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After CVS' Solid Quarter, Focus Is on Aetna Acquisition

We expect the combined company will fundamentally change how healthcare is provided to individuals.

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We are reiterating our $99 fair value estimate for  CVS Health (CVS) after the wide-moat pharmacy benefit manager reported strong first-quarter results. The company reported a robust increase in revenue for all segments as its efforts to become a preferred pharmacy in restricted networks drove the retail top line and a good gain in client wins and client member growth bolstered its PBM operations. Impressively, CVS also expanded its gross and operating margins by 25 and 23 basis points, respectively. The company’s retail segment did experience a 42-basis-point decrease in gross margin as it was forced to discount its generic pharmaceutical products in order to obtain preferred pharmacy status on several PBM pharmacy networks. However, the company was able to offset this headwind with a 96-basis-point reduction in centralized costs, driving overall operating margin for the segment up 54 basis points. We believe management did a great job driving profits and recovering its top line over the quarter, but the main focus for investors moving forward will be the acquisition of  Aetna (AET).

Management said the merger is on track and expected to close by the end of 2018. CVS has established an integration team, realigned its operations to make the transition easier, and issued acquisition-related bonds to lock in a low cost of debt. Aetna reported that it has also reorganized its own operations by combining all healthcare operations and selling its nonhealthcare businesses. In addition, the managed-care organization acquired 279,000 new Medicare members as it looks to build its portfolio in one of the fastest-growing and most consistent health insurance cohorts. This development falls in line with what the management teams of both CVS and Aetna said was their stated operational goal for the new healthcare services company. We believe this preparation well ahead of the transaction closing is a positive, as it should lessen any major integration issues between the two complex companies.

Management also provided more color related to its vision for a new CVS-Aetna healthcare entity. We see two major strategic pillars the combined management team will try to execute:

(1) Acquire high-maintenance and higher-cost members where there is opportunity to service them more efficiently and cost-effectively.

(2) Drive as much healthcare servicing and consumption to non-acute-care facilities, in particular to CVS retail locations and member home-care settings.

We believe this overall strategy has significant potential to drive material economic profits over the coming decades. With this combination, the new CVS-Aetna healthcare services company will fundamentally change how healthcare will be provided to individuals. We view this transaction as a positive from an operational standpoint and believe the new entity will be one of the most powerful players in the healthcare ecosystem. Ultimately, we view a new CVS-Aetna entity as a healthcare services behemoth with the infrastructure to sell insurance and manage/treat members through every aspect of their healthcare treatment regimens.

From our perspective, this capability will be a key asset in servicing members with chronic and recurring medical issues. The companies will be able to leverage the significant retail footprint of CVS and its powerful PBM to better control the cost of treating patients. The companies will also be able to leverage Aetna’s large insurance membership book, solid underwriting and plan design capabilities, and sales and marketing expertise. We believe the combination of these operations will give the new CVS-Aetna entity a key advantage in bringing down the cost of treating traditionally higher-cost individuals.

Vishnu Lekraj does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.