CVS-Aetna Merger Would Be Mostly Positive for Both

Several media outlets have reported that

From a valuation perspective, we continue to see strong upside to CVS, with the market underappreciating its well-positioned pharmacy benefit management business, but we view Aetna AET as overvalued because of excessive growth expectations.

We are keeping intact our fair value estimate and wide moat rating for CVS and our fair value estimate and narrow moat rating for Aetna. We will review our ratings if there is an official announcement of a deal and once we receive detail directly from either company.

While there are positives and negatives to a potential vertical integration strategy, the opportunity to materially touch almost every aspect of the healthcare continuum will make a new CVS-Aetna services company one of the most powerful players in the space. The scale, leverage, supplier pricing advantages, and increased service capabilities will give the potential new entity significant advantages. This strategy falls in line with our overall thesis for the healthcare services space, as we believe companies that can provide efficiency and cost-saving services will thrive over the long term. This is especially the case for companies that have significant scale, and a combined CVS-Aetna would have a level of scale only a few rivals could match.

Nevertheless, there will also be drawbacks as certain CVS PBM insurance clients may find it tough to partner with a major managed-care organization rival, and certain Aetna MCO clients may view an integrated health insurance product, with fixed vendors, as too restrictive. Additionally, the speculation regarding the price CVS will pay to acquire Aetna would make the deal rich based on our stand-alone $94 fair value for the MCO. We do note that synergies and future strategic operational options could add to the net present value of the investment for CVS. With that said, we believe the operational positives largely outweigh the negatives of a potential merger. Below is our initial take for the major positives and negatives of a potential CVS-Aetna deal.

Positives (1) A merger will allow CVS the opportunity to continue its all-encompassing healthcare strategy and further moves the company away from the no-moat retail pharmacy business. It gives the PBM an integrated product it can use to offer various health insurance options to its clients and will allow it to control a significant portion of spending and covered lives across the market, strengthening its already formidable advantages as a major PBM.

Aetna will be able to diversify its own operations and strengthen its long-term advantages by combining with a wide-moat PBM. This will also change the trajectory of how Aetna will perform in the healthcare space and give it (and its shareholders) a pathway to gain economic profit over what it could generate on a stand-alone basis.

(2) A combined CVS-Aetna services behemoth will be able to enjoy increased supplier pricing advantages and cost leverage. It will be able to integrate and cull redundant centralized corporate costs, mail order operations, data analytics, underwriting, and member treatment management. There will also be an enhanced ability to negotiate pricing with providers, pharmaceutical manufacturers, and other retail pharmacies.

(3) CVS and Aetna will be able to leverage the MinuteClinic assets within CVS retail stores into a lower-cost and efficient nationwide provider network. These assets could play a key role in terms of moving members to a lower-cost option for certain less intense medical procedures, such as school/sports physicals, vaccinations, and checkups for minor ailments.

Negatives (1) Both client books may see an integrated model as a negative, given concerns related to having to partner with a major rival and/or the restrictive nature of an integrated suite of services. Some insurance PBM clients may view the necessity of having to share critical operational data and strategies with a major MCO rival as untenable. Additionally, MCO clients may view the restrictive nature of being locked into CVS retail pharmacy assets and formulary options as less attractive than what is offered by other vendors.

(2) The difficulty of combining the two complex entities could pose major issues, as there will be significant integration and member transition risk. Most major healthcare services mergers over the past few decades have run into integration issues, as combining the back-office, sales, and client-servicing functions for several million individuals and thousands of clients is extremely difficult. There could be material client defections if this integration is fumbled. We would point to the recent UnitedHealth-Catamaran, Express Scripts-Medco, and CVS-Caremark mergers as key examples of this dynamic.

(3) The price paid by CVS to acquire Aetna will probably be rich, given our $94 stand-alone fair value estimate for the MCO and its current stock price. If synergies and future positive operational strategies do not yield enough net present value, then there will be material shareholder value destruction. However, we believe there is an opportunity to unlock a great deal of value, given the possibility of a new vertically integrated model that includes end-customer assets.