It is no secret that fears over Amazon (NASDAQ:AMZN) breaking into the mail order drug supply enterprise, and in addition doubtlessly launching its personal pharmacy advantages supervisor or PBM, has wreaked havoc on pharmacy chains resembling CVS Well being (CVS) and Walgreens Boots Alliance (WBA).
CVS information by YCharts
Just lately, I defined why I imagine these issues are overblown, and so I added each firms to my actual cash EDDGE three.zero portfolio.
An enormous a part of the thesis behind proudly owning CVS is that it was considerably undervalued, each on a historic foundation (buying and selling at ahead PE final seen throughout the monetary disaster) and primarily based on its future progress prospects.
As well as, I’ve confidence that CVS’s high quality administration workforce will be capable to adapt to quick altering trade circumstances (as they’ve prior to now) to maintain the corporate’s gross sales, incomes, free money move, and dividend rising properly within the years and many years to come back.
Nevertheless, now the Wall Avenue Journal is reporting that CVS is in talks to purchase Aetna (AET) for $200 per share, or $66.9 billion ($87 billion cope with badumed debt) in one of many largest medical mega mergers of all time.
I’ve rigorously studied the thought, each from a strategic and monetary perspective, and have concluded that such an acquisition would probably be a horrible concept.
The truth is, if administration did find yourself making such a poor capital allocation choice, I worry that CVS’s dividend progress thesis can be considerably degraded, doubtlessly making it a far weaker revenue funding, and doubtlessly forcing me to ultimately promote my shares.
CVS Shopping for Aetna Makes Sense… Kinda
The St. Louis Dispatch has realized that Amazon has acquired wholesale pharmacy licences in a minimum of 12 states, stoking issues that the destroyer of quite a few retail worlds is gunning for CVS and Walgreens.
Buying Aetna will surely be defensive towards Amazon since it could put CVS in a wholly totally different trade, one which, a minimum of to date, Jeff Bezos has proven little interest in (medical health insurance).
As well as, CVS might transfer away from retail fully, and set up minute clinics as low depth ERs in all its shops, thus disrupting the complete trade’s enterprise mannequin earlier than Amazon has an opportunity to.
And as my fellow contributor Wayne Toepke just lately defined shopping for Aetna for the vertical integration might make sense on condition that the way forward for drugs is prone to be dominated by these gamers with the most important economies of scale, who can drive as a lot price out of the medical provide chain as attainable.
The truth is, there may be some precedent for this together with CVS’s $26.5 billion acquisition of Caremark in 2007 (which was one other merger of equals which means CVS purchased an organization of roughly the identical measurement).
By shopping for Caremark, CVS was in a position to turn out to be a dominant participant within the quick rising pharmacy profit supervisor house. The truth is, CVS simply introduced main offers with Specific Scripts (ESRX), Cigna (CI), and UnitedHealth (UNH). These three firms mixed have 243 million prospects and fill over three billion prescriptions a yr.
As well as, CVS simply signed a five-year cope with Anthem (ANTM) to supply again workplace badist for its personal PBM service, IngenioRx, starting in 2020.
In different phrases, CVS buying Caremark was a superb strategic transfer that led CVS to turn out to be a a lot bigger, extra worthwhile and dominant firm; regardless of the huge quantity of shareholder dilution that resulted from the merger.
The truth is, the Caremark merger was instantly accretive to each EPS and FCF/share as a result of Caremark was in a position so as to add sufficient earnings and free money move to greater than offset the brand new shares issued to pay for it.
That allowed CVS to proceed sustaining a really protected payout ratio, and proceed shortly rising the dividend, which as an revenue progress investor is finally my major concern.
Nevertheless, on this case, shopping for Aetna is not prone to lead to almost as lucky an consequence. That is as a result of the economics of a merger between these firms simply would not make sense.
CVS Is Ludicrously Undervalued Whereas Aetna Is Monstrously Overvalued
In the end, for CVS shareholders, there are three foremost issues with shopping for Aetna.
|Firm||Ahead PE||Historic PE||Yield||Historic Yield||Share Of Time Yield Has Been Larger|
|CVS Well being||10.9||17.1||2.9%||1.2%||All Time Excessive|
Sources: Gurufocus, YieldCharts
The primary is that proper now Aetna is buying and selling at very lofty valuations, far in extra of its historic norms.
The truth is, if CVS had been to in truth pay $200 per share for Aetna that may signify 35.1 instances trailing 12-month free money move.
However what concerning the future? Maybe Aetna’s progress prospects are superior to CVS’s and thus inform us one thing that historic valuation metrics do not?
|Firm||FCF/Share||10-Yr Projected FCF/Share Progress||Honest Worth Estimate||Progress Baked In||Low cost To Honest Worth|
|CVS Well being||$5.90||10.1%||$96.12||6.1%||28%|
Sources: Gurufocus, Morningstar, Quick Graphs
Whereas true that badysts anticipate Aetna to develop barely sooner within the subsequent decade than CVS, the distinction is nowhere close to large enough to justify paying $66.9 billion for Aetna.
The truth is, utilizing a 9.zero% low cost fee (the chance price of cash primarily based on the S&P 500’s historic return), I estimate that Aetna, at $200 a share, would signify a 70% premium to its truthful worth, as estimated by a 20-year discounted free money move evaluation.
In the meantime, CVS shares are buying and selling at a deep low cost to truthful worth, which means that now could be exactly the worst attainable time to print new shares to make large purchases.
Which brings me to the most important challenge with CVS buying Aetna, the huge destructive hit it can trigger to CVS’s EPS and FCF/share.
The Math Simply Would not Add Up
|Firm||Income||Web Earnings||Free Money Move||Shares Excellent||EPS||FCF/Share|
|CVS Well being||$180.Eight billion||$5.three billion||$6.2 billion (2017 steerage)||1.05 billion||$four.98||$5.90|
|Aetna||$62.2 billion||$1.6 billion||$1.9 billion||347 million||$four.51||$5.42|
|CVS + Aetna (all inventory deal)||$243.zero billion||$6.9 billion||$Eight.1 billion||2.04 billion||$2.86||$three.36|
Sources: Morningstar, Gurufocus
Aetna’s margins, particularly its web and FCF margin, are just too low for the at the moment described deal to be accretive to CVS shareholders.
The truth is, if CVS the place to purchase Aetna in an all-stock deal, it could successfully must double its share depend, leading to EPS and FCF/share declining by 57% and 43%, respectively.
However wait what about synergistic price financial savings? Whereas there could also be a few of these, say from elimination of overlapping administrative departments (resembling HR and accounting), it is not going to make wherever close to sufficient of a distinction to make this type of deal construction make sense.
In spite of everything, this deal is for elevated vertical integration quite than horizontal, which means it brings in a wholly totally different enterprise, which limits long-term synergistic price saving alternatives.
After all, an alternative choice on this low rate of interest atmosphere is for CVS to tackle a considerable amount of debt to partially and even totally fund the acquisition. This might drastically diminish the dilution of CVS shareholders.
Nevertheless, there too we run into the grim realities of math that simply would not add up.
Shopping for Aetna Means Loopy Excessive Leverage
|Firm||Debt||EBITDA||Debt/EBITDA||Annual Curiosity Value||EBITDA/Curiosity|
|CVS Well being||$27.5 billion||$12.1 billion||2.27||$1.02 billion||11.93|
|Aetna||$20.7 billion||$three.9 billion||5.36||$638 million||6.04|
|CVS + Aetna (all inventory deal)||$48.2 billion||$16.zero billion||three.02||$1.65 billion||9.66|
|CVS + Aetna (all debt deal)||$115.1 billion||$16.zero billion||7.19||$four.1 billion||three.88|
Sources: Morningstar, Gurufocus
One other downside with shopping for Aetna is that the corporate is much extra leveraged than CVS, which means that even when CVS had been to pay for it with all inventory, it could nonetheless lead to taking over plenty of debt (about $21 billion price).
That would lead to a credit score downgrade, a nasty factor to have occur in a rising rate of interest atmosphere. As well as, we won’t neglect that one of many proposed adjustments to the tax code is a possible elimination of curiosity deductions, which might hit extremely leveraged firms particularly exhausting.
It additionally means that there’s primarily no manner that CVS can fund this cope with plenty of debt (to keep away from diluting shareholders). It will lead to debt ranges rising to harmful ranges ($115 billion) and would probably lead to CVS being downgraded to junk standing by credit standing businesses.
|Deal Construction||Professional Forma EPS/Share||Professional Forma FCF/Share||EPS Change||FCF/Share Dilution|
Sources: Morningstar, Gurufocus
The issue is that the one manner for the CVS/Aetna merger to make any type of sense, from a dilutionary perspective, is to do the deal fully with debt, which means borrowing almost $67 billion to overpay for Aetna.
After all, CVS’s precise curiosity prices are prone to be even larger than in my mannequin, since CVS is at the moment having fun with a median rate of interest of three.7%, and it could virtually actually have to pay over four% to borrow such a major sum.
Even worse? Whereas even extremely overvalued mergers normally find yourself changing into accretive to shareholders, within the case of CVS shopping for Aetna, this is not prone to be the case.
|Firm||2026 Projected Web Earnings||2026 Projected FCF||2026 Projected Shares Excellent||EPS||FCF/Share|
|CVS Well being||$12.6 billion||$14.7 billion||838 million (2% buyback fee)||$15.03||$17.59|
|Aetna||$three.9 billion||$four.7 billion||317 million (1% buyback fee)||$12.23||$14.69|
|CVS + Aetna (all inventory deal)||$16.5 billion||$19.four billion||2.zero billion (2% buyback fee)||$Eight.23||$9.70|
Sources: Morningstar, Gurufocus, Quick Graphs
That is as a result of CVS and Aetna are primarily rising on the identical fee, which means that the mbadive quantity of dilution created by this deal will not ever be overcome by elevated gross sales, earnings, or free money move from the mixed firms.
Not except CVS can execute brilliantly on strategic synergies, resembling one way or the other convincing all of its pharmacy prospects to modify to Aetna medical health insurance. One other unlikely possibility can be create a loyalty program just like Amazon Prime that convinces all its prospects to make CVS their one-stop store for all medical wants.
In different phrases, vertical integration for its personal sake is not essentially well worth the destructive dilutionary results of this deal. For instance, if CVS actually needs to dominate each facet of drugs (and thus be protected from Amazon), it would as effectively dilute shareholders into oblivion by additionally buying:
- drug maker Pfizer (PFE)
- medical machine maker Medtronic (MDT)
- America’s largest medical distributor McKesson (MCK)
- America’s largest hospital and nursing house house owners Ventas (VTR) and Welltower (HCN)
All of those acquisitions will surely be “strategic” and obtain vertical integration, however with CVS shares this low cost, they’d additionally so dilutionary that CVS’s dividend would must be lower in order that administration might go about its empire constructing in a determined try to “do one thing”.
The underside line is that any manner you chop it, there is no such thing as a strategy to construction a CVS/Aetna merger at the moment that does not lead to CVS shareholders being made a lot worse off.
And as for the hopes that CVS’s crack administration workforce can one way or the other pull off a miracle and obtain long-term strategic synergies that we won’t but predict (i.e., company buzz phrases), effectively this may certainly occur because it did with Caremark.
However remember the fact that the larger the acquisition, the tougher it’s to tug off efficiently. The truth is, a examine by the Nationwide Bureau of Financial Analysis discovered that of 12,zero23 giant scale mergers over a 20-year interval, 87% destroyed shareholder worth, to the collective tune of over $200 billion.
The danger of this unlucky consequence solely will increase with the scale and valuation of the deal, and since Aetna is buying and selling so richly proper now, this bodes poorly for the last word consequence of such a merger.
Nevertheless, my largest downside with CVS doubtlessly shopping for Aetna is what it might imply for CVS’s future dividend progress potential.
Deal Might Blow A Gap In CVS’s Dividend And Complete Return Profile
|Firm||Yield||FCF Payout Ratio||10-Yr Projected Dividend Progress||10-Yr Potential Annual Complete Return|
|CVS Well being||2.9%||32.four%||12.1%||15.zero%|
|CVS + Aetna (all inventory deal)||2.9%||59.5%||6.1%||9.zero%|
Sources: Administration Steerage, Morningstar, Quick Graphs, Gurufocus, CSImarketing, Multipl.com
For me, the last word motive I personal any dividend progress inventory is due to its robust payout and whole return profile. Which means a horny yield, a protected dividend (robust steadiness sheet and low payout ratio), and within the case of decrease yielding firms (resembling CVS), good long-term dividend progress potential.
CVS Dividend information by YCharts
CVS has traditionally been superb at rewarding dividend lovers, with 14 straight years of accelerating its payout at double-digit charges.
At present, CVS expects to generate long-term EPS and FCF/share progress of 10% to 12%, and badysts anticipate this to translate into double-digit payout progress over the following decade.
Mixed with CVS’s extremely undervalued shares, which means that CVS is a really enticing dividend progress funding.
BUT if it buys Aetna, by means of an all-stock deal (which is the more than likely manner the deal can be structured), then the huge FCF/share dilution would lead to not only a a lot much less protected payout, however one which’s prone to develop at about half the speed over the following 10 years.
That is as a result of administration has stated that it needs to keep up a long-term payout ratio of 35%, and shopping for Aetna would probably end result within the payout ratio almost doubling to 60%.
In different phrases, if CVS had been to announce it was shopping for Aetna in an all-stock deal, then I might anticipate administration would start giving us token $zero.01 per quarter per yr will increase.
Whereas theoretically administration’s payout objectives might lead to a dividend lower, given CVS’s dividend pleasant monitor document, I feel this type of worst case state of affairs is unlikely.
Nevertheless, the maths is obvious, that purchasing extremely overvalued Aetna shares by issuing extremely undervalued CVS shares is a serious long-term blow for CVS buyers, as it could probably cut back the long-term whole returns by about 40%.
The excellent news is that that is nonetheless prone to beat the S&P 500, which is so overvalued that it is prone to underperform its historic 9.1% whole return since 1871. That signifies that in case you are a long-term CVS proprietor, you should not essentially promote it, even when this merger is introduced and goes by means of.
Nevertheless, personally, I’ve a coverage of concentrating on 10+% long-term whole returns, so if CVS finally ends up lacking my 7.5% dividend progress minimums in 2018 and 2019 (two years in a row), I will be promoting it in favor of different extremely undervalued, low-risk dividend progress shares.
Backside Line: CVS Shopping for Aetna Appears Like An Sick Conceived Knee-Jerk Response
Please do not misunderstand me, I am not recommending that CVS shareholders promote shares (particularly at these undervalued costs) over mere rumors of a possible merger with Aetna.
In spite of everything, CVS hasn’t introduced something but, and the thought of probably shopping for Aetna is only one of a couple of dozen potential methods the Board is contemplating. And even when the 2 firms had been to comply with a merger, it could probably require an extended regulatory approval course of whose success is much from badured.
That being stated, I am against this potential acquisition as a result of I do not see the plain strategic rationale behind it, particularly given the huge quantity of dilution that CVS shareholders must endure to make the deal occur.
Dilution so excessive that even a decade down the highway it could probably fail to be accretive to EPS and FCF/share, and thus might lead to far slower dividend progress, and weaker whole returns.
In different phrases, overpaying for Aetna with extremely undervalued shares looks like an sick conceived, knee jerk response to Amazon’s potential entrance into CVS’s house, one that’s prone to find yourself destroying shareholder worth if it occurs.
Disclosure: I’m/we’re lengthy CVS, WBA.
I wrote this text myself, and it expresses my very own opinions. I’m not receiving compensation for it (apart from from In search of Alpha). I’ve no enterprise relationship with any firm whose inventory is talked about on this article.