A Peek Behind the Curtain: Cigna's Acquisition of Express Scripts

BloombergSen Q1 2019 Quarterly Letter Highlight

In our recent quarterly letter to our partners, we reviewed a significant development surrounding our second largest holding (in 2018) – Express Scripts. With the journey very fresh in our minds, we used the letter as an opportunity to highlight how we analyze situations involving our companies. What follows, while somewhat detailed, is a worthwhile read for those who like to see “behind the curtain” at how serious investment managers and business owners make decisions. 

Cigna Announces Intent to Acquire Express Scripts 

On the 8th of March 2018, health insurer Cigna made an offer to acquire Express Scripts (Express) for US$67 billion – a 31 percent premium to its stock price on the prior day. This was not the first time that a major holding of ours was involved in one of the largest takeovers in history. Seven years ago we had a large position in Medco Health, which Express bought for US$29.1 billion – a 28 percent premium. We also owned shares in Catamaran, which was acquired in 2015 by United Health for US$12.8 billion – a 27 percent premium. The pharmacy benefit management (PBM) industry has been fertile ground for us!  

This acquisition of Express was one of the strangest takeovers we have been involved with, and the factors that contributed to this offered us an opportunity to significantly increase our profits. The terms of the deal were that Cigna would pay $48.75 and 0.2434 shares of Cigna for every share of Express. Over the nine-month period from when the deal was announced until it closed on December 20, 2018, Cigna’s stock price ranged from $164 to $225. This equated to a value of $89 to $103.50 per share for Express. Nonetheless, for five months after the merger was announced, Express traded in a band of $68 to $82, far below that value. Over that time period, Express traded an average of 4.3 million shares daily, so anyone could have scooped up as much stock as they wanted, knowing they had a very high probability of realizing a large gain within the subsequent few months.   

Will the Deal Close? 

This begs the question of why, in an efficient market world full of hungry hedge funds, this multi-billion dollar opportunity sat on the shelf for so long. This is what we believe was behind the stock trading so far below the acquisition price for such an extended period of time:   

1. Over the last six years, Wall Street has swung from loving the PBM business to hating it, so it did not like the idea of Cigna buying Express. Some investors wanted Cigna to merge with another insurer like Humana, but the odds of such a merger passing anti-trust scrutiny were low considering that two big insurance mergers – one of which involved Cigna and Anthem – were blocked by regulators as recently as 2017. 
2. In November 2017, the U.S. Department of Justice (DOJ) sued to block the merger of AT&T and CNN-parent Time Warner (TW). As these two companies do not compete directly (TW is a supplier of content to AT&T), this was a vertical merger. Given that the Cigna/Express deal was also a vertical merger, the market feared that the U.S. government would also try to stop it from moving forward.  We disagreed with this view for two reasons: First, we felt the Trump administration was targeting TW over CNN’s attacks on it. Second, based on case law, we felt that AT&T would ultimately prevail in court and the merger would pass. When we studied the history of vertical mergers, it became apparent that they are rarely contested by the government and that they are even more rarely successfully blocked (due to the difficulties involved in proving that the merger will harm competition). Prior to the AT&T lawsuit, the last time the DOJ had sued to block a vertical merger was in 1979, under Jimmy Carter, and it lost the case. The last time the DOJ successfully sued to block a deal was in 1972, nearly half a century ago. 
3. From his time as a candidate, Donald Trump has talked repeatedly about his desire to bring down U.S. drug prices. Given this backdrop, people feared that his administration would implement a plan that would severely hurt the PBM industry. Once again, we disagreed with this view since PBMs play an essential role in arresting drug price growth by using their scale to extract volume discounts from retailers and drug makers. This has been proven in numerous studies, some of which were carried out by various U.S. government agencies. In fact, the Federal Employee Program uses PBMs to buy drugs for government employees. In addition, a significant proportion of the PBM industry’s clients rebid their contracts every year. This “market check” provides further credence to the theory that they are getting the best value by purchasing drugs this way.  
4. In the fall of 2017, rumors started circulating that Amazon would announce, by American Thanksgiving, that it was entering the drug retailing and distribution business. This caused investors to worry and reduce the valuation multiples they were willing to pay for companies in these industries. We did not believe this was as big a threat as people imagined as it was not clear how Amazon would be able to aggregate scale given the sheer size (hundreds of billions of dollars in revenue) and market shares of drug wholesalers, retailers and PBMs. In addition, these companies have low profit margins, which did not fit Jeff Bezos’ maxim that, “Your profit margin is my opportunity.” Finally, pharmaceuticals are a highly regulated business with numerous complexities. If Amazon did decide to enter the drug business, it would likely be in the retailing area, which is not where Express operates.  
5. On August 7th, corporate raider Carl Icahn tried to scuttle the Cigna/Express merger by saying he would vote against it. He refused to reveal how few shares he owned and bizarrely entered far too late in the process. Ultimately, shareholders overwhelmingly rejected his idea and voted to approve the deal. 

As an investor in Express betting on the merger closing, you only had to deal with issues number 2 (the involvement of the U.S. Department of Justice) and 5 (Icahn’s resistance) from the above list, the others being just noise.  

We took advantage of the above noise and uncertainty to add to our Express position. 

So back to the original question: why didn’t more people take advantage of this huge profit opportunity? Much of the time people assume that the market is telling them something, which translates as, “other people knowing something they don’t.” As investors with a highly concentrated portfolio of businesses, we try to know more and take the time to think through things more than others. As Warren Buffett says, “The market is there to serve me, not instruct me.” 

Cigna’s acquisition of Express Scripts officially closed on December 20, 2018. Express traded at $92.33 immediately preceding closing.