It's been over a year since the two blockbuster mergers, Anthem (NYSE:ANTM)/Cigna (NYSE:CI) and Aetna (NYSE:AET)/Humana (NYSE:HUM) were announced, and with the DOJ dragging its feet on the two lawsuits against the mergers, investors are concerned that this drama might take another year to resolve itself. Investors seem to have decided that both of these deals are going to be too messy, take too long, and are probably dead in the water anyway. But are they? In any case, these are all very good businesses, and it's times like these when you can get some real bargains.
While Anthem and Cigna are publicly moving forward, it appears that there is discord between the two. First, Cigna decided to hold an earnings conference call for the first time in a year. They probably had to do this after the DOJ challenge, but the tone was noteworthy. While Cordani said that it was "clearly out intent and commitment" to continue working on the deal, he also said that Anthem "independently decided" to fight the lawsuit. He said:
Given the nature of the concerns raised by the DOJ in the overall status of the regulatory process, which under the merger agreement is led by Anthem, we step back briefly to evaluate our options, consistent with our obligations under the merger agreement...
Anthem independently decided to pursue the lawsuit with the DOJ, as such we are party of that suit. We will take the appropriate steps obviously, to protect the interest of our shareholders, which includes ongoing evaluation and monitoring more options as they unfold. But we are fully engaged in the process as you noted. And we should think about that, but it's a dynamic process right. There is no static process season life and this is not a static process, but we're fully engaged.
Reading between the lines here, I think it's likely that the parties agree to terminate the merger and don't go through the hassle of arguing with the DOJ in court for at least the next six months. This is consistent with the NY Post report in late June (before the DOJ suit) that both parties were considering terminating the agreement.
That doesn't necessarily mean that either Cigna or Anthem is a bad investment; I actually think that Cigna is very well positioned here. A lot of their earnings miss is very fixable (unusual spike in life claims is temporary). They will have around $5 billion of deployable cash next year, including the termination fee, plus a ton of balance sheet leverage. With a $32 billion market cap, they could theoretically retire around 30% of their stock in 2017. That's obviously aggressive, and they will spend some of the funds on M&A, but you could very easily see them retire 20-30% of their stock by the end of 2018 while doing a strong amount of M&A. With continued 5% revenue growth, fixes in disability and life businesses, and the buyback, I'm seeing a quick back of the envelope calculation of 2017 earnings to be: $8.00 2016 earnings + .90 group disability and life business impact reversal + 5% growth +15% buyback, or $10.75. Then with 5% growth and another 10% buyback in 2018, earnings then could be $12.9. That excludes any impact from M&A, operational leverage, etc. I think it's clear that they are being priced as if the deal terminates, and then some.
So let's say that Anthem and Cigna do in fact terminate their deal, where does that leave Aetna and Humana? The DOJ seems to be making two arguments relevant for the Aetna/Humana deal. First, the argument is that consumers will be harmed from less competition if the "big 5" is reduced to the "big 3". Second, the argument is that the healthcare insurance market can be assessed nationally and that the Medicare Advantage sub-market should be analyzed as its own market. The companies can't really argue with the first point for obvious reasons. But they have significant technical arguments as to why the healthcare insurance market is a local market and that Medicare Advantage should be assessed as a product type and not be assessed as a separate market.
If the Anthem/Cigna deal falls apart, I think DOJ will have a much harder time proving that consumers will be harmed by the "big 5" becoming the "big 4". From 5 to 4 is a world different than 5 to 3. Aetna and Humana also announced today the divestiture of certain Medicare Advantage assets representing 290,000 members. That should certainly help assuage the DOJ's concerns about competition in the Medicare Advantage market.
If the Anthem/Cigna deal falls apart, the DOJ is going to be under a ton of pressure to settle to approve the Aetna deal. Not only do their legal arguments become much weaker, but Aetna and Humana are putting a ton of pressure on by threatening to leave the Obamacare exchanges. There's no way to know what will happen, but I'm thinking that the DOJ will settle under those circumstances, and the collapse of the Anthem/Cigna deal, along with the new Medicare Advantage divestiture plan, will provide them just that out.
With Humana trading under $170 and the merger consideration worth $222, you have over a 30% deal premium if the deal is completed. And if I am right and Aetna/Cigna terminate their merger and the DOJ settles with Aetna/Humana rather than pursues the litigation, this deal could theoretically close in 2016. Even if the deal doesn't close, there is a lot to like about Humana's financial profile, earnings, ability to increase leverage and pursue buybacks, and opportunity to exit loss-making Obamacare exchanges.
The market is tired of these mergers and nobody wants to hold through a long, ugly lawsuit with the DOJ. But these are some of the best opportunities in the market today. You do fine if both of these deals die, and you do really well if one of the deals is approved.
Disclosure: I am/we are long CI, HUM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.