· For example, CVS’s 9,709 retail pharmacy locations can serve as a marketing entity of the health insurance business. Such strong exposure to consumers should provide the company an edge against UnitedHealth.

o Weakness

· The very long-term growth might be limited since CVS only seems to focus on the domestic (U.S.) market.

· Health insurance business entails political risks. For example, the demand for private health insurance will plummet if the U.S.A decided to offer free-healthcare.

o Opportunity

· Aging population and increasing health care spending in the U.S. are strong tailwinds for the industry.

· Trump’s corporate tax cut should boost CVS’ after-tax earnings. CVS’s current effective tax rate is roughly about 38%. The tax cut to 20% will be quite significant.

o Threat

· I personally do not believe that Amazon’s entry into pharmacy business alone will be a threat as CVS’s retail locations provide “last mile” advantage in terms of home delivery. However, if Amazon decided to team up with Walgreens, the alliance could be a large threat at it obscures CVS’s location advantage against Amazon.

Valuation Analysis

o Assumptions

I will assume the following for the sake of my valuation and setting a price target. These assumptions include both conservative and optimistic measures.

1. The acquisition completes in 2018 without issue.

- It’s a vertical integration and I believe CVS has sufficient justification to convince the DoJ that the merger will be beneficial to the consumers, lowering the overall healthcare cost.

2. Synergy takes in effect starting 2020. No growth or cost savings in 2018 and 2019.

- Due to the size of each company and its operations, I believe it is reasonable to assume that the post-merger integration (PMI) will take at least 1.5– 2 years. Until PMI completes, I assume no growth or cost savings.

3. The synergy will result in $750 million cost savings in 2020

- This is based on CVS’ own projection. I will use their projection as it is since the explanation seems plausible.

4. 2% annual growth in Free Cash Flow to Firm for 2020-2030 and 0% onward.

- I believe 2% annual growth will be achievable as the CVS-Aetna merger will have a wide range of growth and cost saving strategies as follows:

Ø CVS can use its 9,709 retail location as the sales center of Aetna’s insurance business.

Ø Aetna can provide its insurance members incentives, such as product discounts, to visit CVS’s retail pharmacies and health clinics.

Ø CVS can provide PBM services to Aetna to further reduce the insurance expense.

Ø The CVS-Aetna will have higher leverage to negotiate price with drug manufacturers, significantly lowering its expense. If drug manufacturers do not agree to lower the price, for example, CVS-Aetna can threaten to exclude their drugs from the insurance coverage and stop selling their products.

- Since the CVS-Aetna only has access to the domestic (American) market, I feel that potential growth will be somewhat limited. Though I do expect healthcare spending in the US to keep rising, I assume the 0% terminal growth to keep the valuation somewhat conservative.

5. Discount Rate at 7.21%

- I set the discount rate at 7.21% based on the following assumption:

Ø Cost of Equity = FCF / Price

Theoretically, CVS could have used all of its FCF for dividends and stock buybacks, resulting in 10.8% annual return in equity, assuming the FCF is fixed. In a sense, this is the minimum return that shareholder’s should expect from the company’s investment.

Ø Cost of debt = Highest yield of the company’s bonds

To keep the valuation conservative, I chose the highest borrowing cost that I could think of.

Ø Debt/Equity Allocation = The fund structure which will be used in the Aetna acquisition

CVS will fund the Aetna acquisition with 44.8 Mil debt and 25.1 Mil equity, which translates to 64% in debt and 36% in equity.