Carl Icahn Fires Shots at Express Scripts

Cigna (CI) thinks acquiring pharmacy-benefit manager Express Scripts (ESRX) will give it an edge that boosts sales and profit growth through 2021, but Carl Icahn believes the merger will be a bust. The famous activist investor released a letter this week that urges Cigna investors to vote against the acquisition on August 24. Is Icahn simply talking up his book, or is his critique of Express Scripts' future on point?

In this episode of The Motley Fool's Industry Focus: Healthcare, host Kristine Harjes is joined by Motley Fool contributor Todd Campbell to explain why Amazon.com (AMZN -1.64%) and Washington, D.C. have Icahn betting against Express Scripts' business. Also, Regeneron Pharmaceuticals (REGN -0.09%) has invested $100 million in gene-therapy pioneer bluebird bio (BLUE -4.91%). Harjes and Campbell discuss why Regeneron and bluebird bio made this deal and what it could mean for investors.

A full transcript follows the video.

This video was recorded on Aug. 8, 2018.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is August 8th, it's Wednesday, and we're talking Healthcare. I'm your host, Kristine Harjes, and I'm joined by fool.com contributor Todd Campbell via Skype.

Interesting news on the partnership front from bluebird bio and Regeneron. The companies are collaborating on half a dozen targets in blood cancer, combining bluebird's approach to T-cell modification with Regeneron's VelociSuite technologies. Todd, what's the scoop?

Todd Campbell: Not quite the deal people were hoping for though, probably, right?

Harjes: Yeah, maybe. I still think it's exciting.

Campbell: It is! There are actually a few different takeaways I have. We'll get to the nitty-gritty and why I see a little sanguine about it. I think a lot of people have been thinking, since Juno was acquired by Celgene for such a big amount earlier in the year, and Kite got acquired by Gilead Sciences, and bluebird's working on gene therapies, too, that maybe an entire lock, stock and barrel deal could get done. We're going to get to the details in a minute. I think this maybe suggests that's not going to happen anytime soon. 

There are three big takeaways I have about this news, this new collaboration between Regeneron and bluebird bio. One was the fact that Regeneron was the one that approached bluebird bio about the deal. The next was the fact that the deal doesn't include Regeneron giving bluebird bio any cash up front. Instead, it's a deal for equity in bluebird bio. The third takeaway I have, or thing I found intriguing about this deal, was the fact that leveraging the experience that these two different companies have, I think the angle here might be to dive deeper into the tumor microenvironment. What I mean by that is, move beyond these cell therapies that are targeting blood cancers to tougher to treat, tougher to penetrate solid tumor cancers.

Harjes: Let's take those one by one. The first one you said is, it's interesting that Regeneron approached bluebird. To me, that makes sense, because Regeneron is a much bigger company. It's a $42 billion market cap company, whereas bluebird bio is right around a $8 billion market cap company. So, what makes that interesting to you?

Campbell: What makes it interesting to me is, it suggests that Regeneron feels they have a gap in their knowledge. They've been doing their own work. They have a number of different drugs already on the market. Like you said, a much larger company. They have aspirations to become a much larger cancer drug company. It appears to me, from this deal, that Regeneron feels like maybe they don't have all of the tools they need in-house. That's intriguing, because they have said in the past that they're working on some really interesting things, especially with T-cell receptor approaches and stuff in preclinical and everything. That was one thing that was interesting. 

The other thing that was interesting to me is, maybe it suggests that Regeneron, especially since it's an equity deal, was more interested in the broader company. And then, when bluebird bio said, "Nah," they said, "Well, how can we work together and maybe still get some skin in the game?"

Harjes: Yeah, that's fair. That leads right into the second point that you brought up, which is that this deal does include an equity investment. It's interesting to me. Regeneron is making a $100 million investment in bluebird. It comes at a supposed price of $238 per share, which is a 59% premium over the last close price from bluebird's stock. But, to me, that doesn't mean much. This is almost reminiscent of the Celgene-Juno initial equity funding deal. Yeah, there's an exchange that's going on, where Regeneron will receive this equity stake in bluebird, and bluebird will receive the cash. But there's also so many other moving parts to this deal that, to me, that $37 million premium is essentially a cash payment. Sure, if Regeneron was a normal investor -- you and me, Todd, could have gone on to the market and purchased bluebird's shares a lot cheaper. But then, they wouldn't have all these other benefits of partnership. So, given that they're doing it within a deal structure, they're getting so much more out of it. That's really what they're paying that premium for. That's almost like a cash payment.

Campbell: There are two different ways of looking at that. There's looking at it as a cash payment, which, it is. It's a $37 million premium, and bluebird bio has already said that they plan on applying that $37 million to their share of costs associated with the preclinical R&D that these two companies will be working on. But, in theory, Regeneron could have said, "We'll give you $40 million in cash upfront. We don't want any equity at all." So, it's obvious that they did want to have a stake. 

I don't have the answer to this because I'm not a corporate CPA, but the fact that companies now have to report the quarterly gains and losses from their equity investments as part of their operating performance, I wonder if that somehow comes into play in the way that this deal was structured, with the premium and everything. I don't know the answer to that. 

I think the takeaway is, you're right, bluebird bio gets $37 million in cash that they can now use and treat like a cash payment, and Regeneron walks away with not only the equity but this opportunity to potentially develop six different therapies for six different indications.

Harjes: You mentioned that the third point you found interesting was, they could potentially be using this combined knowledge to dive deeper into the tumor microenvironment. They have these half-dozen targets that are in hematology, but it does seem like eventually, the work could come to be part of solid tumor therapy, as well.

Campbell: You look at what bluebird brings to the table. They have a lot of experience dealing with lentivirus viral vectors. We've talked on the show about gene therapy in the past, and how these viral vectors are used to deliver changes to genes to help address some of these mutations that maybe result in the disease itself. We've seen already some chimeric antigen receptor, CAR-T, therapies, that have made it to market that tinker with the T-cell to be able to allow them to go out and bind to proteins that are expressed on cancer cells, so they can be destroyed. 

bluebird is also working on a similar type of approach. They have a CAR-T, bb2121, which they're developing in conjunction with Celgene for multiple myeloma. They have some experience there. Regeneron has a lot of experience in antibody research that they can bring to the table. They also have some experience in working on T-cell receptors. T-cell receptors are on T-cells, they're what binds to antibodies to be able to trigger immune system response. 

Again, you're looking at all of these pieces of experience or knowledge that they're combining together and trying to connect some dots on how this would differentiate them from, say, a collaboration like Gilead and Kite or Celgene and Juno. Perhaps that's a differentiation, that they can leverage this experience to penetrate the softball of a solid tumor cancer, which has really been a struggle for researchers because it's a very complex environment. It's kind of like unwinding all of the threads around the core of that softball to try to get to it and destroy the cancer. That's not easy.

Harjes: Looking at all the nitty-gritty of this deal, it seems to me like both companies are getting a pretty good deal. This is, for bluebird, a move further into oncology, it gives it another high-profile partner. Regeneron, meanwhile, will be able to also expand its efforts into cancer, which is something that Wall Street is watching. It's a very high-interest area. Do you think one of these companies is getting a better deal than the other?

Campbell: No, I think it's pretty well-balanced. I'm looking at Regeneron. They have six drugs already in the market, they could have a seventh drug, which would be a PD-1 drug -- you and I have talked about PD-1 drugs on the show before -- it's an immuno-oncology drug that could get approved for use in people with small cell cancer. That could be a pretty exciting move for them into immuno-oncology. This certainly does better round out their portfolio in oncology, theoretically. 

The way that the deal is structured is, the two will share costs in the preclinical stage. Then, once they get to the point where they have an a-ha moment and can bring a drug into human trials, then Regeneron gets the option to opt in on future development of that preclinical asset. If it does opt in, it will share in all of the costs of developing that. Eventually, if it's commercialized, it will share in the profit. If they choose not to opt into it, Regeneron cam still end up collecting milestone payments and royalties from bluebird bio. So, if they walk away from the deal later on, they can still profit from it. 

I think this is a good deal for both of them, and maybe it's a sign that there's closer collaboration in the past. Regeneron does have pretty good success with these collaborations. You and I have talked in the past on the show about some of the work that they've done with Sanofi in developing some of these drugs for various indications, including their new eczema drug, which is selling over $200 million per quarter. They have a rheumatoid arthritis drug, a cholesterol-busting drug that they developed with Sanofi. There's reason for optimism on both sides.

Harjes: Sounds good. Back in March, Cigna announced that it would be acquiring pharmacy benefit manager Express Scripts in a $52 billion deal, which was a $67 billion purchase price, including the assumption of $15 billion worth of Express Scripts' debt. This massive vertical integration is part of a move toward consolidation in the broader healthcare industry. 

It appears that not everyone is convinced it's a good idea. Just today, activist investor and billionaire Carl Icahn released an open letter to shareholders of Cigna objecting to the acquisition and urging shareholders to vote against it.

Campbell: The Wall Street Journal was the first to break the news that Icahn was taking a stake in Cigna with the intent of objecting to the proposed acquisition. There were some rumors yesterday that he was penning an open letter to investors explaining why he thinks this is a bad deal for Cigna shareholders. And sure enough, this morning, right before we went on the air to film the podcast, the letter came out. It's pretty scathing in parts. It basically walks through Icahn's thinking of why this is a bad deal, saying that Cigna should be worth way more than it is now, and that Express Scripts is worth way less than it was in March, when this deal was cut. 

Essentially, what Icahn is trying to do is convince people to vote against the merger. If you read between the lines, he's suggesting that perhaps there's a little buyer's remorse on Cigna's part because the marketplace has changed considerably over the course of the last six or nine months. I'm sure we'll talk about that in a second. Essentially, what he's saying is, "If we vote this down, then Cigna won't have to pay a breakup fee. But, if regulators or the board walks away from this deal, then Cigna would have to pay a breakup fee." That's why he's lobbying for the vote against, rather than telling them to walk away.

Harjes: Yeah, exactly. There are a couple of key reasons he points out that Express Scripts is not a company that Cigna should be buying. One of them is that the government has directly challenged the rebate system that Express Scripts' entire business model relies on. This is a growing trend within the regulatory environment. You have high-profile individuals making statements left and right that this rebate model might be completely eliminated. Couple that with the second threat that Icahn highlights, which is the threat of Amazon coming in and disrupting this part of the healthcare system. Icahn makes the argument that Express Scripts might not even be around for very much longer.

Campbell: Certainty not in its current business model. It might be helpful for listeners of the show who haven't heard our previous takes on PBMs to understand a little bit more about what Express Scripts does. It's a pharmacy benefits manager. It sits in the middle between the drug makers and the payers of these drugs. Essentially, what the pharmacy benefits manager does is try to leverage a bunch of different payers' buying power to negotiate better prices with the drug maker, and then passes on those savings to the payer, theoretically, taking a small piece for itself. I suppose you could make the argument that the small piece is somewhere between 5-8%, because if you look at Express Scripts' trailing 12-month gross margin, it's about 8%. If you look at its trailing 12-month operating margin, it's about 5%. 

As you said, with all of the pushback on drug pricing, trying to rein in all of the healthcare spending that we do here in the United States, the idea here is, what happens if we can eliminate these middlemen, and that 5%? Would that then flow all the way back to the consumer? The theory is, there's some perverse price game that's going on now, where because of the existence of these rebates, which get paid from the drug maker to reimburse the pharmacy benefits manager for cutting a good deal, they're based on list prices. The idea is, the list price is being artificially inflated to make the rebate look better, so that the pharmacy benefit manager can pocket more dollars in profit.

Harjes: Do you think the critiques that are laid out in this letter have merit?

Campbell: Yes and no. I think there are a lot of question marks now. Amazon bought PillPack recently, that certainly shows that they're very interested in distributing drugs directly to consumers. No idea yet on how they're going to be buying those drugs. Right now, they have a deal with Express Scripts, actually, as one of their pharmacy benefit managers. We're not sure how Amazon is going to go out and change the system, and if they will negotiate directly with drug makers or not, or if they'll use the existing system. I'm not sure necessarily how much that argument fits. Looking forward, certainly, you could see that. You could see Amazon being a goliath and saying, "We don't need you, PBM, we're going to negotiate directly with companies like Celgene. We're going to be able to get the best price because we have 100 million people that are in Prime." We'll see how that plays out. 

There's also some concern from Icahn in his letter that they're not going to be able to get all of the profit that they've promised to investors from this deal, all those wonderful synergies that we always talk about when we talk about deals. That's a typically a higher-margin business than a fee business, where a PBM would say, "Pay me a lump of cash and I'll negotiate the best deal for you." The rebates are more lucrative. If that business goes away, how much is Express Scripts really worth? Icahn's back of the napkin math, he came out with a price of $58 billion for Express Scripts. That's significantly lower than where we are today, in the high $70s. In his letter, he also says that he thinks Cigna could eventually be worth $250 per share if this deal gets voted down. Of course, that's a substantial premium to where Cigna is trading today. 

But, investors should realize, he has positions. He discloses them. He is long Cigna and he is short Express Scripts. He is talking his book. He has good rationale for talking his book, but he is talking his book.

Harjes: Exactly. I'm so glad that you made that point. That's exactly what I wanted to get to. His incentives are aligned here. He will do better if Cigna's stock does well and Express Scripts' stock does poorly, regardless of whether it's best for the healthcare system or any other altruistic arguments you want to make. This isn't really about business efficiencies, this is about whether or not he's going to make money. He's betting against Express Scripts, so if their stock does poorly, he does well. What he would like Cigna to do is instead use that cash to repurchase shares, boosting the stock price. He even quotes something to the effect of it being a short-term hitting that $250 level. 

As a long-term investor here, I don't love this. I don't think this is a super strong business argument. That's not to say that he's wrong, but that is to say that what screams out to me here is that he's looking to make a quick buck.

Campbell: Yeah. The long-term change in the industry could be that PBMs have to go to a fee-based system that's less lucrative, or that their business model disappears because of an Amazon, or whatever. To your point about what's best for the healthcare system, I'm not entirely convinced that if you get rid of PBMs, drug makers aren't going to end up pocketing more money. 

Let's look back for a second to Pfizer. People who pay attention to healthcare are probably aware that Pfizer had plans to raise drug prices last month on a few different drugs. That drew the ire of Donald Trump, who came out and tweeted and said, "Hey, I don't want you doing that." A conversation was had between the CEO of Pfizer and Donald Trump, after which Pfizer said, "We're not going to raise those prices for the rest of the year. We're going to stay where we are." Then, 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 a marketplace where we don't have rebates. I don't know the speed of that, but I do believe the Administration." 

What I find interesting about that is, it's not like they're coming out and even alluding between the lines that they disagree with the idea of getting rid of rebates. As the CEO of the company, he's talking his own book, too. It could very well be that if you break up a business model like Express Scripts, 80 million patients, and now people have to negotiate on their own, will they be able to get a list price that, net, would match what they get now on the post-rebate? I don't know. It could very well be that drug makers reduce their list prices, but the list prices still end up being a little bit higher than whatever the net would have been after rebates to the payers. If that's the case, it could cause a problem for Medicaid systems, wherein PBMs often pass 100% of the rebate through to those payers.

Harjes: Perhaps it's that uncertainty that ultimately solidifies this argument that Cigna should not buy Express Scripts. We just don't know, at this point, what the future of rebates looks like, what the future for PBMs looks like. If you add in some context that this comes a little over a year after a judge blocked the proposed $48 billion merger of Cigna and Anthem, it almost seems like Cigna buying Express Scripts is a little bit desperate to do a big deal, at any price.

Campbell: Yeah, kind of like a me-too thing. Especially with, you have CVS combining with a major insurer, as well. Maybe they're looking at it and saying, "We need scale." The idea of being able to say, "We'll acquire Express Scripts because that eliminates us having to pay the middleman. We can pocket any rebates to other payers that happen to use the Express Scripts model." That could change now. We don't know. 

There's also some concerns that Icahn expressed about, will payers that are Cigna competitors continue to use Express Scripts after this deal is done? Why would you support a business that's owned by one of your competitors? I think there's reason to debate that, as well. Also, Express Scripts has a chance of losing a very large customer in 2020 that accounts for 30% of its business. 

There are a lot of question marks that make me think, yeah, maybe this deal is one of those things that was, "Let's sign it, let's get this done," and then the market changes pretty rapidly and you're like, "Ugh, I don't know, is this really the best deal that we want to make?"

Harjes: For sure. Cigna and Express Scripts shareholders are set to vote on the deal on August 24th. A majority of the shares outstanding of both companies need to vote for the deal in order for it to close. As you mentioned earlier, if the shareholders vote it down, that breakup fee of $1.6 billion is negated, as opposed to if the board itself of Cigna decided to cancel the deal. It'll be interesting to see whether or not this letter is able to attract enough attention and sway the votes of enough Cigna shareholders for them to vote it down.

Campbell: Yeah. We don't even know whether or not regulators will sign off on this deal. They haven't weighed in yet.

Harjes: Yeah, that's fair.

Campbell: There's that animal to consider, as well. If the breakup was caused by regularies balking at it, then Cigna is on the hook for $2.1 billion instead of $1.6 billion. So, I could see that weighing into the calculus of this deal, as well. 

I really don't know where we go from here. Part of me is thinking that Cigna is going to continue to trade up, at least until the vote.

Harjes: Yeah, I think that's a reasonable prediction. All right, folks, that's all the news that's fit to print -- or record, as the case may be. Thanks for tuning in! As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Today's show was produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!