A Curious Reaction

That's because I own shares in Caremark, the legacy of my recommending (and buying) shares in Advance PCS in my 2002 SmartMoney article "Ten Stocks for the Next Ten Years." (Curiously, this is the second time in as many weeks that one of those stocks has made news. Last week it was Flir Systems (FLIR).) That Advance purchase has paid off handsomely, since it was subsequently acquired at a premium by Caremark for stock and cash. I held the shares, which is why I own Caremark today.

When the market opened, the stocks followed the playbook, at least at first. CVS shares dropped precipitously, and Caremark jumped a few dollars.

I admit to being a little disappointed the premium didn't seem to be richer, but told myself not to be greedy. Then details of the proposed transaction started trickling out. This was to be a "merger of equals" — always a dreaded phrase for shareholders in the target company. In my experience, there never really are any "mergers of equals." Just ask any number of ex-CEOs who thought they were entering into power-sharing arrangements. Too often it's just a phrase to paper over the fact that the proposed price is cheap. Within a few hours of trading, Caremark shares reversed course and dropped, closing down 2%. CVS shares lost 7.4%. They went down even more the next day. It's been a long time since I can remember a deal where shares of both companies involved declined. So much for my eager anticipation.

Still, I always wonder whether an anomaly represents an opportunity, and this was certainly an anomaly. I noticed that analysts were rushing to downgrade the stocks. The rationale I saw most often was "uncertainty." But when does any merger offer certainty? Another notion was that Caremark must have been desperate to sell at such a low price. (Under the proposed terms, Caremark holders will receive 1.67 shares of CVS for each share, so the price fluctuates with the value of CVS shares. At last Wednesday's close of $29.06, Caremark shares were valued at $48.53 each.) This deal only underlined the apparent threat to pharmacies and drug-benefits managers from Wal-Mart Stores (WMT), which has slashed prices on some drugs — a threat that has already driven down share prices of drug stores and benefits managers. While these seem legitimate concerns, they strike me as speculative.

What's not speculative is that this is in part a horizontal merger likely to boost profits, exactly the kind of merger that appeals to me. Although CVS and Caremark aren't for the most part direct competitors, since CVS is primarily a retail chain, CVS does have a significant pharmaceutical-benefits-management unit, which focuses mostly on corporate customers, a nice complement to (and direct competitor of) Caremark. If this aspect of the deal escapes antitrust sanctions, it should reduce competition and yield significant economies of scale.

Then there's the Wal-Mart threat. In my view, Wal-Mart has too many problems of its own to go on a scorched-earth price war in the pharmacy business. Besides, impressive and big as it is, Wal-Mart can't be all things to all people. The existence of Wal-Mart pharmacies doesn't seem to have crushed CVS or Walgreen (WAG). If this new price-slashing push by Wal-Mart is so potent, then how did CVS manage to post a 12% profit gain on a 25% revenue surge last week? I think Wal-Mart fears are overblown.

Finally, and perhaps most important, there's the reason I picked a pharmaceutical benefits manager for the "Ten Stocks" article in the first place: demographics. The baby-boom generation is just getting to the stage of life where pharmaceutical demand is likely to surge. The Medicare drug benefit, whether modified by a Democratic Congress or not, is likely to further fuel demand. A combined Caremark/CVS is in an excellent position to capitalize on volume growth.

I admit I'm a little disappointed that so few other investors seem to share this view. But if they did, these companies wouldn't be the bargains that I believe they are. Given the terms of the deal and the market reaction, it doesn't make much difference whether you buy CVS or Caremark, since both will now trade in line with CVS shares. The question is, which stock do you want to own if for some reason the deal falls through? CVS shares dropped more on the news, so in theory they should rebound more if the merger never happens.