Managed Care Firms Bulk Up

Cigna follows UnitedHealth in purchasing a regional insurer as the industry rapidly changes.
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OKLAHOMA CITY --

Cigna

(CI) - Get Report

is bulking up, hoping that a major acquisition -- its largest in a decade -- will strengthen its position in the fiercely competitive managed care industry.

The health insurer announced late Monday that it agreed to pay $1.5 billion in cash, plus another $400 million in capital investments, for regional managed care provider Great-West Healthcare. The transaction will boost Cigna's health care membership by 2.2 million, or nearly 20%, and establish the company as a major supplier of health insurance to small and medium-sized businesses in the Rocky Mountain region.

Analysts pointed to the buyout as evidence of an ongoing trend, with national health insurers looking for new ways to grow -- and regional players struggling to survive -- as the managed care industry consolidates.

UnitedHealth Group

(UNH) - Get Report

, for instance, earlier this month inked a similar deal, buying

Fiserv's

(FISV) - Get Report

health business for $775 million.

Cigna expects its purchase to close in the first half of 2008 and boost its profits immediately afterwards. The company will suspend its aggressive stock repurchase program in order to finance the transaction, but Goldman Sachs analyst Matthew Borsch predicts that it will come out better in the end.

"We estimate the transaction should be at least 30 cents accretive to 2008 earnings per share, as compared to the 25-cent accretion we estimated for an equivalent level of share repurchase," Borsch wrote in a research note. "We expect the market will react positively to the transaction, given the potential EPS impact as well as the added network and distribution strength."

Cigna's stock was up 1.1% to $49.83 Tuesday following the news.

Borsch has placed his own price target on Cigna under review while he fully analyzes the transaction. His firm, which has investment banking ties to Cigna, included the company on its "Americas Buy List" even before news of the deal first surfaced.

Meanwhile, CIBC World Markets analyst Carl McDonald portrayed the deal as a good one for both parties involved. McDonald has an outperform rating and a $58 price target on Cigna's stock. His firm seeks to do business with the companies it covers.

"At first glance, the health care business of Great West Life doesn't look like much

since earnings have been essentially flat for the last few years as has the company's enrollment," McDonald wrote on Tuesday. "However, the key here is that this is a business worth far more to Cigna than it is to Great West."

Until now, McDonald noted, Great West has lacked the volume necessary to drive bargains like those demanded by health insurers that dominate their markets. But as part of a national powerhouse, that obstacle should immediately disappear, he predicted.

Double Play

While the Cigna acquisition bears similarities to UnitedHealth's Fiserv Health buy, it does lack one component. UnitedHealth not only snatched up a regional health insurer, but an attractive pharmacy benefit manager to boot.

Now, due to tough industry conditions, some experts wonder if UnitedHealth will start relying on the booming PBM business as a new vehicle for growth.

At the moment, three companies --

Medco

(MHS)

,

Express Scripts

(ESRX)

and

CVS-Caremark

(CVS) - Get Report

-- dominate the lucrative PBM industry. UnitedHealth has long relied on Medco, the largest of those three, to handle most of its PBM duties. But some feel that UnitedHealth could soon bring its PBM business in-house instead.

If so, UnitedHealth would strip Medco of its largest client and could reshape the PBM landscape as a whole.

To be sure, UnitedHealth looks interested. Through its 2005 acquisition of PacifiCare, UnitedHealth picked up a major PBM in RxSolutions. Since then, UnitedHealth has added Fiserv's Innoviant PBM as well.

This week, Credit Suisse analyst Glen Santangelo listed some examples of additional steps UnitedHealth has taken toward becoming a major PBM player. In October, Santengelo noted, UnitedHealth completed construction on a huge mail-order pharmacy -- now operating at just 30% capacity -- in Overland Park, Kan.

Two months later, UnitedHealth decided to handle PBM claims for its Medicare Part D customers itself. More recently, Santangelo added, the company has gone on to hire some key PBM managers as well.

Furthermore, Santangelo stressed, UnitedHealth CEO Stephen Hemsley has touted the company's PBM business in two of its last three conference calls. Notably, in one of those calls, Hemsley compared its own RxSolutions quite favorably to Medco, the PBM it has been relying on for years.

"RxSolutions has really strengthened its business," Hemsley said in April. And "while it is not as large as Medco, we would view it as every bit as sophisticated."

New Landscape

Given recent developments, Santangelo sees some chance that UnitedHealth could in fact start handling all of its PBM business itself. By doing so, Santangelo estimates that UnitedHealth could boost its annual profits by about 2% per year. While modest, that gain would far exceed the contribution expected from the looming Fiserv buyout.

Meanwhile, for Medco, the impact could be huge. All told, experts figure, Medco relies on UnitedHealth for more than one-fifth of its annual revenue. Because of steep volume discounts, however, UnitedHealth makes a smaller contribution to Medco's bottom line.

Still, Santangelo estimates that UnitedHealth is responsible for up to 30 cents of Medco's annual profits -- or about 8% of the earnings that the company is expected to generate this year.

For its part, Santangelo notes, Medco has already pledged to stick with its future targets even if the company loses its largest customer. Santangelo assumes that Medco has issued conservative guidance, with upside from high-margin generic drug sales likely, as a result.

Santangelo has a neutral rating on Medco's stock. His firm seeks to do business with the companies it covers.

"While we acknowledge size and scale would instantly make UNH a credible player, we do not believe that one additional captive PBM ... will significantly change the already competitive landscape," Santangelo wrote on Monday. "We caution investors not to get too caught up in this situation and lose sight of the bigger picture, which remains bright for the company and the industry" overall.

As if on cue, Express Scripts immediately followed up on Tuesday by issuing bullish guidance for the coming year. The PBM expects to post 2008 earnings of $2.80 to $2.87 a share, representing year-over-year growth of up to 25%. On average, analysts have been predicting that the company would report 2008 earnings a penny below the bottom end of that range.

"Our outlook for continued strong growth reflects the success of our business model, which is built around alignment of interests with plan sponsors and their patients," Express Scripts CEO George Paz stated on Tuesday. "As we drive greater savings for our clients, our performance improves."

So does the company's stock price. The shares jumped 2.7% to $67.47 following the company's upbeat call. Shares have nearly doubled since the beginning of the year.