For the market to place a forward price multiple less than 10 on CVS Health Corp (CVS, Financial) is absolutely foolish. Along with Walgreens (WBA, Financial), these two firms form a quasi duopoly in retail pharmacy convenience.
The big difference is that while Walgreens looks to double down on retail, as evidenced with its purchase of Rite Aid, CVS doesn’t need to buy an inferior brand to acquire real estate. Instead, it’s focusing on building major ancillary value adds. That is what the Aetna deal is all about.
Aetna brings over $60 billion in sales and $3 billion in net income to the table. Aetna (AET, Financial) 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, including Aetna's debt, the total value of the transaction is $77 billion. Both companies have increased sales and used share buybacks to accelerate earnings per share growth. Since it’s a mostly cash deal, there won’t be much dilution for shareholders.
On one hand, CVS needs this deal. The Omnicare acquisition a few years ago has not met management’s expectations, one reason the value has dragged. Since CVS shareholders approved the merger in March, the stock has dropped 6%. Lower prices mean better long-term gains at this point, and could deliver better than market returns with or without Aetna -- better together obviously.
CVS just launched a new service for delivery of prescription drugs nationwide. It will also deliver other items, including cold medication, vitamins and allergy medication. The company’s 9,800 pharmacies will offer the next-day service for $4.99 and same-day deliveries in select urban markets for a higher fee to start. This could eventually turn into a free service if the scale is large enough. There’s also nothing stopping the company from disrupting the insurance industry itself, potentially giving free perks to its policyholders.
Leveraging their size to lower drug and other healthcare costs, the two companies could reduce costs by about $200 a year per member, possibly helping to pass through those cost reductions to members while adding billions to the bottom line.
Aetna’s CEO had this to say: “These medical savings have tremendous implications for our financial performance as well. Every 50 basis points that we can reduce medical cost trend results in nearly $500 million of additional underwriting margin for our customers and for Aetna.”
Investors would be well-served to buy both stocks at this point, as regulatory approval is highly likely and the deal should close this year. There’s still 10% upside in Aetna, and the combination will add 70% to the bottom line at CVS, with more to come in the next five years. That $8.75 billion in profit is worth more than 10x. At 15x, the market value is $131 billion. At 20x, its $175 billion. That’s assuming CVS poorly integrates its retail with its new insurance division.
There are so many good ideas that would come of this that it's no wonder Amazon decided to stay away from pharmacy operations.
Disclosure: I am long CVS and AET.
