How CVS Health Can Beat Amazon.com

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The Wall Street Journal reports that CVS Health (NYSE: CVS) -- the second largest pharmacy retailer and pharmacy benefit manager (PBM) -- is offering more than $200 per share to acquire Aetna (NYSE: AET), a leading health insurer. The tie-up could help insulate CVS Health's market share from competition from Amazon.com (NASDAQ: AMZN). Will this deal help CVS Health survive in an increasingly competitive market?

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What they do

CVS Health is already a pharmacy behemoth. In the past 12 months, it's recorded $181 billion in sales and $5.3 billion in net income. 

The company operates over 9,700 stores, and thanks to its $26 billion acquisition of Caremark in 2006, it serves millions of consumers through its PBM. CVS Health's stores provide customers with prescription fulfillment and they sell over-the-counter medicines and general merchandise. Its PBM provides services to self-insured employers and health insurers that drive down their drug costs.

Additionally, CVS Health sells Medicare Part D drug plans in some states under the SilverScript brand and operates over 1,100 in-store healthcare clinics under the MinuteClinic brand.

Meanwhile, Aetna is a leading health insurer with $62.2 billion and $1.56 billion in trailing-12-month revenue and net income, respectively.

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It provides medical, pharmacy, dental, and behavioral health insurance products to 35.7 million members. It also runs a PBM serving more than 14 million members, and overall, these businesses accounted for $14.8 billion of Aetna's $15.5 billion in second-quarter revenue.

Most people are enrolled in Aetna's commercial plans, but it also has substantial exposure to Medicare and Medicaid. A total of 1.4 million people were enrolled in Aetna Medicare Advantage plans, 724,000 were enrolled in supplemental Medicare plans, and 2.1 million people were covered by the state Medicaid plans it manages in June. Aetna also provides drug services through its PBM business to 3.1 million Medicare drug plan enrollees.

Previously, Aetna also made money selling group life and disability products. However, the company sold that business to The Hartford for $1.45 billion in cash on Oct. 23.

Why this deal makes sense

If CVS Health acquires Aetna, it could provide it with significant opportunities to drive revenue to its retail stores and mail-order pharmacy.

CVS Health's existing SilverScript Part D plans offer significant discounts to patient copays if patients fill their prescriptions through CVS Health's stores or its mail-order pharmacy. Offering similar discounts to millions of Aetna members could block efforts by Amazon.com and other competitors to chip away at it prescription market share.

CVS Health could also create programs that encourage Aetna members to take greater advantage of CVS Health's in-store Minute Clinics.

Encouraging Aetna's customers to visit CVS Health for prescription fulfillment or primary-care services also offers CVS Health the opportunity to drive front-of-store sales higher because of increasing foot traffic.

Regulatory hurdles

CVS Health's competitor Walgreens Boots Alliance recently failed in its attempt to buy Rite Aid lock, stock, and barrel. Regulators balked at the deal because it would've consolidated too much market share.

Similarly, regulators blocked Aetna's previously planned merger with Medicare Advantage insurer Humana earlier this year. A federal judge put the kibosh on the deal after concluding the tie-up would significantly lower competition in Medicare Advantage markets.

Given these failures, investors can't ignore the risk that regulators could look very closely at a planned CVS Health and Aetna combination. Aetna doesn't overlap CVS Health in the latter's traditional markets, but that doesn't mean that regulators won't raise concerns about the companies' Medicare drug and PBM businesses.

Investor takeaway

It's unclear if Aetna's board of directors will sign off on a deal, and if it does, whether any changes will be required by regulators. Given those risks, it's not surprising that Aetna is trading below CVS Health's rumored $200 per share plus offering price.

Investors should buy Aetna on rumors of an acquisition, but investors might want to consider owning Aetna based on its own merits. Reducing its exposure to Obamacare has improved Aetna's profitability and while health insurance reform creates risks to Medicaid membership, aging baby boomers provide significant growth for its Medicare business. Alternatively, investors might want to approach CVS Health more cautiously. CVS Health's retail footprint is more exposed to an Amazon.com threat and a price war could end up significantly crimping its margins.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Todd Campbell owns shares of Amazon. His clients may have positions in the companies mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.