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The Huge Spread on the Cigna–Anthem Merger

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Merger spread analysis

To perform merger arbitrage, the investor will generally buy the stock of the company being acquired, sell short the relevant ratio of the acquirer’s stock, if applicable, and wait for the deal to close. When the merger is completed, the investor will exchange the stock of the company being acquired for the deal consideration.

In the case of the Cigna–Anthem merger, Anthem (ANTM) is buying Cigna (CI) for a headline amount of $188 a share, comprised of 0.5152 shares of Anthem and $103.40 in cash. Due to the serious antitrust risks involved, the deal will take a long time to complete. It will probably close around the end of 2016.

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Based on prices as of the close on Monday, July 27, the spread is trading at $35.55 or about 24% gross. The annualized return is almost 16%. This means that if an investor bought Cigna and shorted Anthem at the correct ratio and waited for the deal to close, they would make 16.5%, assuming the deal closes at the end of 2016. This spread indicates a deal with substantial risks.

Note the dividend treatment is unusual in this transaction. Cigna pays a 4 cent per share annual dividend, and Anthem pays 62.5 cents quarterly. The agreement allows for Cigna to match Anthem’s dividend to its own shareholders. This means the negative dividend carry is eliminated.

Obamacare changed the game

Given that Obamacare limits profits on individual plans, the way for health insurers to increase profitability is to cut administrative costs. The easiest way to do that is by combining or reducing duplicate or redundant administrative and corporate functions.

Larger insurers also have more negotiating leverage with hospitals and other health care providers. And finally, to enhance profitability, these companies should diversify their operations, as we know the government will be parsimonious with rate increases.

This deal is about scale, synergies, and diversification.

Other merger arbitrage resources

Other important deals include the Humana (HUM)–Aetna (AET) transaction, which is slated to close in late 2016. For a primer on risk arbitrage investing, read Merger arbitrage must-knows: A key guide for investors.

Investors who are interested in trading in the healthcare sector should look at the Health Care Select Sector SPDR Fund (XLV).

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