Fresh Look at Managed Care Results in Moat Upgrades

We’ve taken a fresh look at the managed-care industry and have come away a bit more constructive on health insurers broadly. We raised our economic moat ratings for UnitedHealth Group UNH to wide from narrow and for Cigna CI to narrow from none. We also revisited our industrywide negative moat trend outlook and bumped UnitedHealth up to stable. To CVS Health CVS and Cigna we now assign positive trend ratings, largely attributable to the competitive benefits we expect these businesses to achieve through their integrations of Aetna and Express Scripts, respectively.

We raised our fair value estimate for UnitedHealth to $300 per share from $218, largely driven by our moat upgrade and more optimistic longer-term assumptions for the franchise. We think UnitedHealth is uniquely deserving of a wide moat rating because of the cost advantages and network effects embedded in the largest private health insurance organization nationwide. Unrivaled scale allows UnitedHealth to price its insurance book commensurate with the lowest cost per insured member of the companies we cover, which has led to industry-leading gains in membership over the past five years.

We think Cigna’s merger with Express Scripts has created an organization that deserves a narrow moat rating. As a result, we raised our fair value estimate to $231 per share from $160. While we think the combination of medical and pharmacy benefit management is strategically sound, underpinning our positive trend rating, integration execution will be critical for continued stock outperformance from here.

Finally, we trimmed our fair value estimate for CVS to $92 per share from $96 to account for recent results. Management’s outlook for 2019 came in below our expectations, largely attributable to weakness at the no-moat retail and long-term care segment. We think the Aetna transaction will ultimately lead to an improved competitive position, which appears to be trending ahead of initial expectations.

We’d point investors toward UnitedHealth and CVS as our highest-conviction ideas trading at the most compelling discounts to our revised estimates of intrinsic value. With UnitedHealth currently trading near 16 times our estimate of 2019 adjusted earnings, investors have the opportunity to buy an above-average business at a below-average valuation. The company’s more diversified operations make it less prone to regulatory disruption than peers, in our view, and its leading positions in insurance, ambulatory care, data and analytics, and pharmacy benefits give it advantages that competitors will find hard to replicate. A best-in-class business, combined with exemplary stewardship, gives us confidence in the long-run trajectory of the company, which we think should be a staple in investors’ healthcare portfolios.

The outlook for CVS is a bit more muddied, as the company’s pharmacy business catering to the long-term care market continues through a period of prolonged weakness. We don’t view this as core to the company or our thesis and would encourage investors to look through this volatility toward the longer-term earnings power of a combined CVS and Aetna. We think this transaction puts the company nearest UnitedHealth in terms of competitive positioning, although its reliance on pharmacy and PBM operations make it somewhat more prone to regulatory disruption. With the stock trading below 10 times our estimate of 2019 adjusted earnings, the market appears to be taking a too pessimistic view, in our opinion; despite our reduced fair value estimate, the stock remains in 5-star territory.

While we like the strategic decision to bring Cigna and Express Scripts together, we think the company is the most exposed to idiosyncratic risk out of these three businesses. Express Scripts will account for roughly 50% of companywide operating profit, by our estimate, leaving it most exposed to policy-driven changes percolating within the PBM industry. In addition, the transaction was completed on the cusp of Express Scripts losing its largest customer, Anthem. While management took this into account in its evaluation and valuation of the business, it likely opens the door to incrementally more unknowns than a run-of-the-mill megamerger. Given our relatively higher estimate of uncertainty for Cigna, we think CVS and UnitedHealth offer more attractive risk-adjusted returns for investors.