One of the biggest news items of the day yesterday came when CVS Health Corporation (CVS) announced they had received final regulatory approval for their proposed merger with Aetna Inc. (AET). Announced at the end of 2017, this is an intriguing deal, and not just for the massive $77 billion price CVS is paying for the deal that is expected close this week. Combining one of the largest pharmacy companies with another big player in the heath care provider industry offers the promise of a major shift in the way healthcare is offered and delivered in the United States; it certainly seems to put the combined company firmly at the forefront of a change that could leave the rest of both industries scrambling to catch up.
Earlier this year, pharmacy and healthcare stocks tumbled amid rumors that Amazon (AMZN) was investigating the potential of entering the business as well. That may still happen, and if it does, that should certainly amplify an already highly competitive industry landscape, but a lot of industry reports seem to indicate those fears may be overblown because of the regulatory challenges AMZN would have to hurdle just to make an initial move into the industry. Even if they do, this merger seems like a proactive, forward-looking move by both CVS and AET to set the standard AMZN and every other company is going to have to measure up to.
CVS is a stock that has performed pretty well this year – especially when you compare it to the performance of the broad market indices. It’s up almost 10% year-to-date, and nearly 13% in the last month alone. It’s fair to say that the biggest piece of that surge has come from enthusiasm about this pending merger; it’s been widely praised by analysts and industry insiders since it was announced. I’ve also seen a lot of analysts labeling the stock as a terrific value, based primarily on forward-looking estimates of what the combined company should be able to do. Some of that makes sense, I suppose; the real problem, of course is that forward-looking estimates are just that, and nothing more. The truth is that integrating two companies is a challenging task – and that is even when the two companies operate within the same market space as usually happens when a merger happens. Merging two companies in related, but completely separate industries is another matter altogether, and so a smooth integration and transition is certainly not a given.
There is a lot of promise for the future, to be sure, and the fact is that this is a mega-merger between two large cap stocks that are unquestioned leaders in their respective fields. Each company has significant fundamental strengths they bring to the table, and as a combined company, they offer some interesting potential opportunities, such as the expansion of CVS’ existing MinuteClinics to include AET’s clinical capabilities. Those “concept clinics” are expected to start rolling in early 2019, which means investors generally should have almost immediate feedback to work with in trying to analyze the likely success of the merger. What I want to do with today’s post is to consider what folding AET into CVS’s business structure is going to mean from a fundamental point of view, and from there to try to determine if the resulting company is likely to offer a compelling value to work with.
Fundamental and Value Profile
CVS Health Corporation, together with its subsidiaries, is an integrated pharmacy healthcare company. The Company provides pharmacy care for the senior community through Omnicare, Inc. (Omnicare) and Omnicare’s long-term care (LTC) operations, which include distribution of pharmaceuticals, related pharmacy consulting and other ancillary services to chronic care facilities and other care settings. It operates through three segments: Pharmacy Services, Retail/LTC and Corporate. The Pharmacy Services Segment provides a range of pharmacy benefit management (PBM) solutions to its clients. As of December 31, 2016, the Retail/LTC Segment included 9,709 retail locations (of which 7,980 were its stores that operated a pharmacy and 1,674 were its pharmacies located within Target Corporation (Target) stores), its online retail pharmacy Websites, CVS.com, Navarro.com and Onofre.com.br, 38 onsite pharmacy stores, its long-term care pharmacy operations and its retail healthcare clinics. CVS has a market cap of $81 billion. Aetna Inc. is a diversified healthcare benefits company. The Company operates through three segments: Health Care, Group Insurance and Large Case Pensions. It offers a range of traditional, voluntary and consumer-directed health insurance products and related services, including medical, pharmacy, dental, behavioral health, group life and disability plans, medical management capabilities, Medicaid healthcare management services, Medicare Advantage and Medicare Supplement plans, workers’ compensation administrative services and health information technology (HIT) products and services. The Health Care segment consists of medical, pharmacy benefit management services, dental, behavioral health and vision plans offered on both an Insured basis and an employer-funded basis, and emerging businesses products and services. The Group Insurance segment includes group life insurance and group disability products. Its products are offered on an Insured basis. AET has a market cap of about $69.4 billion
- Earnings and Sales Growth: Over the last twelve months, earnings for CVS increased by about 15%, while sales were mostly flat, increasing about 2%. For AET, earnings increased about 20% in the last year. CVS operates with extremely narrow operating margins, as Net Income was only 1.6% of Revenues for the last twelve months and 2.9% in the last quarter. AET has a wider margin profile, with Net Income that was 5.9% over the last year and 6.4% in the most recent quarter.
- Free Cash Flow: CVS’s free cash flow is healthy, at about $4.3 billion, while AET’s is more modest, and about $550 million. Both companies have good liquidity, with cash and liquids assets for CVS that totaled $41.6 billion in the most recent quarter, and $9.5 billion for AET over the same period.
- Debt to Equity: CVS has a debt/equity ratio of 1.66. This is higher than I usually prefer to see, but is primarily attributable to the massive increase in debt the company preemptively took on at the beginning of the year when the merger was first announced. Total long-term debt is $60.7 billion for CVS. AET has $7.7 billion in long-term debt, which is almost $2 billion less than their cash. CVS has also laid out an aggressive debt reduction program that they expect to lower the total debt the combined company will be working with to much more conservative levels early in 2020.
- Dividend: CVS and AET each pay an annual dividend of $2.00 per share. Whether that means that shareholders in the combined company will get to enjoy receiving a $4 annual dividend remains to be seen; my expectation is that the dividend will remain the same on a per-share basis in order to give the combined company more flexibility in managing their debt service.
- Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for CVS is $35.97 per share. At CVS’s current price, that translates to a Price/Book ratio of 2.21. The stock’s historical average is 2.48, which offers about a 12% upside from the stock’s current price. There is a more compelling argument to be made for the stock on a Price/Cash Flow basis, since the stock is currently trading more than 35% below that historical average. AET, on the other hand, is overvalued based on both its Price/Book and Price/Cash Flow ratios by anywhere from 5% (slightly overvalued) to 50% (very overvalued). Based strictly off of existing, historical information, I expect the combined company to initially be overvalued.
Here’s a look at CVS’ latest technical chart.
- Current Price Action/Trends and Pivots: CVS followed the broad market quite a bit lower in October, but rallied back above its early October high before dropping back a bit until late last week. The market’s enthusiasm for the merger is giving the stock a nice boost right now. Resistance is right at $80, which is almost where the stock is sitting right now. Immediate support is around $69. A push above $80, to about $82 (or whatever price its recent high translates to once the merger is completed), would mark a continuation of the stock’s upward trend since August, while a drop below $74 would mark a reversal of that trend, with a break below $69 representing an indication a new bearish trend could see an extended run. AET, not shown here, has a completely different technical picture, since the stock has been following a very impressive upward trend since February of 2016 and has more than doubled in price over that period.
- Near-term Keys: CVS is a stock that by most measurements would be considered undervalued, while AET is overvalued. It seems apparent that CVS is consciously paying a big premium for this deal. The potential to transform the healthcare industry is a compelling draw, and it’s safe to say that both companies believe they can thrive in that effort by doing it together. Does that make the stock a bargain right now? I think a lot of investors are going to be jumping onto the stock with exactly that expectation, so don’t be surprised if you see the combined company experience a pretty nice rally in the short-term, post-merger period. Over the next few months, I’ll be watching the financial results pretty closely, to see if they seem to line up with the story both companies have been presenting for the last year. No matter which way it goes, this is a deal that could mark a big turning point for both industries.