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

Introduction

On July 9, the Federal Trade Commission (FTC) released its “interim staff report on prescription drug middlemen“, detailing how Pharmacy Benefit Managers (PBMs) profit on both sides of the trade – by driving up drug prices and putting pressure on smaller, non-chain pharmacies. Of course, this is nothing new to anyone who has studied the business model of PBMs like Express Scripts, which is owned by The Cigna Group (NYSE:CI), but regulatory and media attention is obviously increasing.

The New York Times, for example, published a rather detailed article on the subject three weeks ago, referring to PBMs as “The Opaque Industry Secretly Inflating Prices for Prescription Drugs“.

Similarly, OptumRx (owned by UnitedHealth Group Inc., UNH), Caremark (owned by CVS Health Corp., CVS) and Express Scripts are facing lawsuits related to their role in negotiating insulin prices.

In addition, Express Scripts – along with OptumRx – is facing a lawsuit in connection with the opioid crisis in Arkansas, alleging that the PBMs knowingly contributed to the precarious situation. After all, Arkansas had the nationwide second-highest opioid prescription rate in 2016.

Quite obviously, PBMs are coming under increasing scrutiny and as a shareholder of The Cigna Group, I naturally have an interest in this topic. Therefore, in this update, I will share my perspective and explain how I see the potential impact on CI stock.

However, I would like to make it clear that this article should not be misconstrued as taking sides in favor of inflated drug prices and ripping off employers, patients and taxpayers. I simply want to offer my opinion on the potential impact of this obviously changing environment on Cigna in general and its PBM Express Scripts in particular.

How The Changing Environment Could Impact Cigna’s Earnings And Dividend

According to the NYT article, not many people even know that PBMs exist, let alone understand the role they play in the American healthcare system. In many cases, the existence of PBMs only becomes apparent when serious issues arise. Accordingly, PBMs are unlikely to face a significant risk of contract cancellation from individual patients. It is clear that individuals also have the least leverage.

Employers and government agencies that negotiate agreements with PBMs do not necessarily have an incentive to terminate their contract with a particular PBM due to, among other things, lock-in effects – an aspect that I believe is an important contributor to the economic moat of PBMs. I don’t think it’s a stretch to conclude that OptumRx, Express Scripts, and Caremark operate in a highly consolidated oligopoly – managing prescriptions for more than 200 million Americans.

However, it is well possible that the government will increasingly intervene to limit the profitability and growth of PBMs. Below, I will attempt to model the potential impact of a decline in PBM revenues on segment and consolidated earnings, as well as on the dividend payout ratio and valuation of CI stock.

As mentioned above, Express Scripts is Cigna’s PBM business, which in turn is part of the Evernorth Health Services segment. The other reportable segment is Cigna Healthcare (see my previous articles for more details on the company’s operations).

In 2023, Evernorth Health Services was responsible for approximately 75% of Cigna’s revenue before negative corporate sales and intersegment eliminations (Figure 1), having generated more than $153 billion and once again delivered solid growth (9% year-over-year). Last year, Evernorth generated gross profit and adjusted pre-tax operating income of $9.9 billion and $6.4 billion, representing gross and operating margins of 6.5% and 4.2%, respectively.

The margin profile, which clearly illustrates the high-volume nature of the PBM business, is shown in Figure 2 (blue bars). However, it should be noted that the loss of $1.7 bn (corporate) is not included in these margins. Therefore, and knowing the size of the PBM business, Evernorth’s actual pre-tax operating margin is probably closer to 3.5% (red bars in Figure 2). Intersegment sales of around $5.7 billion (3.7% of Evernorth segment sales) would tilt the equation again to a slightly higher margin, but for the sake of brevity, I will not elaborate on this aspect here.

Of course, Evernorth also includes businesses that are not directly related to PBM services, such as eviCore Health and a number of digital solutions like Evernorth Behavioral Health and MDLIVE. However, considering that pharmacy revenue accounts for nearly 93% of segment revenue, I wouldn’t over-interpret their contribution – especially from a bottom line perspective. Viewed differently, considering Evernorth Health Services as a pure PBM, the subsequent sensitivity analysis has a built-in conservative bias.

Figure 3 shows how Evernorth’s pre-tax operating profit and Cigna’s consolidated net income would be impacted by a decline in revenue in the Evernorth segment and after accounting for a decline in segment margin.

Specifically, I modeled scenarios with revenue declines between 5% and 35% from 2023 levels and assumed a segment margin compression between 10 basis points (5% revenue decline) and 70 basis points (35% revenue decline). Although it would be more realistic to model some decline with a contraction of the business, I have conservatively assumed that the company’s overheads attributable to Evernorth remain unchanged. We see that Evernorth’s segment profit declines between 7% and 46% when the company’s overhead is excluded (blue bars), while the decline is up to 57% when the company’s overhead is included (red bars).

However, due to the Cigna Healthcare segment, which makes a significant contribution to earnings, consolidated net profit would fall less sharply than the Evernorth segment’s earnings. In the worst-case scenario – which I consider to be extremely bearish – Cigna’s net profit would fall by 32%.

If we now look at Cigna’s dividend payout ratio (blue bars in Figure 4), it is clear that the dividend remains very safe even in the worst-case scenario and there is still plenty of room for growth. Of course, the scope for debt reduction and share buybacks, which have played their part in EPS growth in recent years (see my previous articles), is increasingly limited.

Cigna stock currently trades at less than 13 times 2023 adjusted earnings, or a blended price-to-earnings ratio of 12.4, according to FAST Graphs. In a worst-case scenario, the ratio would rise to 18.7 times earnings (red line in Figure 4).

In my view, the risk of government intervention in Cigna’s PBM business is the main reason for the current valuation. How else could a P/E ratio of 12.8 be considered reasonable for a company that has grown its profits by almost 14% annually over the long term (Figure 5)? There is definitely something to the saying “the market is always right”.

Taken together, and given that the scenarios modeled are most certainly way too conservative, I can understand why the market has not reacted to the recent news. The impact on Cigna’s earnings is significant, particularly in the high revenue decline scenarios, but lower than expected due to the comparatively low margin nature of the PBM business and good diversification. Given the extremely strong cash flow conversion (see my previous articles and Figure 6), I believe the conclusions are directly transferable.

Entertaining The Possibility Of A Drastically Changing Environment For PBMs – Another Reason Why I Favor Cigna

Having already discussed what I believe would be a manageable impact on Cigna’s earnings even in the highly unlikely event of a double-digit decline in Evernorth’s revenues, I would like to highlight another reason why I am a convinced Cigna shareholder.

As readers of my previous coverage of Cigna know, I thought long and hard about which of the three companies operating a PBM I wanted in my portfolio. In the end, I chose Cigna, primarily because it represents the best compromise of operational quality and valuation.

Of course, UnitedHealth is a very high-quality company, but I always found it too expensive for my taste – despite its slightly better fundamentals.

Compared to CVS, I found Cigna to be operationally much stronger and better managed, but of course CVS is in a rather difficult situation, having evolved from a retail pharmacy chain. On a side note, with that in mind, management (especially former CEO Larry Merlo) definitely deserves credit for diversifying early into the insurance and PBM business, thereby leveraging its strong retail presence.

Valuation aside – which I see as much more compelling in CI’s case compared to UNH – I think this most likely changing environment requires a strong foundation to adapt. Should the government get involved in the PBMs’ business, at least temporary pressure on margins is likely (see above), and with it weaker debt servicing capacity and ultimately less scope for cash returns to shareholders (buybacks and dividends). The current interest rate environment is also playing its part in this context.

I have discussed Cigna’s balance sheet in my previous articles and also took a good look at the company’s investment portfolio during the 2023 banking crisis. So, for the sake of brevity, I will only provide a brief update here.

The discipline to focus on debt reduction can be seen in the development of net debt, which fell from almost $32 billion at the end of 2019 to $22 billion at the end of 2023 (Figure 7), despite share buybacks of almost $18 billion in the last three years. No wonder that rating agency Moody’s upgraded Cigna’s long-term credit rating by one notch to Baa1 in April 2021 and has maintained the stable outlook ever since.

Based on the balance sheet for the first quarter of 2024, Cigna’s net debt in relation to free cash flow (three-year average) is only around 2.6 times. The interest coverage of almost eight times pre-interest free cash flow is similarly reassuring. I have already referred to the low dividend payout ratio – based on net earnings – above. In terms of free cash flow, however, things look even better – in 2023, Cigna paid out less than 15% of its free cash flow after stock-based compensation and working capital adjustments.

Finally, Cigna has a well-spread debt maturity profile (Figure 8), and its current weighted-average interest rate is only around 4.2%. Given the similar interest rates for the buckets coming due over the next years, it would be unreasonable to expect a significant weakening of debt serviceability – even if interest rates remain at current levels.

Gauging The Impact Of Opioid Litigation On Cigna

In my view, Cigna’s strong cash flow and solid balance sheet will help it navigate this changing environment very well, so strong dividend growth and share buybacks are likely to continue. For the same reason, I would not over-interpret the opioid lawsuit in Arkansas.

So far, Cigna has not explicitly listed opioid-related litigation in the risk section of its 10-K report, nor has it made any provisions for it. While this is good news in itself, I still wanted to gauge the potential impact of opioid litigation on Cigna.

To that end, I took a look at the most recent 10-Ks of pharmaceutical distributors McKesson Corp. (MCK) and Cardinal Health, Inc. (CAH) – recall the settlement together with Cencora, Inc. (COR, formerly AmerisourceBergen Corp.) and Johnson & Johnson (JNJ) to pay $26 billion to resolve opioid-related lawsuits.

McKesson estimated in its fiscal 2024 10-K (p. 34) its total liability for opioid-related claims at $6.8 billion, of which $665 million was expected to be paid in fiscal 2025. McKesson currently generates more than $4 billion in free cash flow annually. Cardinal Health’s fiscal 2023 10-K shows $5.9 billion in accrued liabilities, which are detailed on p. 68 of the report. The company currently generates around $2.5 billion in free cash flow.

In view of the fact that the settlements are paid over several years, limiting the impact on annual earnings and cash flow, and given the manageable ratio between the opioid liability and annual free cash flow (1.7x for MCK and 2.4x for CAH), I don’t think the risk to Cigna is material.

Of course, there is no way to accurately determine the potential liability, but even if we assume that Cigna would have to pay $5 billion – which would represent an unrealistically high percentage of the combined settlement of CAH, COR, JNJ and MCK – the impact seems very manageable. I believe it is realistic to expect the settlement to be paid over a ten-year period, which would only reduce annual free cash flow by approximately $500 million (<5% of 2023 free cash flow after adjustments) – an immaterial impact on Cigna’s balance sheet and earnings power.

Conclusion

The recent FTC report, as well as the New York Times article on PBMs, suggest that the regulatory environment for PBMs is likely to become increasingly challenging. Cigna, which acquired Express Scripts in 2018, would be significantly impacted by the new regulations, as would competitors UnitedHealth (OptumRx) and CVS Health (Caremark).

At first glance, the 75% revenue share of Cigna’s Evernorth Health Services (which primarily includes PBM-related revenue) suggests a large downside risk. However, given the comparatively low profitability of the segment and even with some very conservative assumptions, the impact of margin and revenue reducing regulations seems manageable. Even if we assume that Evernorth’s revenues decline by 35% – which is an unrealistically pessimistic assumption – the implied valuation of CI shares would only increase from the current 12.8x to 18.7x earnings. In my view, the market priced in increased regulatory pressure on PBMs a long time ago – how else could a current P/E of less than 13 be justified for a company that has grown its earnings by almost 14% annually over the last 20 years?

Importantly, the dividend payout ratio in relation to net income would likely remain below 30% even in the worst-case scenario. Given Cigna’s excellent cash flow conversion, the cash-related impact would likely be even lower.

In addition, and in light of the recent news that Cigna could now also be held accountable in connection with opioid litigation, I consider the robust balance sheet, balanced maturity profile, and low-interest rate sensitivity to be further factors that make me to sleep very well as a CI stockholder. The impact of impending opioid-related litigation was found to be very manageable – even in the event that Cigna was ordered to pay a disproportionately high payment – in terms of the 2021 settlement of CAH, COR, JNJ, and MCK.

Thank you very much for reading my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there’s anything I should improve or expand on in future articles, drop me a line as well. As always, please consider this article only as a first step in your own due diligence.