New Script at CVS

It claims the Caremark deal wasn't prompted by competition.
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The looming marriage between

CVS

(CVS) - Get Report

and

Caremark

(CMX)

has left investors with cold feet.

Shares of both companies dropped sharply Wednesday, dragging their pharmacy industry peers with them, after the surprising union was announced. The merger will, for the first time, unite a giant drugstore chain with a leading pharmacy benefit manager. It could reshape the entire drug-supply business.

But some observers were left wondering whether CVS isn't in over its head trying to integrate two big mergers at once. Others wondered why Caremark would be eager to sell out in a no-premium transaction -- particularly when its shares have fallen more than 15% since

Wal-Mart

(WMT) - Get Report

stunned the industry with a plan to sell generic prescription drugs cheaper.

SunTrust Robinson Humphrey analyst David Magee understands the market's nervousness even though he embraces the union himself. For one thing, he points out, CVS is still digesting its big acquisition of the Sav-On pharmacy chain. For another, he notes, CVS was supposed to be focusing more on organic growth. And finally, he adds, CVS could now look as if it is simply playing defense against Wal-Mart because of the retail giant's new $4 monthly generic-drug plan.

"Although one could argue that much of the difficult work with the merger integration(s) will be complete by year-end -- and that the impact of the WMT pricing action has been overestimated anyway, thus providing the buying opportunity for assets in this space -- we believe these points will fall on deaf ears," Magee wrote on Wednesday. "Net-net, we view this as a short-term negative for CVS but are cautiously optimistic regarding longer-term implications."

In a conference call late Wednesday, the companies made similar arguments. They insisted that recent developments -- particularly cheap generics at Wal-Mart and proposed changes to the average wholesale pricing system -- didn't force them to act.

Rather, they said they began discussing a possible merger around this time last year and, after much planning, finally decided to move right now. They defended the price tag on the deal as well.

Some investors feel perplexed because CVS will pay less for Caremark's stock than Caremark has paid for its own shares in the past. But Caremark CEO Mac Crawford feels no such uneasiness himself.

"There will be skeptics," Crawford admitted. "I accept that and understand that ... (But) we think this is a transaction that makes an awful lot of sense."

Magee finds the deal attractive for a couple of obvious reasons. First, he says, the combined company will emerge with more buying clout and negotiating leverage. In addition, he adds, it will become an "interesting cash-flow/balance sheet play" with more than $1.5 billion in free cash flow.

Magee has a buy recommendation and a $40 price target on CVS's stock. His firm prohibits analysts from owning stock in the companies they cover and from publishing favorable research in an effort to attract business.

Merrill Lynch analyst Patricia Baker likes the looks of the deal as well.

"While the market may have some difficulty understanding the strategic rationale behind this move, we believe that it makes a lot of sense," Baker wrote on Wednesday. "The deal would provide CVS with an exceptional mail-order business. ... We also see the potential for CVS to benefit from future reimbursement negotiations with payors, as it would be more directly involved."

Like Magee, Baker has a buy recommendation and a $40 price target on CVS's stock. Her firm owns at least 1% of the shares itself.

A.G. Edwards analyst Andrew Speller suggests that CVS has, in fact, made quite a catch. He, too, notes that CVS could now benefit from reimbursement discussions that it had been left out of before. He believes the company could capitalize on the growing shift toward mail-order business as well. And he expects the company to pick up more Medicare Part D customers to boot.

Still, he wonders whether the two companies will really suit each other in the end.

"We are surprised by this development and remain uncertain about the strategic rationale behind Caremark's willingness to sell," wrote Speller, who has a hold recommendation on Caremark's stock and whose firm has no business ties to the company.

"We believe that a combined CVS/CMX would be a dominant force in pharmacy services that would be unmatched by its peers," he adds, "but we question whether the two companies can be successfully integrated."