Why Naysayers Are Wrong About the Cigna-Express Scripts Merger

Despite the concerns of certain pharmacy market participants and investors, we see the merger of

Wall Street Journal

report that a well-known activist investor has accumulated a “sizable” equity stake (described as less than 5% of outstanding equity) of Cigna stock and plans to vote against the deal based on concerns related to increased competition from Amazon AMZN, the potential for increased government intervention related to drug pricing, and the weight these issues may have on Express Scripts. We believe these specific and general market concerns are off base, and we reiterate our positive outlook for the combined company.

We believe the new entity will be a formidable force in healthcare that will be able to wield significant pricing power and leverage major scale advantages. We expect Cigna will be able to build a more powerful business through the merger and improve upon its current no-moat rating, while Express Scripts will gain a strong foundation from which to expand its services, cross-sales, and wide economic moat. Given the discount at which Express Scripts trades to our $89 stand-alone fair value estimate and Cigna’s approximate $92 offer price, we believe investors have an opportunity to acquire shares of a strong wide-moat healthcare services player at a material discount. Additionally, we are reiterating our $160 fair value estimate for Cigna.

Both companies reported strong second-quarter results that we believe showed businesses performing at solid levels, reinforcing our positive outlook for a Cigna-Express Scripts healthcare services behemoth. We would highlight that Express Scripts increased its expected client retention rate to 97.50%-98.50% from 96%-98%. This outlook was boosted by a strong selling season for the pharmacy benefit manager, which in our opinion points to a base of clients that see value in the services they receive from Express Scripts.

We also note that the majority of these clients are large, sophisticated insurance companies, employers, and government-sponsored programs that usually have their PBM contracts audited by consultants annually. Thus, the vast majority of Express Scripts’ clients know the exact financial and operational dynamics of their relationship with the PBM, and most have chosen to renew their services. This fact is a direct counter to many drug market stakeholders’ concerns about Express Scripts extracting an exorbitant amount of value from its clients.

Nevertheless, many investors have questioned Cigna’s motives and strategy with concerns related to the viability of the PBM business model. We believe these concerns are unwarranted. Express Scripts’ approximate 1.7 billion adjusted prescription claims makes it the largest PBM in the United States and gives it approximately 28% market share. This means more than one fourth of all prescriptions in the U.S. are managed by Express Scripts. This dynamic gives the company two key advantages--superior supplier pricing leverage and centralized cost scale--that Cigna will own once the merger closes.

Below we address a few of the top-of-mind concerns investors have related to Express Scripts’ business model.

(1) Most branded rebates flow to the client.

Express Scripts does not make all of its profit from branded rebates. The client dictates how the PBM is compensated and chooses how much of its branded rebates it will pass to Express Scripts. In certain cases, the client passes on a specific percentage of rebates to Express Scripts in lieu of other fees. In many cases, the client asks for all rebate dollars to be passed through and compensates Express Scripts with other fees or increased spread retention of generic discounts. In fact, Express Scripts has reported that 90% of all rebate dollars and 95% of all discounts are passed to its clients.

We would also highlight that the generic fill rate (the percentage of prescriptions that are generic) for Express Scripts and its PBM peers has increased significantly over the past decade, moving from less than 50% during the early 2000s to close to 90% today.

(2) The overall cost of pharmaceuticals is significantly lower for Express Scripts’ clients.

Express Scripts reported that its drug trend (a metric that incorporates pricing and utilization) through the first half of 2018 was 1.1%, well below the national average and on track to eclipse its already low 2017 mark. This compares favorably with the high-single-digit growth in drug costs the U.S. has experienced over the past several years. The company also mentioned that the use of its drug plan management programs has steadily increased for 2018. We believe this is a major contributing factor for the impressive trend run rate and further locks clients into the company’s services.

(3) Potential competition from Amazon is not a doomsday scenario.

Speculation that Amazon will disrupt the pharmaceutical space by leveraging its impressive capital war chest and customer servicing expertise has caused great concern regarding the viability of PBMs. However, unlike other markets that rely on demand/supply cycles, the healthcare space is driven by a reimbursed compensation system predicated upon risk-based insurance underwriting. In addition, we believe many analysts miss a key point: The true end customer in the space is not the consumer of drugs, but rather the insurer, employer, or government that pays for the health benefits of the consumer. Accordingly, the expertise needed to profitably navigate the space precludes an easy entrance into the arena. We believe Amazon lacks this expertise and may not find it advantageous to venture into health insurance underwriting. We see three key variables that are overlooked when market participants and other stakeholders analyze the potential for new meaningful competition in the pharmaceutical market.

(a) Customers.

The true customers along the chain are businesses and other providers of health benefits, not consumers. Providers of health benefits make almost all decisions regarding drug and pharmacy access. Businesses also source and supply all drugs in partnership. This business-to-business market has developed because the use of drugs is health insurance-based to treat medical ailments and not a consumer demand cash-pay market. We estimate that less than 5% of all prescriptions are paid by the consumer directly on a cash-pay basis, or without insurance. This dynamic would take many consumer-based companies that have built their success in a consumer demand-driven market outside of their core competencies if they were to get involved with the pharmaceutical space.

(b) The price of pharmaceuticals.

Some market participants believe Amazon can instantly enter the space and cut the price of drug products right away. However, the actual prices of drugs are already low, given the massive amount of buying power the PBMs, drug wholesalers, and retail pharmacies have accumulated. A new entrant would hold a minuscule amount of purchasing power compared with the massive joint sourcing ventures that have developed over the last handful of years. Thus, the level of generic drug discounts and branded drug rebates a new entrant could command would pale in comparison with the major pharma supply chain players and make it difficult to be price-competitive.

(c) Access to a global supply of drugs is required.

To be a viable player in the PBM space, access to every legitimate drug is required through relationships with retail pharmacies and drug manufacturers. Due to the variability and demands of health insurance products, a viable PBM player needs access to the plethora of drugs that are manufactured across the world. This level of access has already been achieved by the major drug market services players; if a new entrant cannot reach this level, it will not be an option for the clear majority of drug benefit providers, sellers, and purchasers of pharmaceuticals.