Carl Icahn’s argument against Cigna merger with Express Scripts

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Carl Icahn doesn’t want the health insurer Cigna’s $67 billion deal with Express Scripts.

Icahn, who recently took a stake in Cigna , wrote in a letter to Cigna shareholders Tuesday that the deal “may well rival the worst acquisitions in corporate history.” Icahn disclosed that he was also short Express Scripts.

Cigna, one of the US largest health insurers, announced the deal in March, offering $48.75 a share in cash for Express Scripts in a move aimed to cut soaring healthcare costs. The $54 billion price tag was a 31% premium to Express Scripts’ stock price at the time and includes about $15 billion worth of Express Scripts’ debt.

In his letter, Icahn highlighted regulatory challenges facing the pharmacy-benefit-manager business that Express Scripts is in. Drug companies and the Trump administration have been calling for the end of the rebate, which is negotiated through middlemen like Express Scripts and passed along to health plans as a way to discount the price of a prescription drug.

Icahn also noted the threat posed by companies like Amazon, which has gotten more involved in healthcare this year, calling it an ” existential threat ” to PBMs like Express Scripts.

“Purchasing Express Scripts may well become one of the worst blunders in corporate history, ranking up there with the Time Warner/AOL fiasco and General Electric’s long-running string of value destruction,” Icahn said in the letter.

Instead, Icahn argued, Cigna would be better off partnering with PBMs like Express Scripts so the health insurer could develop or acquire a PBM when it’s clear what is best suited for the changing healthcare business.

In April, the Department of Justice asked for an extension to gather more information from Cigna and Express Scripts. The 30-day waiting period needed for the deal to close will not begin until all the information has been obtained, and that process can take a while. Cigna’s shareholders are set to vote on August 24 on the deal.

Here’s the full letter:

WHY CIGNA’S INVESTMENT IN EXPRESS SCRIPTS MAY WELL RIVAL THE WORST ACQUISITIONS IN CORPORATE HISTORY

When Cigna entered into this agreement several months ago I believed a $60 billion purchase price made no sense, but there were at least arguments that could be made by management to try to persuade us into thinking that it was not completely ridiculous. These arguments now disappear in light of certain material events of the last month, such as Amazon’s almost certain entrance as a competitor to Express Scripts and the government’s direct challenge to the highly flawed rebate system. As a result, Express Scripts’ earnings will almost certainly be seriously diminished, but even more importantly, Express Scripts will be existentially challenged, i.e., their very existence might well come into question over the next few years. Even if they do survive, exposing Cigna, a thriving company, to these risks by acquiring Express Scripts now is inexplicably ridiculous. Purchasing Express Scripts may well become one of the worst blunders in corporate history, ranking up there with the Time Warner/AOL fiasco and General Electric’s long-running string of value destruction.

It is imperative that every Cigna shareholder vote against this transaction. Today there is only one possible reason that certain Cigna shareholders might vote to purchase Express Scripts – because they want to see it saved and are willing to sacrifice the value of their investment in Cigna to achieve this end.

Cigna is, in my opinion, undervalued because of the fear that this transaction may be approved by shareholders. It is patently ridiculous to pay $60 billion for a company with the problems Express Scripts now faces. I rarely discuss my current market activity but, for the sake of full disclosure, I am currently long Cigna and short Express Scripts stock. I have made this investment because I believe in the rationality of Cigna’s investors. I also hope and believe that many of the Cigna investors that had also owned Express Scripts have already sold much of their Express Scripts stock knowing the pitfalls that company faces if Cigna does not save them.

I believe that Cigna’s management, whose operating skill I respect, would never have paid anywhere near $60 billion for Express Scripts if they had known about the recent events of the last months. Before these events, Cigna had a definitive agreement with Express Scripts stating that the board would support this transaction or pay to Express Scripts a “break-up fee” of $1.6 billion. The only way to end this terrible transaction and not pay the “break-up” fee is for shareholders to vote down the purchase.

We believe that the proposed Express Scripts acquisition exposes the Cigna shareholders to a number of significant risks that management and the board have chosen to recklessly disregard. It is also important to note that these risks have dramatically worsened since the deal was announced.

Regulatory risk – the current administration is particularly focused on bringing down prescription drug prices for consumers and has specifically targeted PBMs as the part of the supply chain that is overearning relative to the value they produce. There is a strongly held belief that the rebate system, which Express Scripts relies on heavily, is a rigged game with conflicting incentives that might actually be pushing up drug prices. The recent proposed rule to remove the safe harbor protection for rebate payments is a clear shot across the bow for the PBM industry and occurred after the signing of the Cigna/Express Scripts merger agreement.

Alex Azar, HHS Secretary, said on May 11th: “The evidence suggests that many companies in the supply chain may actually contribute to, or even encourage, high drug prices, drug price increases and rising consumer costs.” “Some stakeholders—particularly PBMs—suggest that rebates and discounts lower the cost of drugs for Medicare beneficiaries because these concessions drive down the price paid for a medication. However, rebate arrangements may allow PBMs and plan sponsors to benefit from high list prices if rebates are based on a drug’s WAC. To this point, manufacturers contend that rebates encourage them to set higher list prices to account for price concessions down the road.”

We believe this is the start of a concentrated effort to reform drug pricing and eliminate the highly flawed rebate system. Obviously, neither we nor Cigna can know where the ultimate legislation may end up, but the recent moves by the Trump administration have raised the risk level and, by definition, further impaired the value of Express Scripts since the deal was announced. It is our belief that the PBM industry will move to an entirely fee-based model over time, which already exists for some customer groups. Since rebate customers are among the highest margin for PBMs, this shift is very likely to result in significant margin compression.

Analysts Ross Muken and Michael Newshel of ISI Evercore commented – “HHS appears to be following through with its threat to disrupt the drug rebate system – and faster than we had expected….the scope and details are unknown at this point, but the heightened risk and uncertainty should renew pressure on shares of PBMs, distributors and pharmacies, whose economics are driven off of gross price”

Competitive Disruption – the PBM model is ripe for disruption from large scale competitors who may seek to cut them out of the supply chain and lower consumer prices. During the weeks leading up to the deal (when Cigna was busy bidding against itself), Amazon, Berkshire Hathaway and JP Morgan formed a partnership to create a lower cost, more efficient technology-enabled healthcare solution for their employees and eventually 3rd parties as well. With the scale and size of their potential future constituent populations, there is little reason to believe they wouldn’t seek a significant amount of savings from the sourcing of prescription drugs. Although their full plans are not clear yet, this development further increases the risk to the economics of the PBM business model. Even after this announcement, Cigna management seemed unconcerned and repeatedly raised their bid for Express Scripts. To make matters worse, it is important to note that after the acquisition of Express Scripts was disclosed, Amazon announced its acquisition of online pharmacy PillPack which will immediately put it in competition with Express Scripts’ mail order pharmacy business. With their 100 million prime members, Amazon has become one of the toughest competitors in history (feel free to ask the retail industry), while their ultimate healthcare plans are not revealed yet, it is almost certain the first step of a much larger play in the pharma distribution space. Make no mistake, Express Scripts is no Apple and breaking into the PBM ecosystem is not that difficult for a company that already has the systems, the network and the scale that Amazon does. Knowing this, it is absurd for Cigna to now walk into the minefield that Express Scripts might well become.

Post-Anthem margins and customer retention – It’s well documented that Express Scripts will be losing Anthem as a 30% customer in 2020, one which they were clearly overearning on. Management has attempted to quantify the profit impact and pro-forma post-Anthem margins, but we are skeptical that anyone can accurately forecast the impact of losing such a large customer. In addition to the loss of revenues and profits, there are likely to be significant stranded costs and unabsorbed overhead that will have to be addressed over time. Additionally, Express will go from being the 2nd largest PBM by number of scripts to the 4th largest. It’s impossible to forecast what effect this loss of scale will have. Furthermore, Express Scripts most likely gets some benefit from being the last big independent PBM. We see it as likely that, over time, Express Scripts’ customer retention will decline from current levels, particularly as its soon-to-be larger competitors further strengthen and expand their captive PBM offerings. Additionally, if Express Scripts is part of Cigna, a number of customers that Express Scripts now has might well not be willing to deal with a company that is owned by one of their competitors.

Ross Muken from ISI Evercore echoed similar thoughts shortly after the deal announcement – “ESRX’s income primarily comes from mail order pharmacy, which is secularly challenged, and specialty pharmacy, which is increasingly competitive and likely to see gross margin degradation. Further, the two other large PBM competitors have described target PBM margins of 3-5%, so it seems that ESRX’s current core EBIT margins near 6% may be unsustainable”

Deal Price – Each of these risks is significant enough on its own to seriously impair the business and ultimately the value of Express Scripts to the Cigna shareholder. Put together, we cannot fathom how Cigna’s management and board saw fit to pay an all-time high price for Express Scripts with so many unknown risks lying dead ahead. This amounts to nothing more than a huge bail-out for the Express Scripts shareholders at the expense of Cigna’s. The fact that Cigna offered a 30% premium for Express after a 30% run up in the share price indicates Cigna management’s desperation to do a large deal at any price after being blamed for not being willing to fight for the Anthem deal. According to the proxy, amazingly Cigna repeatedly raised their offer against no competition for Express Scripts until, ultimately, they were paying a 60% premium versus where the stock was only 3 months prior. To believe that they can create significant value above this price to the Cigna shareholder is the height of arrogance in my opinion. The modest amount of synergies that flow to the bottom line benefit of the Cigna shareholders do not nearly compensate for the risks we are taking on or the inevitable multiple contraction of the combined company. We do not accept the comparison of the United Health/Optum multiple as a reliable justification for this deal. Optum is only 20% of United Health’s total profits, has much lower external customer mix and does not rely on rebates and mail order nearly as much. It is our opinion that the combined company will likely trade poorly for a prolonged period due to both the challenge and disruption of integrating two large companies and as the threats mentioned above continue to worsen.

Cigna and Express Scripts Standalone Value – As mentioned above we believe that Express Scripts is a company with major problems whose business could well fall off a cliff. Given the significant worsening of several major risks since the deal announcement, we are confident in saying that Express Scripts on a standalone basis would likely be worth less than $60. Though there is a not another standalone PBM to compare Express Scripts to, we note that drug distributors McKesson and Amerisource Bergen are down 17% and 16% respectively since the announcement of the Cigna/Express Scripts deal and that the risks are likely greater in the case of Express Scripts. Applying the 9x P/E multiple that pharmacies and drug distributors currently trade at to Express Scripts’ 2019E ex-Anthem earnings of $6.50 would result in a $58.50 standalone stock price. We find it unconscionable to pay over $90 for a company that today would likely be worth less than $60.

We believe that completing this merger will result in much lower value for the Cigna shareholder than continuing standalone and investing in its own business and PBM capabilities. Since March 7th, the day before the deal was announced to July 31st, Cigna’s stock price is down 7.6% while its non-deal competitors (United Health, Anthem and Humana) are up an average of almost 12% for a total underperformance of almost 20%. If Cigna had simply performed in-line with it comp group, the stock would likely be $215 per share. We believe that if Cigna shareholders vote down the deal and the cash merger consideration and free cash flow were used to repurchase shares, the stock could be worth up to $250 in a reasonable time frame.

We strongly disagree with the idea that Cigna’s only route to offering a more integrated solution is to make a $60 billion leveraged bet on a company with as many challenges as Express Scripts. For example, Anthem formed a five-year partnership with CVS/Caremark to offer a full suite of PBM services while Anthem builds up their own PBM offering, IngenioRx. According to the merger proxy, Cigna and Express Scripts did start discussing a close partnership with a white-label solution. We fail to see how this wouldn’t be a logical first step in increasing the breadth and depth of Cigna’s PBM capabilities at much lower risk, especially while the regulatory and competitive landscapes are in flux. We suspect this option was quickly disregarded because it didn’t serve management’s sub rosa goal of running a much larger company.

The existential threats to the PBM business model over the next few years are undeniable and largely can’t be analyzed with any certainty. Both the pharmaceutical rebate and mail order pharmacy businesses are facing regulatory and competitive challenges that could change both forever. Despite this, Cigna management is offering to pay an all-time high price for a company that, as a result of secular changes, is currently standing on very dangerous ground.

For these reasons, among others, your vote at the special meeting of Cigna shareholders called to consider and act on the Merger Agreement Proposal (as defined in our proxy statement) is very important to the future success of your investment in Cigna. I hope you will join with us in opposing this transaction for the reasons set forth above.

Sincerely yours,

Carl C. Icahn



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