By: Steve Smith
The political environment has not been kind to drug and health insurers with limits on mergers and pressure to limit pricing power creating an overhang on shares. But once the rhetoric subsides and their continued ability to generate profits is recognized the stocks should deliver healthy returns.
While the pharmaceutical and drug makers face certain challenges such as patent cliffs, the need for heavy research and development spending and uncertain FDA approvals making them potentially risky investments, the health care insurers and primary benefit managers such have a steadier business model with a more reliable earnings stream. They have also shown themselves to be adept at navigating the requirements of the Affordable Healthcare Act (ACA), otherwise known as Obamacare.
In fact, when United Healthcare (UNH) reported earnings on April 20 it announced it would completely exit the ACA exchanges; that and its beating earnings estimates help send shares up some 2.2% to a new 52-week high.
Cigna (CI), which is set to report earnings on May 6, is unlikely to follow suit but I think the company will also beat estimates and provide a very positive outlook and start the stock on a nice healthy run. And also unlike UNH its the shares have ground to make up as they are down some 12% from their 52 week high and have basically been sideways for the better part the year.
The chart shows healthy consolidation above the 50 and 200 dma. I think this offers a good entry point ahead of the positive catalysts the earnings report should provide.
Anthem Merger Good and Will Go
The recent squashing of the merger between Pfizer (PFE) and Allergan (AGN) has renewed concerns that Cigna’s plans to merge with Anthem (ANTM) -formerly known as WellPoint,- could be in jeopardy. While some are opposed to the merger the two are fundamentally different. The former was an attempt to save on taxes by moving the combined company out of the United States. The latter is to combine market share within the US and should not draw the attention of US tax policymakers.
On the other hand, in the case of CI and ANTM, the biggest barrier is the consumer advocate, who fears the combined company will place higher premiums on health care. CI and ANTM, however, have stated that the premiums of the combined company will be lower due to the increased efficiencies in the combined company. In this case, CI and ANTM merely need to show that their combined leverage can reduce premiums to dispel naysayers.
The merged company would become the largest insurance company in the United States and it must show that the merger will not negatively impact those seeking insurance. This is where UNH’s exiting Obamacare will not only help the cause. UnitedHealth’s planned exits means it’ll be more likely that the pending will be approved by regulators, partly because the consolidations will help to preserve access to exchange marketplaces and also there is no evidence of size leads lower premiums exists in the insurance industry.
On the other hand, bigger insurance companies have more bargaining power with insurance providers, allowing the possibility of lower premiums. The bottom line: the merger should provide a boost to steady, if lower margin, profits.
Analysts are expecting Cigna to earn $2.15 a share this quarter and $9.80 for fiscal 2016 giving the stock a relatively low 14.2 p/e. If the company can beat and raise guidance I think the shares could run.
I’m buying some call option spread to establish a bullish position options. Specifically;
-Buy July $140 Calls
-Sell July $155 Calls
For a $4.50 Net Debit
Here is what the risk graph looks like:
This trade gives over 3 months for the bullish thesis to play out. If shares are above $155 at the July expiration one could realize a 220% return.