Background: terms of the deal
As you know, CVS Health announced plans for a friendly takeover of Aetna (AET), a large health insurer with about 22 million lives covered. The announcement date was Dec. 3, 2017. In March, shareholders of both companies approved the deal, which is now waiting regulatory approval.
Terms are as follows:
Aetna shareholders will receive $145.00 per share in cash and 0.8378 CVS Health shares for each Aetna share. The transaction values Aetna at approximately $207 per share or approximately $69 billion1. Including the assumption of Aetna's debt, the total value of the transaction is $77 billion.
If CVS is at $66, then the deal is worth exactly $200 to AET shareholders. If CVS drops to $60, the deal is worth $195. If CVS drops to $54, the deal is worth $190. With CVS projecting GAAP EPS for this year above $5, which includes heavy interest payments for debt it has already incurred, I think that this range is about as low as CVS is likely to drop this year, even if the stock market (SPY) turns a lot lower. So if AET is in the low $180 range, shareholders should make a decent return on the money assuming that the deal closes by year-end, as the parties expect.
And I think that the case for the deal being rejected by regulators is minimal.
The case for AET
The new aspect of the proposed business combination is that an insurer and a retail pharmacy (CVS) come under one corporate umbrella. The other part, that an insurer and a pharmacy benefits manager (Caremark) would be under the same corporate umbrella, is old news. UnitedHealth (UNH) and Humana both already do that.
The other issue is that perhaps either of the above twin relationships could be OK, but for some reason, all three parts being in the same corporation somehow could be deemed anticompetitive.
Question #1, is AET being tied in with a retail pharmacy which also sells general merchandise anticompetitive?
I believe not. AET's 22 MM lives comprise only 7% of the population and a modestly higher percentage of the insured population. So there are lots of choices of insurers should Aetna, under the CVS umbrella, provide policy-holders little choice in pharmacies. Where AET may be a monopoly provider to some defined groups, such as those created under Obamacare, restrictions against tying to CVS pharmacies might be required to approve the deal; but that would be a minor detail given how rare that situation would be.
Turning it around, while CVS is getting near the 10,000 pharmacy mark, total retail pharmacies in the US are likely near 70,000 now. So CVS only has about 14% of the pharmacies in the US, nothing even close to dominance and not a monopoly in any way.
The only situation that comes quickly to mind as an issue would be if a community has only one pharmacy, and that's a CVS. Presumably a condition of approval of the deal would be that this sort of situation could not be abused to force community residents to only be insured by Aetna.
Thus, I like this aspect of the deal passing muster with the regulators.
Since tying a PBM to an insurer is a known, approved situation, my remaining question is whether there is something anticompetitive in having an insurer, a PBM and a pharmacy/retailer owned by the same corporation.
Since I'm not a lawyer or antitrust expert, and have not consulted one, I'll just comment that it's difficult for me to see a problem here.
In addition to the law, which is subject to interpretation, there are politics to consider. CVS is representing that its goal from this merger is to save the public money by improving community health via outreach (Minute Clinic expansion and related activities) and by being more efficient, thus restraining pharmaceutical inflation. If the deal is blocked on questionable antitrust grounds, then if drug price inflation returns, the administration can come under criticism.
So I think the deal has a high likelihood of going through on schedule. Arbitrarily, in the 85-95% range. For investment purposes, I'll go with 90%.
That would make AET, around $181, moderately attractive if $195 is assumed as the take-out value. The reasoning: that's an 8% price gain. Multiplying by 0.9 gives 7%.
What's the downside? I don't think it's at all horrible. Consensus for AET is for $12.05 EPS in 2019 if there is no deal. A normal P/E for it might be 14X in the middle of the year, so that one year from now, if there is no deal, AET might be trading at $12 X !4 = $168. That's only a 7% downside.
Obviously, there is a matrix of possibilities to consider, with different and worse downside risks to AET, but also more upside potential should CVS rise.
Since I like AET, my bottom line is that I'm going to go long this name assuming it does not trade up much from Friday's close.
Next, some comments on CVS.
CVS - deservedly cheap but that provides it upside
I am long CVS at least for a trade and maybe the long term. It did a poor job both conceptualizing the Omnicare acquisition a few years ago, and now it is reporting on its latest conference call that the deal has not met its expectations. This is what happens when you overpay. The expectations have to be inflated for the numbers to pencil in, and then they are rarely met.
Beyond that, CVS has lots of business issues, as a cursory look at its Q1 results will show. It's debt-heavy and struggling in a disinflationary or deflationary environment in its pharmacy business. The front end of the store has all the issues that general retail has, and we can see from Express Scripts (ESRX), a stand-alone PBM, that the PBM business (CVS's Caremark division) is a tough space now.
Nonetheless, using GAAP due to the heavy amortization charges at CVS that tie into its debt load, but adjusting GAAP for the big increase in interest costs due to borrowing in advance to fund the AET deal, I come up with about $6 EPS projected for 2018 excluding the extra interest cost ($221 MM in Q1 alone, almost all due to the AET deal).
That puts CVS, at $66, at around 11X my estimate of "real," or "adjusted GAAP," EPS for this year.
And as noted, I like the AET deal in that I think that CVS is acquiring it at what is, by today's deal standards, a bargain price, only about 16-17X next year's expected earnings.
As far as AET goes, all trading when a takeover is underway involves specialized risks. If the deal collapses, there is no clear bottom for AET in the short run, and one never knows on the long run.
So far as CVS goes, it may look cheap for a good reason.
So, please be careful and consider all the disclosures of risk from either company should you wish to go long, or stay long, one or both of these names.
Concluding points and summary
I have been talking about overcapacity in the pharmaceutical and biotech arena for some time, and recently made the point that M&A between large pharma/biotech companies would take capacity quickly out of the system and thus would be good for investors going forward. For now, the insurers and payors in general are regaining (or, have regained) the upper hand, and this shows in the stock price trends of AET, Cigna (CI), and UNH. At some point this will change, and the pharma companies will have their up-cycle (in my humble opinion). But for now, CVS moving more toward health care and shrinking the proportion of its business that comes from being a general retailer is, I believe, a good thing. I'm hopeful that CVS can execute on the AET deal better than it executed on the Omnicare deal. One simple reason to think this way is that if the deal concludes more or less on schedule, I think that CVS will be gaining a well-run asset at a fair price. That's a rarity in large-scale M&A these days.
I like AET as its own stock at prices not too far below the current price, which is around $181 as I submit this pre-market Monday. And, I think the deal will very likely close with few objections from the Feds. So I like the upside:downside considerations here.
CVS has had its troubles, but the stock is far off its highs both in time and price. I see the stock as having nice upside potential, with new ways to win if it acquires AET at the reasonable proposed price and if it returns to the winning acquisition-related techniques it showed when it acquired Caremark and numerous pharmacy chains.
Thus, I have written this article to provide a point of view for any interested parties. I am long CVS and plan to go long AET if the price is around $181 in Monday's trading. Any stock may be sold, though, at any time. Each stock has its own risk, which all investors should consider.
Thanks for reading and sharing any comments you wish to contribute.
Disclosure: I am/we are long CVS. 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.
Additional disclosure: Not investment advice. I am not an investment adviser. May go long AET, CI, ESRX at any time. May sell any stock that is owned at any time without notice.