It's no secret that fears over Amazon (NASDAQ:AMZN) breaking into the mail order drug delivery business, and also potentially launching its own pharmacy benefits manager or PBM, has wreaked havoc on pharmacy chains such as CVS Health (CVS) and Walgreens Boots Alliance (WBA).
A big part of the thesis behind owning CVS is that it was substantially undervalued, both on a historical basis (trading at forward PE last seen during the financial crisis) and based on its future growth prospects.
In addition, I have confidence that CVS's quality management team will be able to adapt to fast changing industry conditions (as they have in the past) to keep the company's sales, earning, free cash flow, and dividend growing nicely in the years and decades to come.
However, now the Wall Street Journal is reporting that CVS is in talks to buy Aetna (AET) for $200 per share, or $66.9 billion ($87 billion deal with assumed debt) in one of the largest medical mega mergers of all time.
I've carefully studied the idea, both from a strategic and financial perspective, and have concluded that such an acquisition would likely be a terrible idea.
In fact, if management did end up making such a poor capital allocation decision, I fear that CVS's dividend growth thesis would be substantially degraded, potentially making it a far weaker income investment, and potentially forcing me to eventually sell my shares.
CVS Buying Aetna Makes Sense... Kinda
The St. Louis Dispatch has learned that Amazon has received wholesale pharmacy licences in at least 12 states, stoking concerns that the destroyer of numerous retail worlds is gunning for CVS and Walgreens.
Purchasing Aetna would certainly be defensive against Amazon since it would put CVS in an entirely different industry, one which, at least so far, Jeff Bezos has shown no interest in (health insurance).
In addition, CVS could move away from retail entirely, and install minute clinics as low intensity ERs in all its stores, thus disrupting the entire industry's business model before Amazon has a chance to.
And as my fellow contributor Wayne Toepke recently explained buying Aetna for the vertical integration could make sense given that the future of medicine is likely to be ruled by those players with the largest economies of scale, who can drive as much cost out of the medical supply chain as possible.
In fact, there is some precedent for this including CVS's $26.5 billion acquisition of Caremark in 2007 (which was another merger of equals meaning CVS bought a company of roughly the same size).
By buying Caremark, CVS was able to become a dominant player in the fast growing pharmacy benefit manager space. In fact, CVS just announced major deals with Express Scripts (ESRX), Cigna (CI), and UnitedHealth (UNH). These three companies combined have 243 million customers and fill over 3 billion prescriptions a year.
In other words, CVS purchasing Caremark was a brilliant strategic move that led CVS to become a much larger, more profitable and dominant company; despite the massive amount of shareholder dilution that resulted from the merger.
In fact, the Caremark merger was immediately accretive to both EPS and FCF/share because Caremark was able to add enough earnings and free cash flow to more than offset the new shares issued to pay for it.
That allowed CVS to continue maintaining a very safe payout ratio, and continue quickly growing the dividend, which as an income growth investor is ultimately my primary concern.
However, in this case, buying Aetna isn't likely to result in nearly as fortunate an outcome. That's because the economics of a merger between these companies just doesn't make sense.
CVS Is Ludicrously Undervalued While Aetna Is Monstrously Overvalued
Ultimately, for CVS shareholders, there are three main problems with buying Aetna.
|Company||Forward PE||Historical PE||Yield||Historical Yield||Percentage Of Time Yield Has Been Higher|
|CVS Health||10.9||17.1||2.9%||1.2%||All Time High|
Sources: Gurufocus, YieldCharts
The first is that right now Aetna is trading at very lofty valuations, far in excess of its historical norms.
In fact, if CVS were to in fact pay $200 per share for Aetna that would represent 35.1 times trailing 12-month free cash flow.
But what about the future? Perhaps Aetna's growth prospects are superior to CVS's and thus tell us something that historical valuation metrics don't?
|Company||FCF/Share||10-Year Projected FCF/Share Growth||Fair Value Estimate||Growth Baked In||Discount To Fair Value|
Sources: Gurufocus, Morningstar, Fast Graphs
While true that analysts expect Aetna to grow slightly faster in the next decade than CVS, the difference is nowhere near big enough to justify paying $66.9 billion for Aetna.
In fact, using a 9.0% discount rate (the opportunity cost of money based on the S&P 500's historical return), I estimate that Aetna, at $200 a share, would represent a 70% premium to its fair value, as estimated by a 20-year discounted free cash flow analysis.
Meanwhile, CVS shares are trading at a deep discount to fair value, meaning that now is precisely the worst possible time to print new shares to make big purchases.
Which brings me to the biggest issue with CVS purchasing Aetna, the massive negative hit it will cause to CVS's EPS and FCF/share.
The Math Just Doesn't Add Up
|Company||Revenue||Net Income||Free Cash Flow||Shares Outstanding||EPS||FCF/Share|
|CVS Health||$180.8 billion||$5.3 billion||$6.2 billion (2017 guidance)||1.05 billion||$4.98||$5.90|
|Aetna||$62.2 billion||$1.6 billion||$1.9 billion||347 million||$4.51||$5.42|
|CVS + Aetna (all stock deal)||$243.0 billion||$6.9 billion||$8.1 billion||2.04 billion||$2.86||$3.36|
Sources: Morningstar, Gurufocus
Aetna's margins, especially its net and FCF margin, are simply too low for the currently described deal to be accretive to CVS shareholders.
In fact, if CVS where to buy Aetna in an all-stock deal, it would effectively have to double its share count, resulting in EPS and FCF/share declining by 57% and 43%, respectively.
But wait what about synergistic cost savings? While there may be some of those, say from elimination of overlapping administrative departments (such as HR and accounting), it isn't going to make anywhere near enough of a difference to make this kind of deal structure make sense.
After all, this deal is for increased vertical integration rather than horizontal, meaning it brings in an entirely different business, which limits long-term synergistic cost saving opportunities.
Of course, another option in this low interest rate environment is for CVS to take on a large amount of debt to partially or even fully fund the acquisition. This would greatly diminish the dilution of CVS shareholders.
However, there too we run into the grim realities of math that just doesn't add up.
Buying Aetna Means Crazy High Leverage
|Company||Debt||EBITDA||Debt/EBITDA||Annual Interest Cost||EBITDA/Interest|
|CVS Health||$27.5 billion||$12.1 billion||2.27||$1.02 billion||11.93|
|Aetna||$20.7 billion||$3.9 billion||5.36||$638 million||6.04|
|CVS + Aetna (all stock deal)||$48.2 billion||$16.0 billion||3.02||$1.65 billion||9.66|
|CVS + Aetna (all debt deal)||$115.1 billion||$16.0 billion||7.19||$4.1 billion||3.88|
Sources: Morningstar, Gurufocus
Another problem with buying Aetna is that the company is far more leveraged than CVS, meaning that even if CVS were to pay for it with all stock, it would still result in taking on a lot of debt (about $21 billion worth).
That could result in a credit downgrade, a bad thing to have happen in a rising interest rate environment. In addition, we can't forget that one of the proposed changes to the tax code is a potential elimination of interest deductions, which would hit highly leveraged companies especially hard.
It also means that there is essentially no way that CVS can fund this deal with a lot of debt (to avoid diluting shareholders). It would result in debt levels rising to dangerous levels ($115 billion) and would likely result in CVS being downgraded to junk status by credit rating agencies.
|Deal Structure||Pro Forma EPS/Share||Pro Forma FCF/Share||EPS Change||FCF/Share Dilution|
Sources: Morningstar, Gurufocus
The problem is that the only way for the CVS/Aetna merger to make any kind of sense, from a dilutionary perspective, is to do the deal entirely with debt, meaning borrowing nearly $67 billion to overpay for Aetna.
Of course, CVS's actual interest costs are likely to be even higher than in my model, since CVS is currently enjoying an average interest rate of 3.7%, and it would almost certainly need to pay over 4% to borrow such a significant sum.
Even worse? Whereas even highly overvalued mergers usually end up becoming accretive to shareholders, in the case of CVS buying Aetna, this isn't likely to be the case.
|Company||2026 Projected Net Income||2026 Projected FCF||2026 Projected Shares Outstanding||EPS||FCF/Share|
|CVS Health||$12.6 billion||$14.7 billion||838 million (2% buyback rate)||$15.03||$17.59|
|Aetna||$3.9 billion||$4.7 billion||317 million (1% buyback rate)||$12.23||$14.69|
|CVS + Aetna (all stock deal)||$16.5 billion||$19.4 billion||2.0 billion (2% buyback rate)||$8.23||$9.70|
Sources: Morningstar, Gurufocus, Fast Graphs
That's because CVS and Aetna are essentially growing at the same rate, meaning that the large amount of dilution created by this deal won't ever be overcome by increased sales, earnings, or free cash flow from the combined companies.
Not unless CVS can execute brilliantly on strategic synergies, such as somehow convincing all of its pharmacy customers to switch to Aetna health insurance. Another unlikely option would be create a loyalty program similar to Amazon Prime that convinces all its customers to make CVS their one-stop shop for all medical needs.
In other words, vertical integration for its own sake isn't necessarily worth the negative dilutionary effects of this deal. For example, if CVS really wants to dominate every aspect of medicine (and thus be safe from Amazon), it might as well dilute shareholders into oblivion by also purchasing:
- drug maker Pfizer (PFE)
- medical device maker Medtronic (MDT)
- America's largest medical distributor McKesson (MCK)
- America's largest hospital and nursing home owners Ventas (VTR) and Welltower (HCN)
All of these acquisitions would certainly be "strategic" and achieve vertical integration, but with CVS shares this cheap, they would also so dilutionary that CVS's dividend would need to be cut so that management could go about its empire building in a desperate attempt to "do something".
The bottom line is that any way you cut it, there is no way to structure a CVS/Aetna merger at this time that doesn't result in CVS shareholders being made much worse off.
And as for the hopes that CVS's crack management team can somehow pull off a miracle and achieve long-term strategic synergies that we can't yet predict (i.e., corporate buzz words), well this might indeed happen as it did with Caremark.
But keep in mind that the bigger the acquisition, the harder it is to pull off successfully. In fact, a study by the National Bureau of Economic Research found that of 12,023 large scale mergers over a 20-year period, 87% destroyed shareholder value, to the collective tune of over $200 billion.
The risk of this unfortunate outcome only increases with the size and valuation of the deal, and since Aetna is trading so richly right now, this bodes poorly for the ultimate outcome of such a merger.
However, my biggest problem with CVS potentially buying Aetna is what it could mean for CVS's future dividend growth potential.
Deal Could Blow A Hole In CVS's Dividend And Total Return Profile
|Company||Yield||FCF Payout Ratio||10-Year Projected Dividend Growth||10-Year Potential Annual Total Return|
|CVS + Aetna (all stock deal)||2.9%||59.5%||6.1%||9.0%|
Sources: Management Guidance, Morningstar, Fast Graphs, Gurufocus, CSImarketing, Multipl.com
For me, the ultimate reason I own any dividend growth stock is because of its strong payout and total return profile. That means an attractive yield, a safe dividend (strong balance sheet and low payout ratio), and in the case of lower yielding companies (such as CVS), good long-term dividend growth potential.
CVS has historically been very good at rewarding dividend lovers, with 14 straight years of increasing its payout at double-digit rates.
Currently, CVS expects to generate long-term EPS and FCF/share growth of 10% to 12%, and analysts expect this to translate into double-digit payout growth over the next decade.
Combined with CVS's highly undervalued shares, this means that CVS is a very attractive dividend growth investment.
BUT if it buys Aetna, through an all-stock deal (which is the most likely way the deal would be structured), then the massive FCF/share dilution would result in not just a much less safe payout, but one that's likely to grow at about half the rate over the next 10 years.
That's because management has said that it wants to maintain a long-term payout ratio of 35%, and buying Aetna would likely result in the payout ratio nearly doubling to 60%.
In other words, if CVS were to announce it was buying Aetna in an all-stock deal, then I would expect management would begin giving us token $0.01 per quarter per year increases.
While theoretically management's payout goals could result in a dividend cut, given CVS's dividend friendly track record, I think this kind of worst case scenario is unlikely.
However, the math is clear, that buying highly overvalued Aetna shares by issuing highly undervalued CVS shares is a major long-term blow for CVS investors, as it would likely reduce the long-term total returns by about 40%.
The good news is that this is still likely to beat the S&P 500, which is so overvalued that it's likely to underperform its historical 9.1% total return since 1871. That means that if you are a long-term CVS owner, you shouldn't necessarily sell it, even if this merger is announced and goes through.
However, personally, I have a policy of targeting 10+% long-term total returns, so if CVS ends up missing my 7.5% dividend growth minimums in 2018 and 2019 (two years in a row), I'll be selling it in favor of other highly undervalued, low-risk dividend growth stocks.
Bottom Line: CVS Buying Aetna Seems Like An Ill Conceived Knee-Jerk Reaction
Please don't misunderstand me, I'm not recommending that CVS shareholders sell shares (especially at these undervalued prices) over mere rumors of a potential merger with Aetna.
After all, CVS hasn't announced anything yet, and the idea of potentially buying Aetna is just one of about a dozen potential strategies the Board is considering. And even if the two companies were to agree to a merger, it would likely require a long regulatory approval process whose success is far from guaranteed.
That being said, I'm opposed to this potential acquisition because I don't see the obvious strategic rationale behind it, especially given the massive amount of dilution that CVS shareholders would have to endure to make the deal happen.
Dilution so extreme that even a decade down the road it would likely fail to be accretive to EPS and FCF/share, and thus could result in far slower dividend growth, and weaker total returns.
In other words, overpaying for Aetna with highly undervalued shares seems like an ill conceived, knee jerk reaction to Amazon's potential entrance into CVS's space, one that is likely to end up destroying shareholder value if it happens.
Disclosure: I am/we are long CVS, WBA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.