cigna will hold out, in addition to pie charts, is the hope of an expanded price/earnings multiple post merger.

But is that likely? Can Cigna, a company growing faster than peers on a revenue basis, with a clean balance sheet but selling for 11X earnings; will that company now gobble up Humana, a company with a P/E of almost 20X, one with much lower margins and realistically expect to obtain a 50% expansion of the price/earnings ratio, when the actual pro-forma earnings are likely to fall off a cliff for at least a year, maybe two?

They will push, super hard, platitudes and phrases like “transformative” and “competitive scale”.

If one considers a transformation to be an 80% increase in the share count, well, then yes, this floated deal will indeed be transformative, should it actually get through regulatory bodies in my lifetime. If one considers a reduction in overall margins for at least a couple of years to be transformative, then again, they are correct. Transformations can be a lot like plastic surgery; the result is certainly a different look, but sometimes the “after” reveal is actually worse than the “before” pictures, for a variety of reasons. The greatest immediate risk in any takeover is overpayment and given the underlying lack of profitability at Humana, Cigna seems to have not read the memo.

Larger, for its own sake, at the expense of profitability, is contrary to the goals of capital return.

Yet, here we are. Now I have seen everything.

https://www.barrons.com/articles/cigna-humana-merger-talks-wall-street-reaction-be05910e?siteid=yhoof2