[Valuation Analysis] Buy CVS before the Aetna acqusition is completed.

As discussed in the November 2017 portfolio update, I recently purchased two call options of CVS Health Corporation (Ticker: CVS, Exchange: NYSE), an American retail pharmacy and health care company.

Company Overview

CVS Health Corporation (“CVS”) mainly operates in two segments: Retail/Long-term Care Segment and Pharmacy Benefit Management.

o   Retail/Long-term Care Segment

·         CVS has the largest pharmacy store chain in the U.S. with approximately 23.8% share of the U.S. retail pharmacy market.

·         CVS currently operates 9,709 retail pharmacies, online pharmacy websites and over 1,100 retail health care clinics.

·         The pharmacy retail drugstores sell prescription drugs and a variety of over-the-counter and personal care products, cosmetics, etc.

·         Long-term care (“LTC”) operations include the distribution of pharmaceuticals, related pharmacy consulting, etc.

·         CVS serves about 5 million customers each day.

o   Pharmacy Benefit Management

·         CVS offers Pharmacy Benefit Management (“PBM”) to employers, insurance companies, unions, government employee groups, health plans, Medicare Part D plans, etc.

·       Pharmacy Benefit Management includes developing and maintaining the formulary, contracting with pharmacies, negotiating discounts and rebates with drug manufacturers, and processing and paying prescription drug claims.

·         In short, CVS provides services which helps its clients (notably government and insurance companies) reduce pharmacy costs.

·         CVS filled or managed approximately 1.2 billion prescriptions in 2016 for nearly 90 million PBM Plan Members.

Summary of CVS's business lines (excerpt from a CVS investor presentation)

Summary of CVS's business lines (excerpt from a CVS investor presentation)

Aetna Acquisition

On December 3rd, 2017 CVS and Aetna (NYSE: AET), an American health insurance company, announced that they reached an agreement for CVS to acquire Aetna. The transaction is expected to close in the second half of 2018.  It is subject to approval by CVS Health and Aetna shareholders, regulatory approvals and other customary closing conditions.   

o   Aetna Overview

·         The third largest health insurance company in the U.S. with about 6% market share, serving an estimated 44.6 million people.

o   Potential impact of the acquisition (synergy, etc.)

·          Aetna currently has $61 billion in revenue. The combination of CVS and Aetna will most likely make the largest health care company in the U.S. in terms of the revenue. 

(excerpt from a CVS investor presentation)

(excerpt from a CVS investor presentation)

·          CVS is foreseeing $750 million of synergies in second full year after the acquisition. 

(excerpt from a CVS investor presentation)

(excerpt from a CVS investor presentation)

·          CVS also lists several potential long-term synergies. 

(excerpt from a CVS investor presentation)

(excerpt from a CVS investor presentation)

Competitors / Potential Entrants

The following are examples of CVS’s competitors in the Pharmacy and PBM field.

o   Walgreens (Pharmacy)

·         The second-largest pharmacy in the U.S, operating 8,175 stores across the country. CVS and Walgreens account for about 50% of total market share.

·         Unlike CVS, Walgreens does not offer PBM. Walgreens business strategy seems to simply focus on expansion on the pharmacy business, as seen in the acquisition of Switzerland-based Alliance Boots to form a global business.

o   Rite-aid (Pharmacy)

·         The third-largest pharmacy in the U.S.

·         Walgreens has attempted to acquire Rite-aid several times but failed to attain regulator’s approval. After all, Walgreens purchased 1,932 stores of Rite-aid, which is about half of Rite-aid’s store.

o   Express Scripts (PBM)

·         The largest PBM organization in the U.S.

·         The company recently lost its biggest client, insurer Anthem Inc. over dispute about drug prices and rebates.

o   UnitedHealth Group (PBM & Insurance)

·        The largest health insurer, with more than 45 million members in the U.S.

·        UnitedHealth also owns more than 400 surgery centers and urgent-care clinics and runs medical practices for about 22,000 physicians across the country.

·        UnitedHealth offers PBM filling more than 100 million prescriptions per month – taking big customers away from rivals CVS and Express Script. For example, UnitedHealth won a five-year, $4.9-billion contract for the California Public Employees’ Retirement System against CVS and Express Script.

o   Amazon (Pharmacy, potential entrant)

·         There has been speculation that Amazon may enter the retail pharmacy business as media reported that the company has gained approval from a number of state pharmaceutical boards to become a wholesale distributor.

SWOT Analysis

Assuming that the acquisition will go through, the combined entity (“CVS-Aetna”) will have significant strength in my opinion.

o   Strength

·         As far as I know, CVS-Aetna will be the only health care company in the U.S. which offers pharmacy, PBM and health insurance as one entity, which will be a comparative advantage against most competitors in the U.S. healthcare sector. 

Summary of the competitive landscape

Summary of the competitive landscape

·         For example, CVS’s 9,709 retail pharmacy locations can serve as a marketing entity of the health insurance business. Such strong exposure to consumers should provide the company an edge against UnitedHealth.

o   Weakness

·         The very long-term growth might be limited since CVS only seems to focus on the domestic (U.S.) market.

·         Health insurance business entails political risks. For example, the demand for private health insurance will plummet if the U.S.A decided to offer free-healthcare.

o   Opportunity

·         Aging population and increasing health care spending in the U.S. are strong tailwinds for the industry.

·         Trump’s corporate tax cut should boost CVS’ after-tax earnings. CVS’s current effective tax rate is roughly about 38%. The tax cut to 20% will be quite significant.

o   Threat

·         I personally do not believe that Amazon’s entry into pharmacy business alone will be a threat as CVS’s retail locations provide “last mile” advantage in terms of home delivery. However, if Amazon decided to team up with Walgreens, the alliance could be a large threat at it obscures CVS’s location advantage against Amazon.  

Valuation Analysis

o   Assumptions

I will assume the following for the sake of my valuation and setting a price target. These assumptions include both conservative and optimistic measures.

1.      The acquisition completes in 2018 without issue.

-          It’s a vertical integration and I believe CVS has sufficient justification to convince the DoJ that the merger will be beneficial to the consumers, lowering the overall healthcare cost.

2.      Synergy takes in effect starting 2020. No growth or cost savings in 2018 and 2019.

-          Due to the size of each company and its operations, I believe it is reasonable to assume that the post-merger integration (PMI) will take at least 1.5– 2 years. Until PMI completes, I assume no growth or cost savings.

3.      The synergy will result in $750 million cost savings in 2020

-          This is based on CVS’ own projection. I will use their projection as it is since the explanation seems plausible. 

4.      2% annual growth in Free Cash Flow to Firm for 2020-2030 and 0% onward.

-          I believe 2% annual growth will be achievable as the CVS-Aetna merger will have a wide range of growth and cost saving strategies as follows:

Ø  CVS can use its 9,709 retail location as the sales center of Aetna’s insurance business.

Ø  Aetna can provide its insurance members incentives, such as product discounts, to visit CVS’s retail pharmacies and health clinics.

Ø  CVS can provide PBM services to Aetna to further reduce the insurance expense.

Ø  The CVS-Aetna will have higher leverage to negotiate price with drug manufacturers, significantly lowering its expense. If drug manufacturers do not agree to lower the price, for example, CVS-Aetna can threaten to exclude their drugs from the insurance coverage and stop selling their products.

-          Since the CVS-Aetna only has access to the domestic (American) market, I feel that potential growth will be somewhat limited. Though I do expect healthcare spending in the US to keep rising, I assume the 0% terminal growth to keep the valuation somewhat conservative.

5.      Discount Rate at 7.21%

-          I set the discount rate at 7.21% based on the following assumption:

Ø  Cost of Equity  = FCF / Price

Theoretically, CVS could have used all of its FCF for dividends and stock buybacks, resulting in 10.8% annual return in equity, assuming the FCF is fixed. In a sense, this is the minimum return that shareholder’s should expect from the company’s investment.  

Ø  Cost of debt = Highest yield of the company’s bonds

To keep the valuation conservative, I chose the highest borrowing cost that I could think of.

Ø  Debt/Equity Allocation = The fund structure which will be used in the Aetna acquisition

CVS will fund the Aetna acquisition with 44.8 Mil debt and 25.1 Mil equity, which translates to 64% in debt and 36% in equity.

Assumptions and Cash Flow.png

o   Valuation

Based on the assumptions above, I came up with the following valuation:

CVS+Aetna Valuation Summary

CVS+Aetna Valuation Summary


Assuming the Aetna acquisition goes through, I believe that the CVS stock price has a significant upside potential in the near term, possibly within the year upon which the completion of the acquisition is completed. I believe it’s one of the best stocks to buy if you want to gain exposure to the U.S. healthcare sector, which should grow along with the aging population.


Disclaimer: I own the call option on CVS Health Corporation (Ticker: CVS, Exchange: NYSE). I am long CVS and plan to add to my portfolio if the price goes down even further. Since the potential acquisition is involved, the price movement can be pretty volatile. Please be aware of the inherent risk of such an investment. I only recommend purchasing the stock if you can endure the price volatility and potential loss of capital.