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Morningstar | Aetna Reports a Decent Quarter; CVS Merger Remains on Track

Aetna’s merger with CVS will transform the healthcare space as we know it, as the combined entity will seek to implement a new business model predicated upon the direct management of member medical care. As we have previously stated, we are largely positive regarding the deal and believe the new healthcare conglomerate will be able to leverage several key pieces of the healthcare ecosystem into better medical cost management. Additionally, we believe Aetna shareholders are gaining a great deal of value from the deal as CVS’ approximate $207 takeover price is almost double our $104 stand-alone fair value estimate. The Department of Justice recently gave its conditional approval for the deal, which is conditional upon the divestiture of Aetna’s Medicare Part D insurance business. We believe this is a small hurdle to overcome as it has been reported that Aetna has already found a willing buyer in WellCare. However, there remain some key states that are still pushing back on the deal, and thus, we are keeping our 75% approval probability in place. From our perspective, there remains a slight chance the deal in its current form could be hindered or modified given state regulatory concerns. Thus, we are reiterating our probability weighted $181 fair value estimate and narrow moat rating for Aetna.

The firm reported a solid quarter with operating revenue slightly up and operating margin increasing 95 basis points to 8.32%. The firm did a great job in controlling its medical costs as the overall medical cost ratio decreased 40 basis points to 81.50% and was driven largely from a 310-basis-point MLR decrease (to 73.3%) for the government segment. Aetna’s growing membership book and our expectation its MLR will reverse as healthcare utilization ticks up, reinforces our belief that Aetna’s potential merger with CVS is the correct move for the MCO. Of the four major health insurance markets (Employer, Individual, Medicare, Medicaid), we believe membership growth for Aetna will largely emanate from the Medicare and Medicaid markets. We estimate Aetna can leverage the CVS retail store footprint and PBM operations into a lower cost of care and servicing for its operations.