It is not Amazon that CVS Health is Afraid of

Fear of Amazon (NASDAQ: AMZN) is not the primary cause of CVS Health’s (NYSE: CVS) decision to buy the insurance company Aetna (NYSE: AET). Instead, it is a need to survive in a radically-changing healthcare market that inspired the proposed acquisition.

Amazon is simply one of many threats that CVS faces in today’s economy, and it is far from the biggest. The political landscape, retail environment, and health insurance industry are all becoming increasingly hostile to CVS Health.

A sure sign of this is CVS’s income which has begun to fall noticeably. CVS reported a net income of $5.297 billion in June 2017 that fell to $5.042 billion in September. CVS’s net income for 3rd quarter 2017, was actually slighter lower than it was in September 2016, when the number was $5.108 billion.

Another is the low level of income at CVS in comparison to its revenues. CVS reported revenues of $182.35 billion on September 30, 2017. That makes it America’s second largest retailer in terms of revenues, and larger than Amazon.

America’s largest retailer is Walmart which reported $490.01 billion in revenues on July 30, 2017. Amazon is currently number with $161.15 billion in revenues reported on September 30, 2017. At its present rate of growth, there is a good possibility that Amazon will overtake CVS and become America’s second largest retailer in terms of revenue sometime next year.

Can CVS make Money in Drugstores?

More troubling for CVS is the state of the drugstore business. America’s third-largest drugstore operator; Rite Aid (NYSE: RAD) reported a net income of $89.24 million and a free cash flow of $140.53 million on 31 August 2017.

Rite Aid reported revenues of $32.09 billion from 4,621 stores. Those numbers should be sobering to CVS management because their company also has a vast footprint and big revenues, but a low income. CVS Health currently operates 9,700 drugstores and 1,100 clinics in 49 states, the District of Colombia, Puerto Rico, and Brazil.

Not surprisingly, Rite Aid’s management has decided to sell out to Walgreen Boots Alliance (NASDAQ: WBA) because they cannot make any money from drugstores. CVS’s management is afraid the same thing will happen to them so they are looking for new sources of income. Nor was it just Rite Aid, Walgreen’s net income of $4.078 billion for August 2017, was down from $4.173 billion in August 2016.

Drugstore operators are struggling to make money and Amazon has not even entered the business yet. A big reason why standalone drugstores are struggling to make money is intense competition from big integrated retailers such as Kroger (NYSE: KR), Walmart (NYSE: WMT), and Costco Wholesale (NASDAQ: COST). These brands can afford to use prescription drugs as a loss leader, CVS cannot.

A major fear at CVS is that Amazon will follow the same strategy. Another nightmare for CVS would be Amazon buying a drugstore brand; such as Rite Aid, or adding drugstores to its Whole Foods locations. One reason why Walgreen has gone to such lengths to buy Rite Aid is to keep it out of Kroger or Amazon’s hands.

The Real Reason why CVS wants Aetna: Vertical Integration

The real reason why CVS Health wants Aetna is to expand its vertically-integrated business model. Vertical integration means that one company controls as much of the production, financing, marketing, and distribution of a product or service as possible.

CVS Health is already partially vertically-integrated because it operates both drugstores and prescription-management plans. CVS operates clinics in some of its stores for the exact same reason. Buying a health insurance company would give CVS, even more, control over the process.

The next logical steps for CVS would be to buy pharmaceutical manufacturers, hospitals, or urgent care clinics. Owning a generic pharmaceutical maker would give CVS the ability to greatly lower drug prices and increase business. The only real drawback to that might be the Federal Trade Commission (FTC) which as the authority to block mergers.

Companies vertically integrate in order to control prices. CVS is trying to control healthcare and insurance prices for several reasons. A big one is to survive in a country where the government is the largest health insurer.

Is Single Payer Driving CVS’s Effort to Buy Aetna

There are currently around 55.3 million Americans on Medicare, 68.4 million people participating in Medicaid, and 5.9 million kids enrolled in the Children’s Insurance Program (CHIP). Those numbers are likely to grow as the population ages and voters demand single-payer health insurance.

Around 59% of Maine’s voters supported a ballot initiative to expand Medicaid in that state on November 7, National Public Radio reported. Efforts to expand Medicare to all Americans are also gaining in population, 16 U.S. Senators now back a Medicare for All proposal offered by U.S. Senator Bernie Sanders (I-Vermont). Some polls indicate that Sanders; an outspoken advocate of single payer, is the most popular politician in America.

CVS Health might be hoping to cash in on this trend by developing a vertically integrated combination drugstore and health-insurance solution it can market to state or federal governments. The Medicaid market is potentially very lucrative; the potential expansion in Maine would expand insurance to between 70,000 and 80,000 people. That’s 70,000 to 80,000 potential customers for pharmacies with the government footing the bill.

Is Aetna Making Money?

There are other reasons for CVS to buy Aetna including capturing the float, income from Aetna insurance premiums.

Float is a stream of regular income or payments that requires no extra expenses to produce but can be tapped or borrowed against. Float from such sources as insurance premiums is one of the major drivers of Berkshire Hathaway’s (NYSE: BRK.B) incredible ability to generate cash.

Aetna certainly has a lot of cash; it reported a free cash flow of $1.411 billion, an income of $1.799 billion, $614 million in cash from investing, $1.322 billion in cash from operations, and $8.797 billion cash and short-term investments on September 30, 2017.

An obvious reason for CVS to buy Aetna is to give itself more cash in order to fend off intense competition from the likes of Amazon and Walmart. Aetna has plenty of other value including; $57.38 billion in assets reported on September 30, 2017, and an enterprise value of $58.02 billion on 14 November 2017.

A major reason for CVS to buy Aetna is to give itself the ability to issue insurance policies. It can provide incentives for Aetna policyholders to use CVS pharmacies and Minute Clinics.

A customer waits at the counter of a CVS Pharmacy store in Pasadena, U.S., May 2, 2016. REUTERS/Mario Anzuoni/File Photo

Is CVS Health a Good Investment?

CVS Health is doing well without Aetna but it has a hard time generating float. The company reported cash and short-term investments of $2.56 billion on September 30, 2017.

Although CVS does a pretty good job of generating cash, it reported $10.19 billion in cash from operations on September 30, 2017. That number was down from $11.52 billion in June 2017. There was also a free cash flow of $2.087 billion on September 30, 2017.

CVS Health has trouble keeping cash because of the high-operating costs for its drugstore and clinic network. Even though that network gives it quite a bit of value in the form of $92.85 billion in assets on September 30, 2017, and an enterprise value of $95.64 billion on 14 November 2017.

What would CVS-Aetna be Worth?

The hope is buying Aetna is to give CVS more cash and float and to speed vertical integration. The obvious question for value investors here is what would a CVS-Aetna combination be worth?

A rough estimate would $153.66 billion in enterprise value. This figure is based on the enterprise values on November 14, 2017, and obviously does not include any assets the FTC might require the two companies to sell.

There would also be revenues of $243.76 billion, which would create a corporate giant with a vast amount of leverage over the pharmaceutical market. I arrived at this figure by adding Aetna’s revenues of $61.41 billion and CVS Health’s revenues of $182.35 billion reported on September 30, 2017.

That means an Aetna-CVS combination has a lot of potential value if it becomes reality. Whether that combo will survive FTC scrutiny is anybody’s guess because that agency is completely irrational in its regulation of mergers. The commission basically rubber-stamped the Amazon-Whole Foods deal but did everything in its power to throttle Walgreens’ Rite Aid acquisition. It also killed the Office Depot/Staples merger for reasons I cannot begin to comprehend.

Both CVS and Aetna are Pretty Good Stocks

Even if it does not Aetna is a pretty good investment right now because it offered a return on equity of 11.05% on September 30, 2017, and a dividend of 50¢ on October 11, 2017. Aetna’s dividend has doubled over the past year it was 25¢ in October 2016.

CVS is also a pretty good stock; it offered investors a return on equity of 14.35% on September 30, 2017. CVS Health investors also received a 50¢ dividend on October 23, 2017. That was a 7.5¢ increase over the 42.5¢ dividend paid out in October 2016.

There is no guarantee a CVS-Aetna combination would pay a $1 dividend, but both are good stocks right now. If it succeeds and clears, the FTC hurdle, a CVS-Aetna combination has the potential to become an even better stock, if well managed.