A month ago, I wrote about the merger between pharmacy kingpin CVS Health Corporation (CVS) and healthcare insurer Aetna Inc. I decided to try to determine if the deal, which closed shortly after I wrote about it, offered a compelling reason to buy the stock at its price at the time, which at the time was near to its 52-week highs above $80 per share. Since then, the broad market’s decline has taken the stock down a peg or two, pushing it down near to its 52-week lows around $65. That decline – a little over 16% in about a month’s worth of time seems like a good reason to take a second look at the stock and reevaluate the opportunity that is there.
Just a little less than a month after the merger was completed, the company has yet to provide any new financial data with which to analyze the combined company, which means that most of the analysis that can be done at this stage is only possible by considering both Aetna and CVS individually. That means that most of the financial data that I’m going to cover is about the same as it was a month ago; but the stock’s big drop since the end of November is significant enough that I think it merits a second look at the company’s likely value proposition. Combining one of the largest pharmacy companies with a 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.
One of the interesting elements that I think it going to help this deal bear the fruit that most analysts, and certainly the company’s management expect to see is the fact that Aetna’s increasing exposure to Medicare Advantage plans, and the company’s ongoing plans to redesign customer’s in-store experience using 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 $66.6 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. Look for the combined company’s operating margins to fall somewhere in between those two extremes.
- 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 pays an annual dividend of $2.00 per share. At the stock’s current price, that translates to an attractive dividend yield of 3.05%.
- 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 1.81. The stock’s historical average is 2.48, which suggests the stock is now a little more than 27% undervalued. There is an even more more compelling argument to be made for the stock on a Price/Cash Flow basis, since the stock is currently trading more than 42% below that historical average. Just before the merger was completed, AET was overvalued based on both its Price/Book and Price/Cash Flow ratios by anywhere from 5% (slightly overvalued) to 50% (very overvalued). If you factor those two elements together, the stock’s drop in price might not scream “bargain basement value,” but I do think if you consider the way the combined company has positioned itself for the years ahead, the stock’s current price looks much more interesting today than it did after Thanksgiving.
Here’s a look at CVS’ latest technical chart.
- Current Price Action/Trends and Pivots: Yesterday, CVS followed the rest of the stock market to move sharply higher to set up what looks like a strong pivot low near to its 52-week low prices. Assuming the market follows through on today’s surge over the next few weeks, the stock looks to have interesting short-term upside with the nearest likely resistance somewhere between $69 and $71 per share. The apparent bounce at support isn’t a foregone conclusion, however, and you shouldn’t ignore the possibility the stock could push back down again and break below support around $60 to establish new 52-week lows. If that happens, it would als push the stock down to levels it hasn’t seen a little over five years (not shown on this chart), with the mostly support levels around $52 per share.
- Near-term Keys: CVS is a stock that by most measurements would be considered mostly undervalued, even with the inflated price it knowingly just paid for AET. 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 the stock had quite a bit of interest a month ago, even when it was near to its 52-week highs; this drop should give value investors that much more reason to pay closer attention. I’ll continue to watch the stock, and its financial results pretty closely in the months ahead to see if it seems to line up with the story both companies have been presenting for the last year.