I am recommending the purchase of put options on Anthem Inc. (NYSE: ANTM), a leading U.S. health insurer which offers Blue Cross/Blue Shield plans in fourteen states.  The company’s shares have been slowly falling of late and are reaching an attractive price area for this strategy.  I’ll tell you why I think the company is a “black box” in the following paragraphs, but here is a hint as to why I’m recommending this trade: the company has too many unanswered questions that are lingering, and the rising uncertainty in the healthcare system won’t likely help its cause.

The Company Details

Anthem is a big player and it has a well-diversified business base that includes government, individual, Medicare and Medicaid policies. But it is facing some serious headwinds, its management seems sluggish and its balance sheet is clearly in need of repair, or at the very least improvement. First, its cash and total investments column is flat, a potential harbinger of low growth in the future. More concerning is that its operating cash flow dropped nearly one-half on a year-over-year basis in its last quarter, falling below $1 billion.  I also don’t like the fact that it’s issuing more debt and its investments are actually generating losses, some $140 million in the most recent quarter. 

Something else that’s troubling is management’s seeming “no worries” tone when things are clearly not on their best footing.  On their recent earnings conference call the tone was calm and somewhat cautious, but there were no signs of overt worry.  But when analysts pressed management on several topics the answers were often uncertain and hazy, especially when it came to answering questions about the future of its Affordable Care Act (ACA, or “Obamacare”)  business where the company is clearly struggling along with the rest of the sector. 

What emerged from these exchanges between analysts and management was the possibility that the company might have made a major actuarial mistake when it went headlong into Obamacare and it doesn’t seem to know what its real costs structure and earnings will be in the future. While there was talk from the CEO of better than expected revenues for the quarter and there was no change in the guidance for earnings, although they guided revenues higher for the year, the financials reveal that most categories, other than cash flow related ones, are close to flat.  It’s also not very comforting to see that the “better than expected” results were based on lowered expectations and the major improvement on the earnings front was a decline in expenses of some $320 million from the past quarter, which is a return to where they were only a year ago.  

Terrible Timing

Anthem picked a bad time to make an offer to buy its competitor Cigna (NYSE: CI) in the hopes of growing to the point where it could reduce the potential headwinds of the Affordable Care Act.  Health insurance is a simple concept.  Big insurance companies are able to flex their muscles and reduce their payments to providers, while reducing covered services to policy holders, squeezing the upstream and downstream of the business with the design of increasing profits.   And the ACA seemed like the next catalyst for health insurers to get even bigger.

Legal Problems

Anthem will become the largest U.S. insurer if it combines with Cigna, and hopes to complete the deal before December 30, 2016.  But the merger is in doubt for several reasons. For one, the U.S. Justice Department sued to block the merger, along with Aetna and Humana, in July on the grounds that system prices would rise, and competition would be stifled.  The judge in charge of the Anthem lawsuit won’t rule until the end of January.  Cigna does not want to extend the merger deadline beyond April 30 because the two companies aren’t getting along.  It should be clear that this set of circumstances makes life very complicated for Anthem especially when you consider that by January 30^th there will be a new president in the White House and healthcare will be a front and center issue to be dealt with.  Anthem says it is going ahead with the Cigna merger and hints that Cigna has some problems of its own and is not being fully forthcoming with information about its operations in some states.  Cigna’s most recent quarter suggests that Anthem is correct in its assessment. Yet, Anthem doesn’t seem to want to back off the merger, again making me wonder about what management is thinking.

What could go wrong?

The answer to the above question is clear; everything can go wrong, and the results of things not going as planned have led to a high degree of uncertainty for Anthem.  The ACA has led to an increase in coverage of ill patients and the system doesn’t have enough money to cover them, despite premium subsidies. Anthem continues to add lives and lose money as it does.  This means that they still don’t get it.  All insurers made erroneous assumptions, and are now wary of the government because of the losses and because they are not going to be bailed out at taxpayer expense.  The government is no longer willing to let the insurance companies merge and create even bigger corporations.  Thus, the ACA marketplace looks set to implode, possibly creating a seismic event with wide ranging and highly unpredictable effects on the whole system.

Rationale for the Trade: Anthem is a Black Box

Anthem has a multiple partition “black box” problem with its Obamacare business: the questionable and now litigious merger with Cigna, and management’s unwillingness to consider that it should consider changing course.  While other companies are exiting this segment of the business, Anthem is doubling down at the same time that its merger with Cigna is in question,  its cash flow is falling and its balance sheet and earnings are not very appetizing.

Several analysts followed with downgrades of the company after the most recent conference call. And judging by its recent price action, the market is beginning to lose its patience.  This trade is designed to give the dynamics of the healthcare system a chance to unfold, and to allow enough time for circumstances and developments to fully affect this weakening insurer.  

Buy the Anthem December 16, 120 Strike Price Put (Symbol: ATNM121616P120) up to $7.  The 8/26/16 closing price was $5.60.