Why Carl Icahn Is Long Cigna and Short Express Scripts

A sell sign, buy sign, and hold sign in a row.

Carl Icahn is urging investors to vote against Cigna 's (NYSE: CI) planned merger with Express Scripts (NASDAQ: ESRX) , the nation's largest pharmacy benefit manager (PBM). The activist investor believes Cigna is paying too much for Express Scripts and that if the deal happens, it could be "one of the worst blunders in corporate history." Is Icahn right to think Cigna's deal is big mistake?

A healthcare frenzy

Prescription drugs represent only 10% of total U.S. healthcare spending, but drug prices are increasing much faster than inflation. As a result, companies are increasingly interested in mergers and acquisitions to boost their buying power.

Initially, health insurers tried to merge so they could negotiate better deals with drug distributors and PBMs, like CVS Health (NYSE: CVS) and Express Scripts. However, U.S. regulators balked at those combinations, determining that they would give insurers too much control over the healthcare insurance premiums they charge consumers.

Undaunted, the health insurance industry shifted to an "if you can't beat 'em, join 'em" strategy. In December, Aetna (NYSE: AET) announced a $77 billion merger with CVS Health. And in March, Cigna announced its $67 billion merger with Express Scripts.

Specifically, Cigna's agreed to pay $48.75 in cash and 0.2434 in Cigna shares to buy Express Scripts, or about $95 per share, at current prices.

CVS Health and Aetna shareholders approved their combination in March, and it doesn't appear that regulators will sue to block it. But a shareholder vote hasn't been held at Cigna yet, and that means there's still time to derail that tie-up.

Why Icahn hates this deal

When it announced the combination with Express Scripts, Cigna said it expects cost-savings to increase earnings in the first year after the deal closes. It also forecast that revenue at the newly created company will grow by between 6% to 8% annually through 2021, and earnings per share will be $2 to $3 higher in 2021 because of the merger.

It's anyone's guess if Cigna can make good on that outlook, but it seems Icahn is skeptical. In his view, Cigna is "dramatically overpaying" for a company that faces "existential risks" that could crimp its business in the future.

The existential risks Icahn points to include Amazon.com 's (NASDAQ: AMZN) decision to get into the pharmacy business; the newly created Amazon, JPMorgan Chase (NYSE: JPM) , and Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) healthcare nonprofit ; and the likelihood that Washington eliminates drug rebates , a key source of profit for Express Scripts.

In June, Amazon.com's interest in the pharmacy business was confirmed when it bought PillPack , a prescription mail-order start-up serving patients who take multiple medications daily. PillPack synchronizes patient prescriptions so they're all on the same schedule, automatically renews prescriptions, and delivers pre-sorted pill packs to patients in a dispenser. The move threatens Express Scripts mail-order business, and if Amazon begins negotiating with drugmakers directly, it could more broadly disrupt Express Scripts' business.

Similarly, while Amazon.com, JPMorgan, and Berkshire Hathaway haven't named their nonprofit, they've said its goal is to reinvent healthcare to drive costs lower and improve patient outcomes. If its solutions are eventually rolled out to other companies, then it could emerge as a powerful competitor to PBMs, including Express Scripts.

Express Scripts outlook is further muddied by the fact that drug price rebates are under fire in Washington, D.C. PBMs combine the purchasing power of multiple payers to negotiate rebates from drugmakers, keeping a small percentage of the savings as profit in the process.

In June, Health and Human Services (HHS) Secretary Alex Azar said, "We may need to move toward a system without rebates, where PBMs and drug companies just negotiate fixed-price contracts ... [because such] a system's incentives, detached from these artificial list prices, would likely serve patients far better, as would a system where PBMs receive no compensation from the very pharma companies they're supposed to be negotiating against."

Washington's growing opposition to rebates was also highlighted by Pfizer (NYSE: PFE) CEO Ian Reed in July, when he said: "On the rebates, I do believe that the intention of the administration is to remove the safe harbor for rebates. Today, I would believe we're going to go to the marketplace where we don't have rebates."

If rebates do disappear, it could hurt Express Scripts' bottom line, because the profit margins associated with rebates are reportedly higher than the margins on fixed-price contracts.

What's next

Icahn isn't lobbying Cigna's management to abandon this deal, because if Cigna walks away, it will have to pay Express Scripts a $1.6 billion breakup fee. There's no breakup fee if shareholders vote against the merger, so that's Icahn's preferred strategy.

If the deal does get derailed by shareholders, Icahn believes Cigna's shares could trade up to $250. If so, that would be a windfall for Icahn because he's long Cigna stock. We don't know what his average cost is on his shares, but Cigna's stock is only trading around $190 currently, and that's after the news broke about Icahn's stake. A "no" vote could also benefit Icahn because he's short Express Scripts shares. There's no telling what Express Scripts could be worth if this deal falls through, but Icahn's estimate is that it's worth less than $60.

Icahn's track record suggests his opposition to this deal shouldn't be dismissed, but we won't find out for sure how other investors feel until Cigna's vote on the merger on Aug. 24. Stay tuned!

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Todd Campbell owns shares of Amazon and Pfizer. His clients may have positions in the companies mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Berkshire Hathaway (B shares) and CVS Health. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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