Cigna Group: Weaker Than Peers But Still A Buy (NYSE:CI)

Introduction

This will be the third and last article of my three-part series on three big health insurance providers in the U.S. I will link the first two articles here because I will refer to both of them several times throughout this article:

• Humana: Recent Selloff Might Present A Buying Opportunity
• UnitedHealth Group: Attractively Priced Compounder But Regulatory Risks Remain

This article will focus on The Cigna Group (NYSE:CI). Since I covered the most important topics regarding health insurance and the healthcare services market in my Humana (HUM) and UnitedHealth Group (UNH) articles, this article will be shorter than the other two. I will refer to the previous articles or quote from them when needed. I recommend reading both of my previous articles to avoid any misunderstandings.

This is officially the last article of this series. However, as I got a good overview of the two aforementioned markets while writing these articles, I plan to write two more on CVS Health (CVS) and Elevance Health (ELV) in the near future.

Business Overview

Cigna operates in two segments: Evernorth Health Services and Cigna Healthcare. The following slide gives a quick overview of what these two segments do:

This is the same kind of segment reporting that we have seen at UNH. UNH reports for the Optum segment (the equivalent for Evernorth) and the UnitedHealthcare segment (the equivalent for Cigna Healthcare).

Another similarity between the two companies is that they both report what is called intersegment revenue. This is revenue that is billed from one segment to the other and has to be deducted in the consolidation process.

Here is a screenshot from the segment reporting in the recent FY2022 10-K:

What I think is interesting is that compared to UNH, intersegment revenue is pretty low. Evernorth only billed $4.5 billion to other internal segments while billing $135.8 billion to external customers. In comparison, Optum (UNH equivalent segment) billed a total of $185.5 billion with only $74.4 billion being external revenue. This is a huge difference so I wondered how this is possible. I looked at what kind of revenue Cigna reports for Evernorth. Here is a slide from the FY2022 financial supplement document:

Here we can see that from the $140.3 billion revenue, $133 billion was “pharmacy revenue” and $7.3 billion was Fees and other revenues. This doesn’t help us. Here is another overview from the FY22 10-K report showing what products and services Evernorth offers:

Evernorth contains Pharmacy Benefit Management (PBM), Home Delivery Pharmacy, Specialty Pharmacy, Distribution and Care Delivery and Management Solutions. The aforementioned pharmacy revenues should include everything except Care Delivery and Management Solutions revenues.

We know that Cigna bought Express Scripts at the end of 2018. Express Scripts was one of the largest PBMs in the U.S. and also included Accredo, the specialty pharmacy business. Evernorth external revenue jumped from $5.4 billion in FY2018 to $94.1 billion in FY2019 so it is safe to say that most of Evernorth’s revenue should come from the PBM, home delivery and specialty pharmacy business (this can also be seen in the thin margins for the Evernorth segment compared to UNH’s Optum). In the most recent Q2 2023 earnings call, CEO David Cordani said that Accredo (specialty pharmacy) was a $30 billion business when Cigna bought Express Scripts and is now close to a $60 billion business, making up around 40% of Evernorth revenues.

This still doesn’t explain why intersegment revenue is so low for Cigna compared to UNH though. I think the answer lies in the membership structure of the health insurance business, so let’s cover that segment now.

Cigna Healthcare

As I did in my other two articles, I want to start with an overview of Cigna Healthcare Memberships. Here is the overview from the most recent Q2 2023 financial supplement document:

It’s very interesting to see how the membership structures differ from the different health insurance providers. As a reminder: Humana has strong exposure to the Medicare Advantage market and military “services only memberships” while UnitedHealth is broadly diversified. Here we can see that Cigna Healthcare’s memberships are mainly “services only” memberships.

Quick reminder: Services-only refers to Cigna only doing administrative services like handling claims without assuming the risk of both medical and administrative costs for its customers.

Since Cigna is only providing services, the margins for Cigna Healthcare are way better than for example for UnitedHealthcare (I will come back to this in the “Financials” section).

Here is a table showing the development of the membership structure since 2017:

We can see that there was very little membership growth from 2017 to the end of 2022. TTM is referring to Q2 2023. Here we can see that Medicare + Medicaid and Commercial – Services only have shown quite some membership growth. Overall though, I have to say that the membership growth is mediocre. Just take a look at the much bigger UnitedHealthcare which grew memberships with a CAGR of 6.4% from 2016 to 2022 (Cigna’s CAGR from 2017 to 2022 was just 1.9%).

I think the high exposure to services-only memberships is a blessing and a curse at once. They deliver very good margins which is positive but on the other hand, they are very hard to grow. We have seen the same thing at Humana with the military services-only memberships. Humana was able to acquire a TRICARE contract in 2018 that doubled those memberships from one year to the next but besides that, they were unchanged since 2016 (and the possibility that the military changes the service provider after the contract ends is still there). I think there is just no real outlook for organic growth here and it shows.

Now I want to end my discussion on the intersegment revenue being very low for Cigna. As I said earlier, UNH bills a lot of Optum revenue to the healthcare division which Cigna doesn’t seem to do. I think this also comes down to the fact that the memberships for Cigna are mainly services-only, meaning that Cigna doesn’t/can’t put priority on its own healthcare services division (remember: They only do administrative work). I guess that Evernorth would bill much more revenue towards Cigna Healthcare if the medical memberships were risk-based rather than fee-based.

In conclusion, I am not impressed by Cigna’s health insurance segment. Memberships didn’t really grow over the past few years and the services-only focus of memberships might make it hard to grow in the future.

As a side note: Cigna seems to see it the same way. Management separates the business into two categories: “Foundational growth” (meaning slow growth) and “Accelerated growth” (meaning faster growth). As can be seen in the slide from the investor presentation below, the whole segment except for “U.S. Government” (mainly Medicare + Medicaid) is categorized as foundational growth:

I don’t think we can expect very much growth here.

Evernorth Health Services

I already gave an overview of the Evernorth segment earlier so I will keep this short. I want to focus on the slide above and how Cigna’s management categorizes Evernorth into the overall growth strategy.

So the PBM business is categorized as foundational growth. I will refer to and quote my article on UNH where I wrote the following regarding UNH’s PBM business Optum Rx:

I think that this is a pretty straightforward segment. In my most recent article, I outlined that the elderly population (the ones who should make up the largest part of pharmacy spending) in the US is expected to grow with a CAGR of 3.6% until 2030. Additionally, I guessed that the pricing power for such non-discretionary spending should allow for price increases a bit above GDP growth at around 4%. This would result in around 7.6% growth in the future. Interestingly, this is exactly the kind of growth Optum Rx has been able to achieve over the past five years. External revenue grew from $26,801 million in 2017 to $38,837 million in 2022 (CAGR: 7.7%).

Source: Author’s article on UNH

I think that all of this holds true for Cigna’s PBM business.

The specialty pharmacy segment is listed under accelerated growth. According to this article from McKinsey (January 4, 2021), the specialty pharmacy market was expected to grow with a CAGR of 5-10% from 2019 to 2022. This is right in line with my aforementioned forward assumptions regarding the PBM business. Accredo has been able to outpace this growth rate. Cigna’s CFO Brian Evanko mentioned the following in his opening remarks on the most recent Q2 2023 earnings call:

Evernorth’s results in the quarter were driven by continued strong performance in our differentiated specialty pharmacy business, which had year-over-year revenue growth in the mid-teens, and our focus on providing a variety of solutions that drive affordability and lowest net cost for our customers and clients.

Source: Seeking Alpha – Q2 2023 Earnings call transcript

Accredo grew faster than the overall pharmacy market, probably due to market share gains and the fact that specialty pharmacy has seen a trend of making up a bigger part of total pharmacy prescription revenues. According to the same article from McKinsey I linked earlier, specialty pharmacy is expected to make up 44% of pharmacy prescription revenues in 2023, up from 24% in 2013. Accredo’s position and growth in this market is one of Cigna’s strengths.

“Evernorth Care Services” is labeled as accelerated growth. This is directly comparable to UNH’s Optum Health segment so I will again just refer to my article on UNH (specifically the Growth prospects – (2) Optum Health chapter). For your convenience, I will outlay the main points again: According to an article by McKinsey, Healthcare provider EBITDA was projected to increase from $249 billion in 2021 to $325 billion in 2025. This would be a CAGR of around 7%. UNH was able to achieve much higher growth rates through M&A activity. Even without any M&A, the underlying healthcare industry is already growing at 7% per year. Any kind of M&A activity presents upside potential.

In conclusion, Cigna’s Evernorth segment looks strong. This is where the potential future growth should come from so investors should focus on the Evernorth segment’s results going forward. I assume that Cigna may be able to outpace the already good industry growth prospects due to Accredo’s positioning in the market for growth rates in the high single digits.

Financials

As I usually do, I want to start by taking a look at the balance sheet. Here is the balance sheet that was reported in the most recent 10-Q filing for Q2 2023:

Cash and investments amount to a total of $10.5 billion while short and long-term debt amount to $32.7 billion for a net debt position of $22.3 billion. Compared to Humana and UNH, this is the weakest balance sheet we have seen so far. Humana had a net cash position of around $2 billion when I wrote about it in the middle of July. UNH has a similar net debt position of $19.3 billion but generates more than double the net income.

Cigna’s TTM net income (adjusted) currently stands at $6.81 billion so that net debt is more than three times net income. For UNH, net debt is below one year of net adjusted earnings. While debt levels are not concerning, I have to point out that Cigna has the weakest balance of the three companies I covered so far.

Next, I want to take a look at external revenue. Here is a chart showing external revenue from 2016 to 2022 (note that I only start with FY2016 because the segment reporting doesn’t allow for a good comparison in the earlier years):

Here we can see two things I already mentioned throughout this article: (1) the Express Scripts acquisition at the end of 2018 taking effect in FY2019 and (2) the fact that the Cigna Healthcare segment barely grew revenues throughout this timeframe.

Now I want to visualize another thing I mentioned earlier which is the fact that the services-only focus in the Cigna Healthcare segment leads to higher margins than peers. Here is a comparison of United Healthcare’s EBIT margins and Cigna Healthcare’s EBT margins:

With interest costs being deducted, Cigna Healthcare still has way higher margins than UnitedHealthcare. While the gap narrowed a bit over the past few years, Cigna Healthcare is still able to achieve a 50% higher EBT margin than UnitedHealthcare’s EBIT margin due to the significant exposure to services-only memberships.

The next chart shows consolidated EBT for both business segments:

I have to give a little bit of context for this chart as you won’t find these numbers anywhere in Cigna’s financial reports. Cigna reports EBT for both segments and then another number that is called “Corporate & Eliminations”. This number contains intersegment eliminations and interest expenses and is therefore always negative. This means that the EBT numbers Cigna is reporting for both business segments (a) are unconsolidated numbers and (b) don’t take into account all interest expenses which seems kind of weird to me (why not just report consolidated EBIT or EBT per segment just like UNH does?). I deducted the “Corporate & Eliminations” number from the segment numbers to reach what we need for our analysis which is the consolidated segment EBT.

Anyway, here we can see what I outlined several times throughout this article. The health insurance segment isn’t growing while Evernorth has shown good growth. It is safe to say that acquiring Express Scripts in 2018 and diversifying into other markets was a very good strategic move by management.

Now to finish earnings numbers, let’s take a look at consolidated (adjusted) net income and free cash flow (FCF). The adjustments are fine in this case because they mainly contain amortization of intangible assets. Here is a chart showing both numbers since 2016:

Here we can see the same thing that we have been seeing while looking at HUM and UNH, which is that FCF is much more volatile than net income. On average, cash conversion hovered a bit above 100% so that we can again focus on net income. We can see that the Express Scripts acquisitions nearly doubled net income in 2019. Meanwhile, the diluted share count “only” grew by 50% (Cigna issued new shares to finance the deal). After that jump in 2019, net income grew in the low to mid-single digits.

The last thing I want to highlight is a peer group comparison between Cigna, HUM and UNH regarding return on equity (ROE). Here is what I wrote in my most recent UNH article:

Lastly, I want to make some comments on business quality. As I mentioned in my prior article, I usually use return on capital employed (ROCE) to gauge business quality. Because UNH has a big insurance business, we can also look at the ROE. UNH’s ROE stood at 25% in FY2022 (and also stands at 25% for the TTM), up from 20% in FY2016. This is a decent number but not as good as for more capital-light businesses. In the comment section of my prior article, one of my readers pointed out that ROE in the mid-double-digit percentage range is very good. I agree. This also becomes obvious by looking at the peer group. I will save this for another day though.

Source: Author’s UNH article

This day is today so here is a chart comparing the aforementioned peer group’s ROE:

Just like we have seen in the balance sheet comparison, Cigna is again the weakest member of this three-member peer group. Since Cigna is only trading at 1.84 times book value (considerably lower than peers), ROE in the mid-teens percentage is not bad. We still have to conclude that Cigna seems to be inferior from a business quality point of view. The fact that Cigna also had inferior total returns over the past decade, as can be seen in the chart below, might be another indicator of this.

Recent results and share buybacks

These are two topics that I want to address shortly. For the recent results part, I will use the earnings for the first half of FY2023. Here is a screenshot from the most recent Q2 2023 financial supplement document:

I want to focus on two things:

(1) Consolidated after-tax adjusted income from operations (our adjusted net income) declined from $3,921 million to $3,438 million (-12% YoY). The main drivers for the decline were lower earnings in Cigna Healthcare due to rising expenses outpacing the increase in revenues (which was to be expected according to this SA news article) and a much higher reported loss for “Corporate and Other Operations” which consist of intersegment eliminations and interest expense.

(2) Weighted average shares outstanding declined from 319,784,000 to 297,936,000, a YoY decline of 6.8%. Cigna bought back shares aggressively, spending $6,349 million on share repurchases over the last twelve months (at a market capitalization of $82.9 billion). This is something we have seen since the Express Scripts acquisition in 2018. The share count jumped from 250,225,000 in 2018 to 379,817,000 in 2019 and declined to:

• 368,389,000 in 2020 (-3% YoY)
• 340,966,000 in 2021 (-7.44% YoY)
• 313,065,000 in 2022 (-8.18% YoY)

down to the 297,936,000 shares outstanding as of today. This helped the growth in adjusted earnings per share to outpace the growth of adjusted net income. In the investor presentation, Cigna outlines that it plans to allocate around 70% of the future free cash flow towards share repurchases and strategic M&A so it is highly likely that the pace of repurchases will continue.

Valuation

There are 296,879,000 shares outstanding at the current price of $279.23 per share. This results in a market capitalization of $82.9 billion. As I outlined earlier, we can use adjusted net income as a proxy for free cash flow (because cash conversion was a bit above 100% on average over the past few years and adjusted net earnings are less volatile. Adjusted net income for the TTM stands at $6,810 million for a current price-to-earnings ratio (P/E) of 12.2. If we invert this number, we have an earnings yield (=FCF yield in our case) of 8.22%. As I always say: The long-term return potential of any stock should be the sum of the expected growth and the FCF yield. So we need to gauge a reasonable future growth rate.

As I described earlier throughout this article, I assume that Evernorth should be able to grow in the high single digits over the foreseeable future because the underlying markets are growing in this kind of range. I also mentioned that I think the health insurance segment is kind of mediocre compared to peers so I don’t expect much growth from here. Let’s just assume Cigna will be able to organically grow overall earnings by 4% per year, a conservative assumption in my opinion. In this case, long-term return potential excluding changes in valuation should be 4% + 8.22% FCF yield for a total of around 12% per year. Since valuation and a possible rerating of the stock need to be taken into account, I will again perform a simple supplemental DCF calculation.

DCF calculation

With the current price of $279.23 per share and the normalized FCF yield of 8.22%, the current normalized FCF per share stands at $22.94. I will assume a 10% discount rate (as I always do), 4% growth over the next 10 years and then 3% thereafter (lower than for peers UNH and HUM, where I calculated with 4% perpetual growth, to take into account the fact that I think Cigna is a lower quality business than the other two). Here is the result:

According to the DCF calculation, Cigna shares should be worth around $363 per share, a possible upside of 30%. So Cigna looks very undervalued at the current price.

Risks

I already outlined all of the risks for the health insurance market and the healthcare services market in my prior articles on HUM and UNH so I want to refer you to these two articles. For your convenience, I will shortly repeat the most important points here. Here is what I wrote in my UNH article regarding risks in the health insurance market:

There are three types of risks for this segment and they are all related to regulations:

(a) Drug price regulation: Lower drug prices will naturally lead to lower premiums. This would mean lower revenue, lower earnings and lower margins.

(b) Healthcare system change: A switch to a single-payer model.

(c) Medical care ratio regulation: Health insurance providers get forced to spend a bigger percentage of premiums (currently at least 80%) on clinical care and quality improvements. This would cause be disastrous to the bottom line of all health insurance companies.

However, I rate these risks low because of the high political hurdles to bring any of these regulations.

Source: Author’s article on UNH

All of this holds true for Cigna Healthcare, but I want to note that the risks are even lower for Cigna because of its large exposure to services-only memberships.

For the healthcare services market, I outlined the possibility that further regulations might pose a risk to the whole sector. According to this SA news article from July, the U.S. Justice Department recently started a monopoly probe of the managed-care industry.

The last risk that just surfaced recently is related to the PBM business. The WSJ reported that the non-profit health insurer Blue Shield of California dropped CVS Health’s Caremark as its pharmacy-benefit manager in an effort to lower costs. If this proves to be successful, others might follow which would hurt all PBMs.

Conclusion

As this was supposed to be a three-part series, I want to give an overall verdict where I take into account all three covered companies.

HUM seems by far the most promising to me. It has the strongest balance sheet, good growth prospects, a low valuation (despite the price increases since my initial article) and the lowest risk profile. It is also a proven dividend grower which is something that I like to see. Between UNH and Cigna, it is a very close call. While UNH has a better balance sheet and better diversification, Cigna’s valuation is cheaper and the DCF calculations show that Cigna is far more undervalued than UNH. However, I have to give second place to UNH due to (1) the much higher ROE indicating that it is a higher-quality business and (2) the amazing track record for M&A in the Optum segment. I mostly consider myself a quality investor rather than the often used terms “value” or “growth” investing so when in doubt, I tend to turn towards higher quality rather than lower valuation.

However, I will give Cigna a buy rating as well. It has good growth prospects coupled with a low valuation. I am confident that investors will be able to generate low double-digit returns (resulting from share repurchases/dividends coupled with some organic growth) going forward. If you want to diversify into the health insurance/pharmacy market, there are no reasons not to consider Cigna as a possible investment.