January 08, 2018 - 1:40am EST by
2018 2019
Price: 78.45 EPS 7.11 8
Shares Out. (in M): 1,020 P/E 11 9.75
Market Cap (in $M): 80,019 P/FCF 10.5 9.7
Net Debt (in $M): 20,826 EBIT 15,718 16,680
TEV (in $M): 100,845 TEV/EBIT 10.9 9.7

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Summary:  Buy CVS and AET.   

CVS has more upside, but also potentially more downside.   AET has little downside,  but plenty of upside as well - Aetna has better risk reward.  I like both outright though.  

I think the CVS+AET merger should go through (since it's a vertical merger and not much that should derail the deal expect for some Part D overlap that is easily divestable)

- The merger spread is 13.5%,  pretty attractive,  but of course, it'll be a lengthy regulatory process.

- The deal is mostly cash ($145 cash, rest stock, to get to $210.41 total consideration at the moment), vs. AET at $186 now.  



AET on a standalone basis is a great company and actually reasonably valued as well, trading at 18x 2018 P/E (compared to ANTM and CI trading at 17.5x).   

- So even if the deal breaks, I don't see much downside in AET.  AET (and HMOs) have also been sandbagging the benefits from tax reform since they also want to get the HIF fee waived as well, and there are plenty of puts and takes with MLR floors and state regulators.  And the HMOs have been saying that much of the tax savings will be competed away.  Even taking in all the foregoing, tax reform is a big benefit for a space that has some of the highest tax rates out there

- I think HMO (aka payers) multiples deserve to be up here since they're increasingly an oligolopy toll collector on healthcare spend with steady HSD/LDD EPS CAGR, steady rev growth, and favorable cost trends.  AET has a long term EPS growth target of 12-14%

- AET also has some of the best Medicare Star ratings (a hot secular growth area in HMOs) and had been taking share there



- Pro forma CVS EPS is $8 in 2019< tax reform is a large boost

 - so CVS is trading at 9.75x pro forma P/E, and 8x EV/EBITDA  (after a full year of owning AET and lapping the dilutive pre-financing of the acquisition).  After the deal is done, I think a 13-14x multiple is fair multiple (12x on the pharmacy/PBM side, which is 70% of pro forma revs, similar to where WBA/ESRX trade;  and 17x on the HMO side - 30% of pro forma revs). CVS could be up ~40%,  which equates to a 27% return in AET

  - The blue sky scenario is if CVS+AET become the next UNH and trade at 20x+ P/E, or 100%+ upside

- And it looks like they've sandbagged the synergy number as well.  CVS guided to $750mm in synergies in year 2 (and didn't talk about further synergies), while AET expects $2.4bn by year 5

- I think CVS stock has also put in a floor with their recent, good enough 2018 guidance, return to script growth, and decent PBM numbers.   They already talked down Q4 results also.  So numbers are pretty set for the next quarter and year, leading to few surprises and making it a pretty safe name to own for now.   Sentiment has bottomed around the pharmacy side and the Amazon risk has been well discussed and mostly baked into multiples.  I don't think Amazon will make a major splash on the pharmacy side, and the newsflow around that has calmed down

 - Adding in AET improves the narrative around CVS, and opens the possibility towards them becoming a secular grower and share gainer, meanwhile expectations around the merger are low

- on a standalone basis, CVS should do around $7.50 in EPS in 2019, so it's trading at 10.5x P/E, which is roughly where it should be trading given the secular issues around PBM and pharmacies (and roughly the right multiple if you blend ESRX and WBA's multiples). But at the end of the day, this is CVS. It's a great and integral company to the healthcare system. Despite all the competition, people still need and want to get their drugs from a brick and mortar pharmacy (either due to convenience or speed). If you have something wrong with you, you're going to want to get your drug ASAP, and that's what pharmacies do best. They're not going away. Plus the integration between CVS pharmacies and Caremark is already a big competitive advantage when designing networks.

- CVS also sports a decent 2.6% dividend yield


Why does CVS need AET?


Brick and Mortar Pharmacy

CVS needs AET to get them away from 4 wall and PBM competition.  Obviously, the front end of pharmacies is slowly melting / under pressure from online/e-commerce.  There’s a lot of wasted space in all the pharmacies.  Front end has been challenged with SSS consistently flat to down LSD % YoY all the time.


Walgreen's has been very aggressive on price in order to take share. Meanwhile the CEO is aggressively cutting costs and doing deals to extract synergies. So it's been a race to the bottom


Pharmacy Benefit Management

PBM was one of the best businesses out there (they took a cut of drug spend basically in return pushing around papers).  They were supposed to be saving payers money and reducing drug spend, but clearly it was in their best interest to keep drug prices high (hence why there are often huge rebates on top of very high list prices).  Yes the ‘net price’ was low, but the huge rebates (e.g. 50% of the price of a $30k drug), got spread around the drug supply chain.  In hindsight, they were over-earning for a while when the good times in drug pricing lasted.  Now that's all going back to normal.  And you're already seeing it in the slower growth and margin pressure on the PBM side at CVS and ESRX

I think they've already been exposed for ripping people off.  Just look at the ANTM debacle and the renewed price competition among PBMs.  ANTM took its business away from Express Scripts and gave part of it to CVS recently and will bring a bunch of it back in house).  Payers are wising up.  And want to keep more of the PBM margins for themselves.  Plus they can benefit from the data and integration of pharmacy and medical benefits to get a better picture and better manage patient care.

The drug companies (e.g. Mylan) also did a good job pointing the finger at ESRX and PBMs and deflecting the blame for higher drug prices.  I don’t think PBMs need to be dragged in front of Congress partly since it’s a relatively small and obscure industry

For CVS, when they're vertically integrated, they're also legitimately incentivized to reduce drug costs and gives them more control over care.  So the merger changes the narrative around CVS Caremark from being the bad guy to being a good guy

That being said, I think ESRX increasingly looks like a strategic asset maybe for a Walgreen's, another HMO, or maybe even WMT/Amazon.  Hence the big rip after CVS+AET was announced


Amazon Threats

Amazon remains a wildcard / cloud over pretty much all of the drug/medical supply chain (pharmacies and distributors).  It seems like every week there’s another article saying how Amazon will either become a pharmacy, drug distributor, and/or medical supply distributor.  And of course we all know that Bezos views anyone’s margin as his opportunity

- but it's starting to sound like Amazon is more interested in being a distributor,  and not the actual pharmacy (being the distributor plays to their strengths).  Getting through all the regulatory and medical issues of setting up pharmacies is quite tough and probably something that Amazon doesn’t want to do

- it's looking tougher for Amazon to make a big splash unless they buy their way in,  which also seems unlikely.  Amazon might be great at selling batteries,  but selling diabetes drugs or prescription drugs opens a whole new can of worms

- also, I think investors are finally tiring of all the Amazon pharmacy / drug newsflow, and the news is getting ‘baked in’ to multiples (which have compressed a lot across the drug supply chain)

- Amazon reportedly also took its PBM function in house, but that's not a big deal since they don't have the access or relationships to do anything


On the plus side for CVS, getting AET changes that narrative a bit and diffuses those concerns somewhat (AET is around 30% of pro forma revs)


WBA is a decent short against CVS/AET.  It trades at 11.9x NTM P/E and I don't see them doing too well against a resurgent CVS and tough reimbursement environment.  Plus maybe they reach for a vertical acquisition and face arb pressure and/or overpay

Why did AET sell?

It's a bit odd that AET sold at what seems like a low premium and in front of big tax reform benefits.  Plus things in HMO land are going very well and will continue to go well.  

- It's still a  29% premium to the unaffected price though ~20x 2018 P/E.  < not bad, but not great.   CVS couldn't pay up much more given leverage and accretion constraints.  

- Just recently AET was trying to buy HUM and wanted to participate in horizontal consolidation (along with ANTM+CI) in 2015.  But of course the government wasn’t going to allow a 5 to 3 consolidation move.


In healthcare, it's all about scale though.  The HMOs have been seeking more horizontal scale and vertical integration however they can get it.   e.g.:

- UNH+Optum PBM has been a winning strategy.  They're adding more services on top (e.g. ambulatory surgery centers, and buying up doctors )

- ANTM building their own PBM again (BTW, I really like ANTM as well since EPS can double there over the next ~4 years

- HUM buying KND’s home health segment

- ANTM tried to go after Cigna and now is going after smaller Medicare Advantage players



- AET had already outsourced its PBM business to CVS, so it’s a good fit already


So seems to me that they're trying to replicate the UNH/Kaiser vertically integrated model, which is the trend across the industry.  Basically AET (and other HMOs) have a captive customer base, and the opportunity to sell them/provide a lot more services to each patient other than just insurance


Generally, the more healthcare is vertically integrated, the better the care and lower the costs.  E.g. hospitals and many doctors are paid on a fee-for-service basis (i.e. they’re incentivized to just do a ton of tests and procedures and get people in the door).  But if the health insurance company is the one also providing the actual health care, they’ll clearly be more careful around the costs since it’s coming out of their own pocket).  


The ability to transform CVS’ stores and pharmacies into a cheaper and effective site of care is unlikely though, but that’s been the hope to better utilize the space.  Maybe they add some testing sites (e.g. like a LabCorp or Quest), or they put some doctors or nurses in there (which is difficult because there’s a shortage of physicians and nurses in general).


This deal also helps Aetna get more of the tax reform benefits since Aetna already has lower MLR floors than peers.  CVS and AET could massage the revenues and costs in order to push more of the profits (and tax savings to CVS)

CVS + AET merger details

On 12/3/2017, after months of speculation CVS bought AET for $207: $145 cash, rest stock ( AET = $145.00 + 0.8378 CVS)

- closing expected 2H 2018

- CVS expects low-to mid-single digit accretion in the 2nd full year post close < lower than people hoping for MSD/HSD accretion.  No accretion in year 1.  Plus there was a lot of confusion around CVS’ accretion guidance, and CVS didn’t guide for 2018 (people assumed the worst and expected an ugly guide)

- only $750mm of near-term synergies om 2nd full year (given that it's a vertical merger), compared to pro forma $221mm in LTM revs and $18.5bn in EBITDA < some were hoping for more

- they touted CVS' Minute Clinic and ability to use the store to manage and influence patient's care < this has been talked about for years to help utilize the stores, but nothing has really happened here

- didn't outline much that's exciting, other than the basic blocking and tackling

- pro forma leverage of 4.6x is high, they want to lower it to 3x


All in all, the details were disappointing and the stock went down.  But after CVS finally gave clear guidance on Jan 4, 2018 (and people got a better handle on the numbers), the stock started shooting up


In the merger S-4, AET spoke to 2 other retail and healthcare industry participants

- AET did a pilot program with Party Y's retail health service clinics and also discussed data analytics and a potential co-branded Medicare product  < sounds perhaps like WMT, people think it's WMT partly because there were also recent rumors that WMT is looking at HUM,  which seemed far-fetched, but less so today

- with Party X discussed a strategic partnership, JV, or business combination;  but was not in a position to acquire AET  <  sounds maybe like WBA since WBA loves partnerships and JV,  and was busy with RAD at the time

- AET had hinted before that they were talking to WMT and WBA


CVS started talks with HMOs after the HMO mergers fell apart in Feb 2017


The S-4 guidance is inline as well


Antitrust / DoJ review

Vertical mergers have a history of being approved for obvious reasons. Of course, the recent AT&T/Time Warner vertical merger being held up has cast a pall on vertical mergers.  However, clearly the Trump administration is targeting and singling out CNN.  Also, it is slightly concerning that AT&T and DirecTV could theorhetically hold back Time Warner’s rather popular content and cajole consumers into switching to DirecTV or some AT&T pay-TV product (either mobile or set top box).  I’ve heard that regulators wished they could have blocked Comcast + NBC Universal.  Concerns around T/TWX have also caused the CVS/AET vertical merger spread to be wide.  

AT&T helpfully explained that the last time the DOJ tried a vertcial merger case was in 1977.  The last time the DOJ blocked a vertical merger in court was in 1972


Most industry experts and sell siders expect this merger to close with pretty high probability (75%+).  I agree. But even in the case where it doesn't close, CVS is already trading where it should as a standalone pharmacy+PBM, and AET is trading where it should be as a standalone HMO


They have some local Medicare Part D overlap that should be easily divestible and pretty minor.  The overlap is generally in areas where one of the two already has high share.  In the Part D Prescription Drug Plan segment the merger combines the #1 player (CVS with ~21% share) with the #5 player (AET, ~8% share).  Within the low-income subsidy enrollment in PDP, the transaction combine the #1 player (CVS, ~29% share) with the #3 player (AET, ~9% share)


Also, it’s not as if there aren’t other brick and mortar pharmacies to choose from (e.g. Walgreen’s, supermarkets, Wal-Mart, independent pharmacies, mail order, etc.).  CVS has 23% share of prescription revs, Walgreen’s 16%, Express Scripts 11% (mail order/specialty pharmacy), Walmart 5%, UnitedHealth 4%, Kroger 3%, Alertsons 1%, Costco 1%, etc.


The main antitrust concern that's bubbling up would come from smaller HMO companies.  The smaller insurers will probably argue that they only have 1 legit independent PBM option left (ESRX), since Caremark and Optum/Catamaran would be tied up with HMOs themselves

- that being said, small HMOs do work with UNH (e.g. even Cigna), so it's not like CVS would really change the PBM landscape

- AET has outsourced its PBM business to CVS and signed a 12 year contract back in 2010 - so it’s not like the industry relationships are all that different

 - And there are plenty of other PBMs (Express Scripts has 28% share, CVS Caremark 26%, Optum 19%, Prime 7%, Envision RX 6%, and other small ones)

   - and there are a bunch of smaller PBMs out there

- guys like ANTM are also creating their own PBM,  so clearly it’s possible to create a PBM and be successful


It's hard to argue that this would be negative for patients,  since AET+CVS should be able to reduce costs and lower prices for consumers




Health Maintenance Organization / aka Managed Care Organizations (MCO) aka Health insurers

- structurally advantaged, well positioned to help control cost, value proposition stronger, value based care tailwinds, consumerization of healthcare also a plus, etc.

- they've shown very impressive resilience, stability, and growth through Obamacare and the various limitations around the business models

- generating consistent HSD/ LSS % EPS growth from a combination of memebrship growth (mostly Medicare Advantage and Managed Medicaid)

 - plenty of room for accretive capital deployment and share repurchases

- Medical cost trend have been very subdued

- an improving economy should help their generally lagging commercial / group business


HUM trades at 21.2x 2018 P/E.  It continues to trade at a premium to the group due to takeout speculation since every HMO wants to get bigger in Medicare Advantage (given the growth there)

People think CI could try to buy HUM again (they tried in 2015).  Recent rumors are that WMT is interested


UNH 20.5x trades at a premium because they’re best in class by far.  Their vertical integration of health insurance, PBM, services, data/analytics, ASCs and doctors has helped them gain a lot of share and put up impressively fast and steady growth.


ANTM trades at 17.5x 2018 P/E, CI 17.8x, AET 18x < all about the same with some puts and takes)

HUM's multiple (along with all HMOs) are back around 2015 peaks.  But again, I think a high teens multiple makes sense.  They’re not ‘insurers’ anymore.  They’re a toll booth on secularly growing healthcare spend


CVS 2018 guidance

CVS gave 2018 guidance and more color on Jan 4, 2018.  Overall the headline guide was light on revs and EBIT,  but beat on script growth (due to expanded relationships with PBMs and plans)

- Implied EPS guidance ~$6.40,  above $6.28 cons.  < helped a lot by lower tax rate going to 27% down from 38%

Overall the numbers were light but better than feared after CVS bungled the AET merger announcement by not providing 2018 guidance at that time.  People assumed that 2018 guidance would be bad,  which is it,  but better than feared.   Also, one bright spot is that they're also picking up script growth again; expecting 2018 SS scripts to be +6-7%, vs. -3% in 2017.  So they're picking back share which is a positive


2018 guide - overall light

- expects +1-4% EBIT growth,  below +4.3% cons.

- revs +0.75% - 2.5%  below +4.4% cons.

- Total SSS +2%-3.5%

- pharmacy revs +2.5-4% above +1.9% cons.

   - SS scripts +6-7%  much improved (was down -3% in 2017) due to new narrow network deals and relationships with PBMs and plans.  Picked up some Part D wins

- PBM sales +1.5-3.5%,  below +5.4% cons.

 - PBM claims +8%

- PBM EBIT up LSD %,  below +4.8% cons. < headwinds: cost to implement the ANTM contract and divestitures are impacting it by 125bps.  Also lower brand inflation pricing pressure. and generic introductions

- tax rate 27% down from ~38% in 2017

- higher interest to fund the Aetna deal is a big headwind as well for 2018 (most will back this out)

- suspension of share repurchase reduce EPS by 20-36 cents


Q4 2017 - light

- EBIT and EPS to be at low end of prior guide due to softer margins in PBM and suspension of share repurchase

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


- AET+CVS merger is approved

- T/TWX gets approved

- Amazon doesn't do anything in pharmacies for a while

- better earnings and script growth at CVS 

- HMOS continue to do well, and tax benefits surprise to the upside

- drug prices continue to go up, helping PBMs.  Pharmacies have done a better job neutralizing themselves from drug price fluctuations after the recent swings up and down 


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