CVS: An Interesting Trade On The Cigna-Express Scripts Deal

By now you are aware of Cigna Corp's CI proposed acquisition of Express Scripts Holdings Co ESRX. Cigna will be purchasing Express Scripts in a $52B cash and stock transaction with Cigna taking on Express Script's $15B debt load. This is yet another merger in a continued string of healthcare consolidation. As healthcare companies feel increasing pressure from regulators and potential third-party entrants into the market, they have looked towards acquisitions to cut costs and increase profits.

With the announcement of the Cigna and Express Scripts merger many investors will look to Cigna stock as a long-term play on a consolidated healthcare industry, or Express Scripts stock as a potential merger arbitrage trade. However, the news of this merger may just be creating an opportunity in a different company CVS Health Corp CVS.

While Cigna has been up over 13 percent over the past 12 months, even including an 11 percent drop today, CVS shares have been hit hard. CVS has underperformed the market significantly over the past 12 months as investors fear a decline in the company's retail sales, a potential Amazon.com, Inc. AMZN entry into the insurance or drug distribution market, and the company's merger with Aetna Inc AET.

Ironically Cigna's proposed merger with Express Scripts is positive news for CVS for two main reasons.

CVS's share price has been depressed as investors and analysts fear a potential Amazon entry into the drug distribution and insurance markets, with many speculating an Amazon, ESRX buyout. With Express Scripts off the table, an Amazon entrance to this industry will become much more difficult. In addition investors were also wary of CVS's purchase of Aetna, as many saw it as an act of desperation, but Cigna's acquisition of Express Scripts further shows how consolidation is the trend in the healthcare industry.

Amazon Threat

When looking at the healthcare market, and pharmaceutical distribution market in particular, there are a few key players. In the process of getting a drug from a manufacturer into your kitchen cabinet the key players are insurance companies, pharmacy benefit managers, and retail pharmacies. A pharmacy benefit manager such as Express Scripts serves as a middleman between drug manufacturers and insurance companies. They negotiate prices and use their scale to get discounts and rebates for their millions of members. Given that pharmacy benefit managers interact with all facets of the healthcare market, a PBM would be the most logical purchase for Amazon were it to enter the healthcare market. A PBM could help Amazon navigate the regulatory hurdles it would face in both the pharmaceutical drug distribution and insurance markets, both of which Amazon has expressed interest in. However, with Cigna buying Express Scripts, the 3 largest public pharmacy benefit managers (Caremark – owned by CVS, Optum – owned by United Healthcare, Express Scripts – owned by Cigna) will now be housed under larger retail pharmacies or insurance companies. While Amazon could potentially go it alone in its foray into the healthcare market, this likely wouldn't be wise as the company has struggled to navigate regulatory hurdles in the past. It took Amazon years to get into the alcohol distribution business, and the company has also struggled to get wholesale pharmacy licenses, shown by its cancellation of an application in Maine. These wholesale pharmaceutical licenses only allow Amazon to ship medical supplies and were the company to distribute pharmaceuticals, it would have to acquire numerous other more complex licenses. This is significant for CVS in that the company's stock has been repeatedly hit by news that Amazon plans to enter the healthcare market.

Now that Amazon has lost its most viable partner to enter the healthcare market, CVS's share price should begin to reflect this lessened threat.

Aetna Merger

Investor sentiment towards CVS's merger with Aetna has been overwhelmingly negative with the company's stock trading down on both transaction rumors, and the official announcement of the transaction. Investors and analysts saw it as a desperation play by the company to fend off Amazon and diversify away from their pure-play retail segments. However, this acquisition was just the first in a series of healthcare mergers and acquisitions. CVS's acquisition of Aetna doesn't represent a hail mary play by the company, but rather a calculated first step in an industry rampant with consolidation. Since the company announced the transaction, other dominoes have fallen with Walgreens buying the rest of AmerisourceBergen and now Cigna purchasing Express Scripts.

On the announcement of the transaction, investors and analysts were also concerned with the potential regulatory hurdles the company may face. The past mega-mergers in the healthcare industry had faced significant regulatory hurdles with Aetna's deal to buy Humana, Anthem's deal to buy Cigna, and Walgreens deal to buy Rite-Aid all being blocked or significantly altered by regulators. Cigna's purchase of Express Scripts further shows that the new trend in healthcare is vertical integration. These vertical mergers should face less regulatory hurdles than their horizontal counterparts as it will be much easier to show how consumers will benefit. Not only will Cigna and CVS be able to show how the consumer benefits from the proposed mergers, but these combinations exist in the marketplace today. United Healthcare, an insurer, has a PBM in-house in its Optum unit. CVS and Cigna will be able to point to this as they deal with regulator concerns.

Conclusion

While many will look towards Cigna or Express Scripts stock as a result of this announcement, investors should take a step back and look at who else this merger could benefit. This holistic view will reveal a great opportunity in CVS as the transaction takes Amazon's most likely healthcare partner off the market and helps to further quell regulatory concerns facing the company's proposed merger with Aetna. As the healthcare industry continues to consolidate, CVS, with its retail pharmacy, PBM, and insurer segments, will be well positioned to take advantage.

Disclosure: Some clients of Joule Financial own CVS and ESRX. No positions in CI at the time of this article.