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Morningstar | Reassessing Our Managed-Care Coverage; Moat, Trend, and Fair Value Changes Across the Board. See Updated Analyst Note from 06 Mar 2019

We've taken a fresh look at the managed-care industry and have come away a bit more constructive on health insurers broadly. We're raising our moat ratings for UnitedHealth and Cigna to wide and narrow from narrow and none, respectively. Additionally, we're revisiting our industrywide negative moat trend outlook and bumping United to stable. For CVS and Cigna, we’ve assigned positive trend ratings, largely attributable to the competitive benefits we expect each business to achieve through their integrations of Aetna and Express Scripts, respectively.

For United, we're raising our fair value estimate to $300 per share from $218, largely driven by our moat upgrade and more optimistic longer-term assumptions for the franchise. We think United is uniquely deserving of a wide moat rating driven by the cost advantages and network effects embedded within the largest private health insurance organization nationwide. Unrivaled scale allows the firm to price its insurance book commensurate with the lowest cost per insured member of the firms we cover, which has led to industry-leading gains in membership over the past five years.

At Cigna, we think its merger with Express has created an organization that deserves a narrow moat rating. As a result, we're raising our fair value estimate to $231 per share from $160. While we think the combination of medical and pharmaceutical benefits management is strategically sound, underpinning our positive trend rating, integration execution will be critical for continued stock outperformance from here.

Finally, we're trimming our fair value estimate for CVS to $92 per share from $96 to account for recent results. Management's outlook for 2019 came in below our expectations, largely attributable to weakness at its no-moat retail and long-term care segment. We think the Aetna transaction will ultimately lead to an improved competitive position, which appears to be trending ahead of initial expectations.

We'd point investors toward United and CVS as our highest-conviction ideas trading at the most compelling discounts to our revised estimates of intrinsic value. With United currently trading near 16 times our estimate of 2019 adjusted earnings, investors have the opportunity to buy an above-average business at a below-average valuation. The firm's more diversified operations make it less prone to regulatory disruption than peers, in our view, and its leading positions in insurance, ambulatory care, data and analytics, and pharmacy benefits give it advantages that competitors will find hard to replicate. A best-in-class business, combined with Exemplary stewardship, gives us confidence in the long-run trajectory of firm, which we think should be a staple in investors' healthcare portfolios.

The outlook for CVS is a bit more muddied, as the firm's pharmacy business catering to the long-term care market continues through a period of prolonged weakness. We don't view this as core to the firm or our thesis, and would encourage investors to look through this volatility toward the longer-term earnings power of a combined CVS and Aetna. We think this transaction puts the firm nearest United in terms of competitive positioning, although its reliance pharmacy and PBM operations make it somewhat more prone to regulatory disruption. With the stock trading below 10 times our estimate of 2019 adjusted earnings, the market appears to be taking a too pessimistic view, in our opinion--despite our reduction in fair value, the stock remains in 5-star territory.

While we like the strategic decision to bring Cigna and Express together, we think the firm is the most exposed to idiosyncratic risk out of these three businesses. Express will account for roughly 50% of firmwide operating profit, by our estimate, leaving it most exposed to policy-driven changes percolating within the PBM industry. In addition, the transaction was completed on the cusp of Express losing its largest customer, Anthem. While management took this into account in its evaluation and valuation of the business, it likely opens the door to incrementally more unknowns than your run-of-the-mill megamerger. Given our relatively higher estimate of uncertainty for Cigna, we think both CVS and United offer more attractive risk-adjusted returns for investors.