Merrill Lynch upgraded Aetna Inc. (NYSE: AET) to Buy from Neutral but maintains its price objective at $132, implying an 18% upside. Since the announcement that Aetna will acquire Humana on July 3, shares dropped 12%.

Kevin Fischbeck and Stephen Baxter, analysts for Merrill Lynch, view the pullback and current valuation as overly discounting the concern about Humana’s earnings trajectory and the risk that the acquisition will not be approved. The firm remains positive on the strategic merits of the deal and expect double-digit accretion by 2018, ex potential PBM savings.

While Merrill Lynch believes the deal will ultimately be approved, it acknowledges that the outcome of the DoJ’s concurrent review of the 3 announced managed care organization (MCO) deals is difficult to predict.

According to the firm, since providing EPS guidance back in December of $10+ in 2018, Aetna’s 2015 guidance has already increased 6%. Assuming 2018 EPS of $10.25, and applying a conservative 11.2-times multiple, the stock should trade at $115 a year from now, implying that the market is already fully discounting a failed deal.

In the report, Merrill Lynch detailed another scenario:

Assuming the acquisition of Humana is low double-digit accretive to the $10.25 of standalone Aetna 2018 operating EPS we assume above, pro forma EPS would be approximately $11.50 before any potential PBM savings or potential upside to synergy targets. Using a 13x multiple, which we think is conservative but is higher than the base multiple to account for these upside levers and to reflect the improved long-term growth profile for Aetna pro forma Humana, we believe the stock could trade at $150.

However, the biggest earnings risk to any MCO is the potential that medical costs will increase more quickly than pricing, causing margin compression, and downside to the standalone value above. Meanwhile, Humana has missed consensus for 4 straight quarters, lowering visibility into earnings. Humana believes it has addressed the issues with 2016 bids, and Merrill Lynch noted that the Humana has 2 more bid cycles to ensure target margins are achieved by 2018. At the same time, the firm estimates that Humana’s Medicare Advantage margin would have to be below 2.6% (or 46% below its target of 4.5% to 5%) for the deal to be dilutive to Aetna’s standalone EPS.

Shares of Aetna were up 1.3% at $114.07 on Thursday afternoon. The stock has a consensus analyst price target of $139.07 and a 52-week trading range of $71.81 to $134.40.

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