Strategic Mission
CVS Health Corp. (NYSE:CVS) is out to make healthcare a “retail option”, fully recognizing that healthcare is becoming local. CVS seeks to deliver healthcare where people are (at home and at work).
Despite the significant drop in revenue and profit growth in 2017, CVS is piecing together a compelling plan to get back to growth.
To this end, one of the primary investment areas for CVS in 2017 is to pilot enhanced healthcare service offerings within its retail stores.
Example: CVS signed an agreement to offer its customers the new GlaxoSmithKline (NYSE:GSK) shingle vaccine called “Shingrix”. Shingrix is recommended for patients whether or not they had chickenpox as a child.
CVS is focused on building a vertically integrated business model in order to capture an oversized share of its industry growth.
In recent years, CVS’s Pharmacy Benefits Management (PBM) business segment acquisitions (e.g. Caremark) have been a primary driver of corporate growth.
Company Background
The CVS business model has had the benefit of several macro, growth tailwinds (that remain intact):
- Aging population
- Increased production utilization
- Demands for cost management to address rising costs
- Movement to value-based care
- Increased realization of healthcare
CVS Business Model:
- 9,700 retail locations
- 1,100 walk-in healthcare clinics
- ~90 million PBM members
- 1 million senior pharmacy care patients seen annually
- Expanding specialty pharmacy services
- Leading stand-alone Medicare Part-D prescription drug plan provider
Major Business Components:
Caremark – A Pharmacy Benefits Management company
Omnicare – An industry-leading, long-term care pharmacy services provider focused on supporting community residents and staff throughout the continuum of care.
MinuteClinic – Retail clinics that are staffed by nurse and doctor practitioners who specialize in family healthcare.
Major Business Segments:
1A. Retail Pharmaceuticals
- 7,980 CVS stores
- 1,674 pharmacies
- 38 online pharmacy sites
- *Located in 48 states, D.C., Puerto Rico and Brazil
1B. Long-Term Care (LTC) Pharmaceuticals
LTC is comprised of hub spoke pharmaceutical stores located in 32 central hub/spoke units and 120 spoke-only units
2. Pharmacy Services Segment which operates:
- 23 retail specialty pharmacy stores
- 13 specialty mail-order pharmacies
- 4 mail-order dispensing pharmacies
- 864 branches for infusion external services including:
- 73 ambulatory infusion suites
- 3 centers of excellence
*Located in 41 states, Puerto Rico D.C.
Pharmacy solutions target market:
- Employees
- Unions
- Healthcare plans
- Insurance companies
- Medicare Part-D
- Managed Medicare plans
- Government employee groups
- Plans offered on public private exchanges
- Other sponsors of health benefit plans
Competitive Advantages
Vertical integration of retail and mail-order pharmaceuticals, PBM services, retail clinics and long-term care.
The company believes it owns an outsized portion of the “last mile” of care delivery. CVS business retention rate is 97%.
Huge operating cash flow allowing:
- CVS to return $6.3B to shareholders through dividends and stock buybacks in 2017.
- Dividends to increase 21% in 2016 and 18% in 2017.
Aetna Merger – Pros Cons
Potential Benefits Opportunity
On the plus side, the merger of CVS Health and Aetna Insurance (NYSE:AET) would further expand upon CVS Health’s vertical integration strategy. And CVS views Aetna as a major catalyst for continued growth opportunities; especially in the area of bundled, new, retail services offerings.
CVS-Aetna possesses deep assets and healthcare expertise that resides in each company. And both companies have demonstrated ability to execute successfully on goals and objectives.
Piper Jaffray analyst Sarah James sees Aetna’s long-term growth rate at 10%. CVS clearly plans to capitalize on Aetna’s growth and to add another 3% or more of its own organic growth to that. Combined, CVS-Aetna would achieve an annual growth rate of at least 11%. This would meet/exceed CVS’s long-term growth target.
In 2017, Aetna paid down $12.7B in corporate debt. This had a major impact on FCF, and bodes well for FCF in future years. Over the past five years, Aetna’s average annual FCF was $2.9B (Source: www.morningstar.com).
Reduced debt service and a lower maximum Federal Tax Rate (35% to 21%) will provide a significant bump in Aetna’s net income and FCF in 2018 and beyond. It is this analyst’s estimate that Aetna’s total cash flow improvement will be in the ballpark of $1.45B ($500M in tax benefit and $950M in eliminated debt service).
Potential Cost Uncertainty
CVS will borrow $44B in new debt to close the merger deal with Aetna. This analyst estimates that the new debt service cost on this new borrowing will be in the range of $2.2B-$2.6B annually (Assuming an interest rate between 5% and 6%).
This analyst has not been successful in uncovering any overwhelming evidence that the combined CVS-Aetna merger will be able to produce an ongoing, combined annual growth rate of 10% plus. Neither has this analyst been able to (yet) identify any new bundled services that CVS alone, or the combined enterprise, may offer.
CVS said it will freeze dividends at $2.00/share over the next 1-2 years and will suspend share buybacks during this same time frame in order to support the newly acquired debt burden and future merger success.
CVS says it will increase staff wages and benefits in the next 3-12 months in order to increase employee loyalty and reduce staff turnover. If robust growth does not return, this SGA cost increase will negatively impact profitability and EPS.
Threats
From this analyst’s vantage point, there are three possible, external threats to CVS’s business model.
The first and perhaps the most overhyped threat is from the Amazon (NASDAQ:AMZN), Berkshire (NYSE:BRK.A) (NYSE:BRK.B), JPMorgan (NYSE:JPM) consortium. Recently, this group lost its bid to buy Express Scripts (NASDAQ:ESRX) to the insurance giant Cigna Corporation (NYSE:CI). This consortium presently has no CEO on board, but expects to hire one within 12 months. Also, RBC has reported that Amazon canceled its pharmaceutical wholesaler application with the state of Maine (Note: Amazon has similar licenses with 15 other states).
Unless the DOJ outright rejects Cigna’s merger acquisition of Express Scripts – which would give the Amazon consortium a second chance at acquiring Express Scripts – Amazon is rapidly losing opportunities to break into the PBM field in any significant and meaningful way. General ongoing industry consolidation also continues to reduce the Amazon consortium’s opportunities.
The second threat revolves around the scenario of the CVS-Aetna merger not working out as planned. There are reasons why this may occur:
- Aetna is not able to maintain a long-term 10% growth rate.
- CVS and Aetna are not able to develop enough meaningful “bundled services” to drive 10-15% combined business growth.
- Few meaningful cost reductions can be achieved from this merger. CVS currently estimates that there are $750M in cost synergies with this MA. Leerink analyst Ana Gupta says she is skeptical in regards to CVS-Aetna achieving such cost savings. This analyst is also skeptical.
The third and most significant long-term threat to CV-Aetna and the rest of the health industry is the potential for the federal government to pass “Medicare For All” legislation, essentially creating a single-payer health system for the USA. This would be the death knell for America’s “for-profit” healthcare industry.
While this analyst does not see this happening anytime during the next two to possibly six years, there is no telling what a new Democrat controlled presidency and Congress is capable of in the future.
Value Analysis
Because there are far too many degrees of uncertainty regarding the approval of the CVS-Aetna merger and the success of said merger post a DOJ approval, this analyst chose to value CVS today as a stands-alone operation.
Using an Earnings Justified Model and a Discount Rate Justified Model, this analyst finds that CVS’s common stock is selling at a significant discount to its intrinsic value in the range of 45-95%. With a closing price on March 28th of $62.25/share, a long-term value investor would be able to acquire CVS common stock at an annual “no growth”, steady-state E/P return rate of 10% on their immediate investment.
The common stock price of CVS is presently selling at a five-year low as well as near the bottom of its annual High-Low price spread.
The next chart displays the historical “discount”, “neutral” and “premium” price to value the spread for CVS’s common stock over the past 10 years.
The following chart represents the previous 10-year trends for Revenue, Operating Cash, Net Income and Free Cash Flow growth.
What Does An Aetna Merger Add?
Improved annual cash flows estimated at $1.2B for CVS and $500M for Aetna (or $1.7B) due to the recently approved Federal Corporate Tax Rate reduction (35% to 21%). Now add to this the annual interest cost savings of $950M obtained by Aetna for paying down $12.7B in corporate debt. The total annual cash flow improvement of the combined entities amounts to $2.65B.
This cash flow improvement should be enough to cover the annual debt burden on the $44B debt issued by CVS to complete the merger agreement with Aetna. This also leaves CVS-Aetna with virtually all of previous cash flow to support dividends, debt reduction, share buybacks, and new business growth.
A couple of very important points that a value investor should monitor with this combined CVS-Aetna entity going forward would be:
- The number and estimated financial impact (size) of new bundled service offerings created? This activity should be observed and quantified very quickly both pre- and post-merger.
- The quarterly financial results to verify that growth is occurring on both ends of this newly combined entity. Are they achieving a 10% plus annual growth rate? Not immediately, but certainly within 18-24 months post merger.
Wrap-Up
This analyst believes that CVS common stock represents an undervalued investment opportunity. However, the stock will very likely continue to see downward pricing pressure due to three key factors:
- Ongoing Amazon, Berkshire and JPMorgan threat to enter the industry.
- Uncertainty regarding the DOJ’s approval of the CVS-Aetna merger.
- Uncertainty for the successful outcome of any approved CVS-Aetna merger.
Therefore, a value investor would be wise to employ a slow accumulation strategy until a definite change in the stock price trend is confirmed. Once a position is put on, the investor can sit back and collect an annual $2.00/share dividend while waiting for the stock price to return to fair value.
More sophisticated investors might entertain selling Put Options on CVS common stock at a more attractive price point than what is currently offered by the market today and collect a fee while waiting for the price trend to change. If the stock price dips below the seller’s Put strike price, the seller of the Put would be able to acquire CVS common stock at this reduced strike price and further reduce his/her cost basis by the amount of the fee collected.
Full Disclosure: I/we are long CVS common stock. Before making any purchase decision the reader should complete his/her own research and investigation to support or disclaim this analysis. Any and all purchase decisions ultimately made by the reader are the reader’s sole responsibility.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CVS over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Article source: https://seekingalpha.com/article/4160245-cvs-health-stock-oversold