I think it’s fair to say that the general reaction to Cigna (CI) rejecting  Anthem’s (ANTM) $184 a share takeover offer has been disappointment. Cigna’s share price, which shot up on news of Anthem’s bids of $175/share and $184/share, has come back down to earth lately. As you can see below, Anthem’s share price exhibited the same trend, albeit far less pronounced. Some have accused Cigna’s board of greed , citing the takeover offer’s 34% premium to Cigna’s unaffected share price.
I have a different take. Anthem buying Cigna would’ve have meant one company financing the acquisition of an not-much-smaller, better-run, fiscally-sounder company with $30 billion in debt. I’ve written before  that Cigna is a strong candidate for long-term investment, and I still believe in that thesis. Anthem buying Cigna would take away a quality opportunity.
While Cigna’s board may have rejected Anthem’s offer because they genuinely felt lowballed or were trying to protect their top executives’ jobs, I suspect another motivation. In their rejection letter, Cigna’s board listed as reasons to reject the deal Anthem’s perceived lack of a growth strategy, their membership in Blue Cross Blue Shield, and a data breach earlier this year. Keep in mind, this is coming from a company whose CEO thinks  they can double their size in eight years. I think Cigna’s rejection stems largely from a well-founded belief in its own future. The company’s revenue growth is expected to be about 8-10% this year and next, leading to 7% earnings growth this year and 11% next year.
Why I Like Cigna So Much
Let’s start by taking a more detailed look into Cigna and Anthem using Stock Rover. First, as shown below, Cigna has the best margins of the “Big Five” health insurers, and by a pretty decent stretch. Their returns on capital are similarly near the top of the pack, along with the largest insurer, UnitedHealth (UNH). Anthem performs about half as well as Cigna in both margins and returns on capital. Looking only at this chart, one would think Cigna should be in charge of a merged Cigna-Anthem operation.
Another area that separates Cigna from Anthem is the balance sheet. Their Debt/Equity ratios are comparable – 0.6 for Cigna and 0.7 for Anthem – but that fails to tell the whole story. When we take out intangibles left over from prior acquisitions, Cigna still has equity, $5 billion worth. Anthem’s tangible equity, on the other hand, is $1.6 billion in the red. Cigna has more cash than Anthem – $2.8 billion to $1.4 billion – and less debt – $5 billion to $14.8 billion. Anthem’s interest expense is almost twice Cigna’s. Cigna has a debt/tangible equity of 1.0, Anthem’s is negative because they have negative tangible equity.
Now take Anthem’s balance sheet, and add $30 billion worth of debt.
To be clear, I’m not projecting bankruptcy or anything like that. The health insurance business is still a good one to be in, and consolidation should help the big five increase their profits. My point is simply that an Anthem takeover would result in a new company laden with debt where two companies not unduly laden existed before. I see three other potential problems with the attempted takeover: the two company’s relative size, possible negative market reaction to a deal, and regulatory rejection.
Anthem is trying to buy a company that by many measures isn’t much smaller than it is. Where Anthem dwarfs Cigna is in revenues, where Anthem brings in $75 billion compared to Cigna’s $36 billion. But if you look at EBITDA, that gap narrows considerably: Anthem brings in $6.3 billion to Cigna’s $4.2 billion. Anthem’s market cap, around $42.5 billion, isn’t much bigger than Cigna’s current cap of $39 billion, or their pre-takeover-rumor cap of around $35 billion. By Enterprise Value, which designed to model theoretical takeover cost, Cigna is actually bigger than Anthem, $43 billion to $38 billion. The two companies would have about the same EV using Cigna’s unaffected share price. This explains much of why Anthem’s balance sheet would come under heavy strain if the company buys Cigna.
Beware The Aetna Effect
Under the terms  of Anthem’s offer, Cigna shareholders would receive 31% of their compensation in Anthem equity. The problem with this is that if the new company is widely perceived as being weak, Cigna shareholders could end up with less value than initially announced in the deal. Aetna’s (AET) acquisition of Humana (HUM), announced last week, is funded by $125 a share in cash and 0.8375 Aetna shares. At the time of the deal’s announcement, that combination was worth $230 a share. But since then, Aetna stock has dropped 10%, cutting the value of the package by almost 5%. If the market reacted similarly to an Anthem/Cigna deal, Cigna shareholders could be in for disappointment. If the market sees the same problems in the resultant company from an Anthem/Cigna acquisition that I do, Anthem’s share price, and thus the deal’s value, could both fall.
Regulators Step In?
Throughout all of this is the possibility regulators will block any or all mergers, or force companies to divest some divisions for local competitive reasons. Already, this possibility is affecting market reaction to the Aetna/Humana deal: Humana is trading around $185/share, considerably less than the Aetna offer for it. If that offer falls through for whatever reason, I expect Humana shares to fall pretty precipitously. Cigna’s share price could be subject to lots of volatility going forward, depending on how merger negotiations stand.
Ok, Now What?
To find the optimal play for this situation, let’s break it down into a couple of scenarios.
Scenario one is that there’s no deal: Either Cigna and Anthem never come to terms, or they do, but regulators break them apart. In either of these situations, current owners of Cigna would be well-served getting out now, taking an 8% return over unaffected share price, and looking to get back in after the dust settles. If you’re looking to get into Cigna but you don’t think there will be a deal, I would hold off for now, but once the dust settles, Cigna is still a strong investment opportunity.
Scenario two is that there is a deal, but that the resultant company is weak. One way this could come about is that Anthem raises its bid to, say, $200 a share, putting its balance sheet under greater strain. In this case, owners of Cigna may still make some arbitrage profit, but that profit will come with the risk of a big selloff of the resultant company’s stock. This would be a similar situation to what just happened to Aetna after the Humana deal.
Scenario three is that there is a deal, and it’s a merger rather than an outright acquisition. This spares Anthem balance sheet pain, and brings on some of Cigna’s high-performing management. If you think this is the more likely scenario, buy Cigna, then happily take your premium and equity in a new Anthem/Cigna merged unit.
Thanks to Alexander Valtsev  for his strong article on the Anthem takeover proposal. Some of my figures, for example, the $30 billion in new debt, are taken from his article.