CVS: Great For All - Apart From Shareholders

| About: CVS Health (CVS)

Summary

CVS's near-term tangible growth opportunities post-deal are small.

Low to mid-single digit accretion expected in 2nd full year.

CVS is undervalued relative to growth.

Investment Thesis

The market remains highly doubtful that CVS Health (CVS) will be able to merge with Aetna (AET). While I assume that the merger is more likely than not to complete, even if CVS succeeds in merging with Aetna, CVS's stock has limited upside potential.

Financials of the deal

The deal is being spun as being value-enhancing for shareholders. While on the surface I would agree, upon deeper analysis, the combined company's growth prospects appear quite modest, in fact. The combined company would have low to mid-single digit accretion starting in the 2nd full year (let’s assume the mid-point, which points to a growth of 3%, starting in the 2nd full year or late in 2020, assuming the deal does actually close in mid-2018). Meanwhile, CVS would ultimately have a stronger physical presence - which is an interesting and a noteworthy strategy, particularly on the backdrop of so many brick-and-mortar stores trying to cut back on their physical presence, with so much Amazon (AMZN) fear in the investment community.

Moving on, while the deal does not create many synergies, the business model should benefit from being a low-cost operator. Essentially, the acquisition is costing CVS $77 billion, with the expectation that it would bring in roughly $6 billion in adjusted EBITDA - therefore not shockingly expensive, particularly to gain control of a company which has had a 13% 5-yr CAGR, as well as remarkably strong and stable free cash flow profile.

Therefore, on the back of the acquisition, CVS would be left with an additional $45 billion of debt, which I calculate, adding to its existing outstanding debt would end up being approximately $83 billion in total. Moreover, CVS estimates that the pro-forma adjusted EBITDA of the combined entity might generate approximately $18 billion - with slightly improved EBITDA margin for CVS at 8.4%. Thus, CVS would be trading at less than 9 times EV to EBITDA. Overall, it is not shocking expensive. Again, since management highlights that the deal will only be accretive in the 2nd full year, with roughly 3% EPS accretion, investors would have to be very patient throughout this period for a timely and highly costly integration to run on time and on budget – the cynic in me believes that there are just too many assumptions in the plan, for not so much icing on the cake down the road.

Additionally, since CVS's share repurchase program will be suspended, its excess free cash flow will now be earmarked to pay down debt. Thus, what had been offering its EPS number a boost will now be removed. This is noteworthy since in the past 3 fiscal years CVS repurchased very roughly $4.5 billion - which undoubtedly helped its EPS number grow in the face of margin pressure, which CVS had been under during fiscal 2016 and up to the first 9 months of 2017.

Valuation

CVS's stock has languished the S&P 500 (SPY) during 2017. Whereas the S&P in 2017 is up 17% in its year-to-date performance, CVS's stock is down close to 10%. While CVS appears to unjustifiably trade at a discount to itself, the uncertainty of whether Aetna will indeed be successfully acquired or not has not helped investors' sentiment in the stock.

Also, while on a P/Cash flow 5-yr average CVS was being priced at closer to 14 times, it now trades for practically half that multiple, at 7 times. So, on the one hand, its valuation appears enticing, although on the other hand, the ultimate tangible growth opportunities here appear slim. Which might seem at odds with what management is preaching, as CVS speaks of numerous synergies but presently only highlights $750 million of actual synergies towards 2020.

Takeaway

As the valuation section above alludes to, this investment will not be a strong home run for CVS's shareholders. Many shareholders who were investing in the stock for its fair and growing dividend yield will find themselves uninterested in remaining invested in the stock, while having to wait many years for CVS's debt burden to meaningfully reduce from roughly 4.6X to below 3X - so that CVS's balance sheet will once again have the flexibility to resume growing its dividend.

If I was pressed between CVS and Walgreens (WBA), I think Walgreens carries a slightly more favourable margin of safety.

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Disclaimer: Please do your own due diligence to reach your own conclusions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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