Morningstar | AET Updated Forecasts and Estimates from 11 Oct 2018
There was a lot to digest from CVS' second quarter, but we believe the positive quarterly results, the firm’s rigorous defense of its pharmacy benefit manager business, and encouraging update related to its proposed Aetna acquisition reinforce our positive outlook for the healthcare services conglomerate. We are reiterating our $96 fair value estimate, which incorporates the Aetna acquisition, and narrow moat rating for the combined entity. Considering the significant discount CVS’ equity currently trades to our fair value estimate, we believe investors have an opportunity to acquire shares of a strong healthcare services firm at an advantageous price. The firm reported a decent increase in revenue for all segments as its efforts to become a preferred pharmacy in restricted networks drove solid retail pharmacy prescription volume and a good gain in client wins and client member growth bolstered its PBM operations.Management provided a vigorous defense of its PBM model, especially against branded drug manufacturer criticism of rebates. Management emphasized that rebates do not drive branded drug prices, as branded drug categories with little competition experience price increases at faster clips than most other categories. These uncompetitive markets also carry rebates well below those of branded treatment areas that have multiple manufacturers/options. We agree with management regarding this assessment and believe CVS will be able to produce significant client value and economic profitability over the long term. Management also disclosed that for 2018 it expects to pass through approximately 98% of rebates to its clients and that its rebates will constitute approximately $300 million or 3% of adjusted earnings. We applaud management for the detail and clarity surrounding rebates and believe these figures highlight the value PBMs bring their clients and the misinformation that has permeated the market regarding the PBM business model.
Management provided a great deal of commentary regarding its acquisition of Aetna; it said a substantial number of states have approved the deal, with more approvals expected during the current quarter. The federal regulatory review of the deal remains on track, and CVS expects the transaction to close by the end of 2018. The firm also said it is making major progress in preparing for the upcoming integration and has formulated an executive management team to help lead these efforts. We view this transaction as a positive and believe the new entity will be one of the most powerful players in the healthcare ecosystem.
We believe CVS’ and Aetna’s overall strategy has significant potential to drive material economic profits over the coming decades. With this combination, the new CVS-Aetna healthcare services firm will fundamentally change how healthcare will be provided to individuals. Ultimately, we view the new entity as a healthcare services behemoth with the infrastructure to sell insurance and manage/treat members through every aspect of their healthcare treatment regimens at a lower cost.
From our perspective, this capability will be a key asset in servicing members with chronic and recurring medical issues--especially key for the Medicare insurance cohort. The firms will be able to leverage the significant retail footprint of CVS and its powerful PBM to better control the cost of treating patients. The firms will also be able to leverage Aetna’s large insurance membership book, its solid underwriting and plan design capabilities, and sales and marketing expertise. We believe the combination of these operations will give a new CVS-Aetna entity a key advantage in bringing down the cost of treating traditionally higher-cost individuals.
For a more detailed analysis of the CVS-Aetna merger, including our breakdown of the competitive dynamics driving this deal along with our moat and valuation analysis of the new healthcare services entity, please see our recent report, "The Creation of a New Business Model: The CVS-Aetna Merger Is Moatworthy and Will Change the Way Healthcare Is Delivered."
Aetna is a health care benefits company. The company conducts its operations in three business segments: Health Care, which provides medical, pharmacy benefit management services, dental, behavioral health and vision plans provided on both an insured basis and an employer-funded basis and businesses products and services that complement its medical products; Group Insurance, which primarily includes group life insurance and group disability products and long-term care products; and Large Case Pensions, which manages a variety of retirement products (including pension and annuity products) primarily for tax-qualified pension plans.
Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.
Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.
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