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Carl Icahn’s argument against Cigna Express Scripts merger

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Carl IcahnREUTERS/Brendan McDermid

  • Billionaire investor Carl Icahn is not a fan of Cigna’s
    plan to purchase pharmacy benefit manager Express Scripts, a
    $67 billion deal that was announced in March. 
  • In a letter
    to Cigna stockholders sent Tuesday
    , Icahn said the deal
    “may well rival the worst acquisitions in corporate
    history.” 
  • Icahn cited the regulatory
    challenges
    that the PBM model is facing, as well as
    competitive risk from Amazon. 

Carl Icahn doesn’t want 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 per 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 Express Scripts’
debt.

In his letter, Icahn highlighted the regulatory challenges facing
the pharmacy benefit manager business Express Scripts is in.

Drug companies
and the
Trump administration
have been calling for the end of the
rebate, which are 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 in 2018 gotten more involved in
healthcare
, 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 better 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 will 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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