Are Health Insurers Coming Down With a Bad Case of Merger-Mania?

As the Affordable Care Act picks up steam, investors are anxiously waiting for the Supreme Court's decision in King v. Burwell.

When the Supreme Court rules on the legality of paying health insurance subsidies to people who bought their plans through the federal exchange, the insurance space could either become an investor's dream or nightmare. To add to the intrigue, rumors of mega-deals are swirling around top players with market caps upward of $40 billion for the top players. But, as we know, rumors are just rumors. Find out who to back, on today's Industry Focus.

A full transcript follows the video.

Michael Douglass: Health insurer merger-mania, or at least that's the rumor. This is Industry Focus.

Hi, Fools! Welcome to Wednesday's healthcare edition of Industry Focus. I am your host Michael Douglass, back from a two-week vacation in Italy. Sunny, overly hot Italy. I can you tell you a lot of the places I went to weren't too heavily into air conditioning. So I'm certainly glad to be back in Alexandria, although it was really a wonderful trip. Todd, how did things go while I was gone?

Todd Campbell: Well, we missed you Michael. We're glad to have our world traveler back in his seat.

Douglass: Aw, shucks. You're very kind. How are things in New Hampshire weather-wise, by the way? I would assume it's a bit more temperate.

Campbell: Yeah, beautiful blue skies, about 65/70 today. Ocean water is on schedule to get palatable probably in about another month and a half.

Douglass: Wow. Yeah, in Virginia Beach I'm pretty sure it's already plenty warm enough. All right. Speaking of hot water, actually, let's hop right into the news -- or at least the rumors of the day. Before we get into it, I've got to say first off -- everybody who's listening -- rumors are in fact rumors. I do not personally buy or sell stocks based on rumors, and would recommend you not do the same, particularly on merger and acquisition rumors because even when a merger and acquisition look like they're going to go through, sometimes it doesn't.

Folks who invested in the AbbVie (ABBV 1.05%) and Shire PLC (NASDAQ: SHPG) deal last year certainly found that out to their chagrin, when it ended up falling through. That wasn't even a rumored deal. That was a confirmed deal with everyone in agreement, and then AbbVie pulls out at the last minute. Rumor is several steps more risky than that. So please, please look at the underlying business, look at the investment thesis of the business as a stand-alone, make your decisions based on that, not based on rumors.

That said, some very interesting rumors in health insurance. Todd, we've got UnitedHealth (UNH 2.15%)  reportedly interested in Aetna (AET), which is reportedly interested in Humana (HUM 1.87%). We've got Anthem (ELV 0.40%), which is reportedly interested in Cigna (CI). Where do we start?

Campbell: I think everybody is going to try and buy everybody. That's basically where we stand right now in the health insurance industry. There is a good, old-fashioned land grab going on here. I don't know how this is all going to shake out. If any of these deals are going to come to fruition, or if this is all a lot of posturing.

Douglass: And these are big, potentially -- again, rumored -- but potentially very large deals. Aetna has a market cap at last check of $43 billion. You can assume pretty safely that any potential deal would have to be offering more money than that. That is a big chunk of change in health care, or really in any industry.

Campbell: Right. Cigna's looking at -- Anthem buys Cigna it's going to be a deal that's north of $45 billion. If UnitedHealth buys Aetna it's going to be north of where we are now at $43 billion. These are huge potential deals, and it would create monstrously large health insurers. But that's what this industry wants. This is a business of scale. It's all about leverage. It's all about low margins and being able to leverage more people against your fixed costs.

If you can get UnitedHealth to buy Aetna and get rid of all the fixed costs that are duplicated, you could free up a lot of money for the bottom line. Traditionally, this is a -- as you know -- mid-single-digit margin business. This is not a technology-oriented business. They act as a middleman between patients and care providers, or drug companies. So the more people that they can have in membership, the easier it gets for them to go negotiate favorable terms with hospitals, with doctors, with drugmakers. Again, this is a play for scale.

Douglass: Yeah. Especially as you have all of these new insured folks coming on the market because of the Affordable Care Act, because of Medicaid expansion. As you have folks shifting into Medicare Advantage plans from traditional Medicare in a lot of cases, you've got these massive opportunities for folks who are willing to strike.

Campbell: Yeah. What I found interesting too is all of this rumor activity is occurring right at the floor of the Supreme Court is set to hand down its findings on the King v. Burwell case, which could impact subsidies. So it's interesting that so much activity is swirling about prior to something that could theoretically pose a hurdle that would have to be overcome for Obamacare.

Douglass: Right. Why do you think that is, Todd?

Campbell: It's hard to say. Who knows? All I know is that you look at these deals and the anatomy that might be behind them, and they're very intriguing. Look at UnitedHealth. UnitedHealth is a goliath already at $35 billion in quarterly revenue. If they were to buy Aetna they would become a $50 billion a quarter company. $200 billion revenue [...]

What's interesting here, too, with the UnitedHealthcare play for Aetna is it would also expand UnitedHealthcare into group life products, into disability products, long term care products. Those products would be a small piece of this much larger pie, but it certainly would help diversify them slightly away from traditional individual market health insurance.

Douglass: Right. If a potential Anthem and Cigna deal were to occur you'd get Cigna's supplemental insurance and their group disability and life businesses added to the Anthem umbrella, which could give them some interesting opportunities.

Campbell: That raises a really good point, too, Michael. You think about these other parts of the business and we had talked about what's going on with the Supreme Court decisions soon. The other thing that's happening in Washington is that we're more likely to see rates go higher over the coming months than lower. For the first time in years we're talking about rate hikes. The reason this is important for investors is because a lot of these insurers have money in short-term, fixed-income instruments. If rates go up, then theoretically you could see earnings benefit from that.

Douglass: That's interesting because usually when we're talking about stocks being affected by rising rates it's to the negative, but if they are able to move into something that's a little bit higher yield for them that could be an opp.

Campbell: You also touched on something else that I wanted to follow up on, which is the demand for Medicare products. You look at the population of baby boomers, and the fact that so many baby boomers are now turning 65, they're more active than they ever were before and they're demanding more healthcare than ever before. Medicare Advantage has become an incredibly important revenue generator for health insurers.

I think we talked about "why would a company be interested in Cigna," and "why would a company be interested in Aetna"; but I think that's what makes Humana so interesting to all of these companies. It's because Humana is such a huge player in Medicare advantage and Part D drug plans. They get the majority of the revenue from that business. So it could be that these insurers are looking at it saying "At some point we're going to reach critical mass from enrollment tied to health care reform. Where else can we grow our business beyond that?" Maybe it's in disability, maybe it's in life, or maybe it's just serving more Medicare customers.

Douglass: Sure. That's a good point. There's always this inherent tension in healthcare, and you see it in pharma and you also see it in insurance, and you see it -- to some extent -- in the hospitals as well, where you have these core areas that are very good at certain things. Pharma, in a lot of ways, has been slimming down to where a lot of these big pharmas are focusing on two or three things that they're really good at, and getting rid of a lot of those "noncore assets."

Whereas here, you might have the potential to actually have some diversification. There are arguments to be made on both sides because on one hand, focusing on what you're good at, theoretically, these are the areas that you're going to make your most money. It's where you're going to have your best margins, where you're going to be able to create some sort of plus compared to your competition.

On the flip side, if something happens that majorly disrupts one of those businesses; that becomes a big issue. That greater diversification can then allow you to plow more money into something where you've been growing your expertise on the side. So there's an argument to be had both ways. With that in mind, of the three rumored potential transactions, which would be the most attractive to you, Todd?

Campbell: That's a toughie. These companies are all intriguing for a lot of reasons. Think about this from the perspective of "where can you free up money if you're the acquirer?" Each one of these companies has returned in the past year or so, about $1 billion just in share buybacks to investors. Theoretically you've got money that can be freed up there. The money that's being paid out in dividends could be freed up.

I think that investors should focus -- instead of trying to pick which is the best one to buy that might be acquired, they should just focus on which one is most likely to benefit from the larger trends that are affecting health insurance. In that case -- for me -- it's going to come down to UnitedHealth and Anthem. How about for you?

Douglass: For me it's got to be Anthem. Of course, to some extent, that depends on what happens in King v. Burwell and with the larger Affordable Care Act story because Anthem, in a lot of ways, is the story of a health insurer that really moved in aggressively on the Affordable Care Act. They've been aggressive in the exchanges, they've been aggressive about benefiting and making sure they're competing for Medicaid expansion. I think they've done a good job of identifying the fact that you are going to see a lot of growth in healthcare tied to the government of one sort or another.

Medicaid, Medicare, whatever the case may be. When you look at the overall trends in healthcare today, I think Anthem's the best prepared of the group. That said, if something transformative happens to the Affordable Care Act I think all bets are off. You have to reevaluate. That's the thing you have to do with any investment thesis. When some key part of it changes, that's when you have to come back and say, "Do I really like this company still? Is this the growth story that I originally invested in, or that I was original confident in?" That's my two cents on Anthem. Todd, I think that's all the time we have today.

But thank you, as always, for your two cents and for sharing your expertise with me and with the broader Motley Fool audience. Folks, check back to Industry Focus every day, or at least every weekday in the future.

As always folks who are involved in Industry Focus may have interest in stocks that they talk about. The Motley Fool may have active recommendations either for, or against stocks that we discuss. So never buy anything based just on what you hear. Thanks much. Fool on!