CVS Deep Dive
Skeptical of integrated healthcare strategy, but CVS still looks extremely attractive
When most Americans think of CVS what comes to mind are the retail locations and the long receipts. In fact, CVS is one of the largest healthcare services companies in the U.S. Specifically, CVS operates the largest retail pharmacy in the U.S. with 26% market share, the largest Pharmacy Benefit Manager (PBM) with 32% market share, and the 3rd largest health insurer with 23 million members. CVS’s front store retail business only accounts for 7% of overall revenue and 15% of overall gross profits.
The layout for this write-up is as follows:
• Analysis of the key drivers and outlook for each of CVS’s three primary businesses
• Discussion of the benefits of integrating these businesses under one roof
• Recent management changes and capital allocation priorities going forward
• Analysis of the greatest risks facing CVS
• Financial model
• Valuation analysis
Retail/Long-Term Care (~40% of earnings)
The Retail/Long-Term Care segment operates 9,900 retail locations, including 1,100 walk-in MinuteClinics, and 650 HealthHubs. CVS is a ubiquitous retailer in the U.S., as 70% of the U.S. population lives within 3 miles of a CVS, and 50% live within 10 miles of a MinuteClinic. Pharmacy accounts for 77% of this segment’s revenue, and front store (OTC drugs, consumer health products, beauty products and personal care products) accounts for the remaining 23%. As noted, CVS is the largest retail pharmacy in the U.S., with a 26% market share, with 65mn customers and 1.5bn prescriptions filled annually. I have included a detailed flow chart of the U.S. pharmacy and distribution system at the end of this write up.
In addition to its front store and retail pharmacy offerings, CVS recently expanded the range of healthcare services it offers. CVS’s MinuteClinics focus on low-acuity services like minor illnesses and injuries, health screenings, vaccinations, and physicals. While HealthHUBs focus more on chronic disease management, providing services like sleep apnea assessments and blood draws, as well as treatments for common illnesses. HealthHubs are staffed with providers like nurse practitioners or nutritionists, with over 20% of the store's space dedicated to areas for these consultations, as well as medical equipment and other medical supplies.
CVS’s retail footprint serves as a key differentiator relative to its healthcare services peers such as UNH, ANTM, and CI who lack a retail presence.
While CVS’s front store offerings are not an attractive business on a stand-alone basis, the ability to offer low cost and convenient healthcare to over 100 million Americans should benefit CVS (discussed in more detail below). As management noted during its 2019 Investor Day presentation:
“Now our ability to interact with consumers through a broad range of channels, it does provide us unique competitive advantages versus our managed care peers…. And our numerous touch points with health care consumers, it enables us to provide healthier behaviors. That's going to lead to better outcomes and ultimately lower medical costs, benefiting consumers, clients, and shareholders. “
Operating margins in this segment have declined over the past five years, from 10% in 2015 to 6.7% in 2020 as gross margins declined from 30.5% in 2015 to 26% in 2020, driven by reimbursement pressure on generic drugs. Revenue/generic script declined 37% during that time frame leading to a decline in revenue/script from $51 in 2015 to $48 in 2020. Additionally, CVS’s generic dispensing rate increased from 84.5% in 2015 to 88.3%, and generic drugs sell for a much lower average selling price than brand name drugs. CVS also experienced lackluster results in its front store offerings, where revenue was flat from 2015-2019. Furthermore, CVS experienced no operating leverage, as any possible operating leverage was offset by higher wages, and increased costs from store openings/closings.
I do not expect declining generic reimbursement rates to abate due to continued pressure from PBM’s and Health Insurers to lower overall drug spend. CVS will also increase its minimum wage to $15/hr. in 2022, which will add $600mn of incremental labor costs over three years. While higher wages should lead to lower employee turnover and higher productivity, CVS will face near-term margin pressure as a result. The key metric to monitor will be additional healthcare services revenue generated by the expansion of healthcare services, as CVS reformats stores. Given the slower than expected roll-out of HealthHubs, I have forecasted only modest increase in healthcare services revenue, included in the Front-End revenue line item below.
Pharmacy Services (~30% of earnings)
The Pharmacy Services segment provides a full range of pharmacy benefit management (PBM) solutions, including plan design and administration, formulary management, mail order pharmacy, specialty pharmacy, and infusion services.
As mentioned, CVS operates the largest PBM in the U.S. with a 32% market share, with 105 million plan members, and 2.1bn prescriptions filled annually. PBM customer relationships are quite sticky, with CVS noting a 98% retention rate for the 2021 selling season. As shown below CVS has maintained a low 30% market share over the past few years. 85% of PBM claims are processed through its pharmacy network of 66,000 retail pharmacies (inclusive of CVS’s retail network), with the remaining 15% processed through mail choice where prescriptions are mailed to members.
Historically revenue and earnings grew at mid-single digit rates driven by high single digit growth in scripts filled, driven by the aging U.S. population and modest market share gains for CVS. However, revenue/script declined over time driven by reimbursement pressure related to generic drugs similarly to what we noted for CVS’s retail pharmacy. Revenue/generic script declined 45% from 2015-2020, and CVS’ generic dispensing rate increased from 84% to 88.2% over that time frame. Pharmacy Services has consistently generated 3.5-4% operating margins, with gross margins in the 4.5-5% range and operating expenses consistently at 1% of revenue from 2015-2020.
I expect these trends to continue with mid-single digit growth in scripts filled driven by an aging U.S. population, offset by weakness in revenue/script due to the continued decline in generic reimbursement rates. Growth in specialty drugs which generate much higher revenue/script will partially offset reimbursement pressure related to generics. Additionally, it will be challenging for CVS to increase its PBM market share as ANTM (2nd largest health insurer) launched their own PBM, IngenioRX in 2019. I expect operating margins to stay around 4%, in line with the recent past.
Healthcare Benefits (~30% of earnings)
CVS is now the 3rd largest health insurer in the U.S. with 23mn members, following its $77bn acquisition of Aetna in November 2018.
As shown below the Commercial Risk market is unlikely to experience much growth in enrollment as nearly all employers who want to provide health insurance already do so. However, Medicare Advantage is forecast to grow enrollment by high single digits driven by the aging U.S. population and the increase in dual eligible (people eligible for Medicare and Medicaid). Medicaid is expected to grow enrollment by mid-single digits driven by the expansion of Medicaid in 39 states (including D.C.).
In the Commercial market, CVS ranks 3rd with a ~10% market share, ranking 3rd in Commercial Risk with a 5% market share and 3rd in Commercial ASO with a 15% market share. As mentioned above, minimal enrollment growth is expected in Commercial Risk or Commercial ASO due to how mature the market is. Additionally, enrollment is sticky in the Commercial market, CVS has a 97% client retention rate for Commercial heading into 2022, and I believe it will be challenging for CVS to take market share. CVS will launch an individual ACA product in 8 states in 2022, which may drive modest membership growth over time.
In Medicare Advantage (MA), CVS ranks 3rd with an 11% market share, and Medicare Advantage is the fastest growing market with expected enrollment growth of 6-9%/yr. MA penetration is currently at 39% of eligible seniors and is expected to increase to 51% by 2030, leading to a 67% increase in MA enrollment from 24mn in 2020 to 40mn in 2030. Seniors consistently rate MA more favorable than the government run FFS despite higher costs, due to the higher level of benefits associated with MA and caps on out-of-pocket expenses.
A key driver for CVS is its strong plan ratings from the Center for Medicare & Medicaid (CMS) quality ranking system, which is a pay for performance system, with plans rating 4 stars or above (out of 5 stars) receiving quarterly bonuses. For the 2021 Star Ratings Year, 83% of CVS MA members are in plans rated 4 stars or higher, over the last two years.
CVS ranks 6th in Medicaid membership, with 3% market share. Medicaid is also a faster growing line of business as the U.S. population ages (dual eligible) and because of Medicaid expansion in 39 states. Managed Medicaid is expected to increase from roughly 56% of the eligible population in 2020 to 61% by 2027, providing a tailwind for CVS and other health insurers.
CVS/AET experienced no growth in medical membership from 2015 to 2020, as AET lost 1mn commercial members from exiting the public exchanges in 2017, offset by growth in Medicare Advantage and Medicaid. I expect high single digit membership growth for Medicare Advantage, mid-single digit growth for Medicaid given the tailwinds in those lines of business, and minimal membership growth in Commercial given how mature that market is. As noted CVS will enter the individual exchange market in 8 states in 2022, but I expect modest membership growth as a result.
Historically revenue and earnings grew at mid-single digit rates driven by premium growth, with minimal membership growth. I expect similar revenue growth as medical membership increases by 2%/yr. and margins stay relatively flat. Specifically, I expect CVS to maintain an 84% medical benefit ratio (MBR) in line with its performance in 2018/2019, as cost reductions from increased integration with retail/LTC are offset by increased Medicare/Medicaid membership which have higher MBR’s due to the 85% MBR floor mandated in the ACA. 2020’s outstanding results are not repeatable and reflect lower healthcare utilization because of COVID-19.
Benefits of Integration
During its 2019 Investor Day CVS laid out a strategy to reduce healthcare costs and expand access to care. Specifically, by expanding into health insurance through the acquisition of Aetna, CVS would benefit from better cost control over drug spending, and by incentivizing members to utilize minute clinics and health hubs to lower healthcare costs and improve health insurance margins and drive membership growth.
CVS guided to aggressive run rate synergies of $1.5-$2bn by 2022, driven by technology modernization, and productivity improvements with an annual cost to achieve of $200-$300mn. These initiatives include the modernization and optimization of IT platforms, eliminating manual processes, and reducing and optimizing CVS’s internal spend for products and services.
Additionally, CVS guided to $850m of increased operating income in 2022 and $2.5bn over the long-term (no date specified) driven by $900mn of medical cost savings for the health insurance business by shifting care to lower cost sites, $600mn of increased revenue opportunities because of cross-selling, and $1bn from new business opportunities.
CVS realizes two clear benefits for integrating health insurance into its PBM/Pharmacy footprint. First, by vertically integrating Health Insurance/PBM, this allows for better cost control over drug spending. As a result, vertically integrated entities can save costs and drive synergies by shifting prescription volume from a physician office to retail clinic location where appropriate. A combined medical and pharmacy benefit is more likely to allow the enterprise to have a more holistic view of the patient and send the patient to the most cost-efficient site of care.
Additionally, CVS can drive down healthcare costs leading to improved health insurance margins and membership growth, by driving consumers to lower cost sites of care such as MinuteClinics and Health Hubs. For example, CVS recently launched a health insurance produce called Aetna Connected Plan, where members pay $0 copay at local HealthHub and MinuteClinic locations, and includes other benefits such as standard formulary, the use of the CVS Health Coram infusion services, 1–2-day prescription delivery, and the use of virtual care. CVS expects to generate $350mn in incremental revenue in 2021 because of increased pharmacy penetration into the Health Care Benefits segment through increased cross-selling of medical and pharmacy plans.
CVS also launched integrated healthcare programs aimed at chronic conditions such as the Transform Diabetes Care program which combines local points of access to healthcare professionals at MinuteClinics and HealthHubs, remote biometric monitoring, and personalized guidance and resources, to help the 34 million Americans with Diabetes. Another program is aimed at kidney care to address chronic kidney disease (CKD) and end-stage renal disease (ESRD), by focusing on early identification of kidney disease, engaging with patients, and education to slow disease progression. CVS notes that an estimated 37 million Americans live with CKD and 700,000 have ESRD.
However, CVS’s earnings and FCF have not yet increased because of the Aetna acquisition and its integrated healthcare strategy. Specifically, comparing CVS’s operating income in 2017 prior to the acquisition to CVS’s expected operating income in 2021, shows that the entire increase in CVS’s operating income ($5.3bn), is attributable to the acquisition of Aetna. Similarly, the acquisition of Aetna accounts for nearly all the increase in CVS’s FCF from 2017-2021. The legacy CVS business (Pharmacy Services and Retail/Long-term Care) failed to increase earnings or FCF over that time frame despite CVS achieving $900mn in cost synergies.
Furthermore, it is not clear that CVS will achieve its $1.5-$2bn synergy target for 2022, and I’m highly skeptical of the $2.5bn of long-term additional operating income CVS guided to at its 2019 Investor Day presentation. I expect management to address these challenges and lay out additional financial guidance at its Investor Day presentation in December.
Additionally, while CVS’s plan to lower healthcare costs is a net benefit for Americans, a large portion of reduced healthcare costs won’t benefit CVS directly. Given that CVS insurers roughly 23mn Americans, most of the 100+mn Americans who utilize CVS’s services are not insured by CVS. For example, if a UNH insurance member receives care at a CVS HealthHub as opposed to at a hospital, UNH would realize most of the benefits of the reduced healthcare costs. And so far, CVS’s insurance segment has not yet realized higher margins due to lower healthcare costs.
I will caveat this by acknowledging that the Aetna acquisition closed in late 2018, and so it is likely too early to tell whether the integrated strategy will eventually lead to lower healthcare costs. Additionally, CVS’s financial results in 2020 and 2021 have been heavily impact by COVID-19 and as a result it is challenging to determine if CVS has improved margins in its insurance operations.
So far, the market agrees with my skepticism about CVS’s integrated healthcare offerings. CVS has significantly underperformed most of its peers and the S&P 500 since the Aetna acquisition was announced in late 2017. During that time frame, CVS generated a total return of 30% compared to 78% for the S&P 500, 100% for UNH, 73% for ANTM, and 65% for HUM. Only CI fared worse, generating a lackluster total return of 4.5%, and has also been ensnared in a large acquisition (Express Scripts).
Recent Management Changes
CVS has undergone recent management changes with Karen Lynch replacing long-time CEO Larry Merlo in early 2021, and Shawn Guertin appointed CFO in May of this year. Both executives have extensive healthcare backgrounds largely focused on the health insurance sector. Karen served as Aetna’s President from 2015-2021, held senior roles at Aetna from 2012-2015, served as President of Magellan Health Services, and held senior roles at Cigna Corporation. Shawn Guertin was previously CFO of Aetna from 2013-2019, and held senior finance roles at Coventry Health Care, a leading health plan acquired by Aetna in 2012, UnitedHealthcare, and The Travelers.
In terms of executive compensation for 2020, PSU’s are granted largely based on Adjusted EPS growth with modifiers based on CVS’s Leverage Ratio and CVS’s Total Return, and accounts for roughly 50% of total compensation. Stock Options account for an additional 20% of total compensation based on stock price appreciation. Ultimately, I would like to see a measure such as ROIC or ROE included given how much CVS’s ROIC declined following the Aetna acquisition. Additionally, FCF per share would be a preferred metric to Adjusted EPS which allows for greater management discretion.
Since the Aetna acquisition closed, CVS has focused on deleveraging and has paid down $17.6bn of debt from 1Q19-2Q21. Management expects to achieve its low 3x’s leverage (Debt/EBITDA) target in early 2022. At that point, CVS will turn share repurchases back on, and will likely raise its dividend which has not been increased since 2018. Additionally, as shown below, CVS is not contemplating major M&A although bolt-on M&A is likely.
As noted on its 2Q21 earnings call:
“My first use of that and my most preferred use of that capital all the time is to grow the business. And undoubtedly, there are capabilities that we will need over the next few years to sort of affect our strategy as efficiently as we can, and so M&A is a part of that. But I've also found that balanced deployment of capital tends to produce sort of the best long-term results, and so that is a combination of M&A, a dividend that moves up as EPS moves up, and share repurchase that's accretive to your EPS growth on sort of a steady basis.”
In terms of M&A, I don’t expect CVS to pursue any major acquisitions given how consolidated health insurance and PBM’s are in the U.S., with unlikely regulatory approval of any proposed deal. Two areas CVS may consider expanding into are provider groups and healthcare IT.
UNH has already proved that this model works, by operating large organization of provider groups, and the largest global healthcare IT business. CVS would need to make acquisitions to expand into provider groups but could build out a healthcare IT business organically using CVS’s existing patient data. Healthcare IT businesses generate stronger operating margins of 18-20% compared to 6-7% for CVS’s other businesses and provide another way to monetize the patient data CVS already has. CVS has not explicitly mentioned either growth avenue, but I wouldn’t be surprised to see this announced at CVS’s upcoming Investor Day later in 2021.
As shown below, CVS’s ROIC declined from 11% in 2015 to 8.5% in 2019, following the Aetna acquisition. I expect CVS’s ROIC to increase back towards 11% by 2025.
U.S. Healthcare reform
I wrote extensively about healthcare reform risks in my UNH write up, and so this section will be largely copied from that write up.
The key risk for CVS and the health insurance sector is an overhaul of the U.S. healthcare system leading to a single-payer system which minimizes the need for private health insurance. Healthcare costs as a percent of U.S. GDP continue to increase, and now make up roughly 18% of the economy, although the rate of increase has slowed sharply over the past few years. Furthermore, 9% of Americans remain uninsured and healthcare outcomes in the U.S. lag other developed countries.
However, it is important to note that medical care inflation has largely declined since the early 1990’s, and has outpaced overall CPI by about 1-2%/yr. over the past few years down from much a larger spread in the early 1990’s. To the extent health insurers/PBMs can continue to drive down healthcare costs through bundled services/capitation models that should ultimately lead to reduced political pressure to reform the sector.
Given President Biden’s modest proposed changes to the U.S. healthcare system, historic inertia around major changes to healthcare, declining healthcare inflation, American’s general satisfaction with the cost and quality of their healthcare, and the exorbitant cost of a single-payer system, I believe the risk of a significant overhaul of the U.S. healthcare system is vastly overstated.
Historically overhauling the U.S. healthcare system has been challenging given its many complexities, healthcare inertia and prohibitive costs. President Obama had initially campaigned on a single payer system, yet ultimately modified his stance to: "For us to transition completely from an employer-based system of private insurance to a single-payer system could be hugely disruptive, and my attitude has been that we should be able to find a way to create a uniquely American solution to this problem that controls costs but preserves the innovation that is introduced in part with a free-market system." President Obama was unable to enact a single payer system during his first term as President despite a Democratic majority in the House and Senate.
Furthermore, while President Biden’s healthcare proposals announced during his campaign involve increased government intervention and subsidies for individuals but would only marginally impact on CVS’s health insurance business. Specifically, Biden’s plans include increasing subsidies for marketplace plans, allowing individuals with employer-based coverage to be eligible for marketplace subsidies, increased support for Medicaid, and lowering the age of eligibility for Medicare age. As a result, I view a Medicare for All as highly unlikely over the next four years of Biden’s Presidency.
Additionally, the majority of Americans are satisfied with their existing coverage and are not interested in switching to a single payer system, for fear of losing access to their providers. Americans rate the U.S. healthcare system quite favorably in terms of both quality and cost. A majority of Americas are satisfied with the quality and coverage of the healthcare they receive.
Satisfaction is also quite high surprisingly, in regards to healthcare costs, which reached its highest level ever in 2020 per a recent Gallup poll.
Another impediment to a single payer system is the astronomical cost of such a program, which would financially strain Federal and State governments. For example, Bernie Sanders’ campaign estimated that Medicare for All would cost $30 to $40 trillion over 10 years. Other estimates showed the cost in the $32 to $34 trillion range, implying at least $3 trillion per year compared to the 2020 Federal budget of roughly $4.8 trillion.
Finally, it would take years to institute a major overhaul of the U.S. healthcare system. The Affordable Care Act (ACA) was signed into law in early 2010, but many provisions of the ACA such as the public health insurance exchanges, and rules for health insurance coverage, did not go into effect until 2014. As a result, even if a single payer system was voted into law in the 2025-2028 time frame, it is unlikely to be implemented prior to 2030. As such, CVS would have time to prepare for a transition, which I view as extremely unlikely based on the above mitigants I have described.
Continued decline in generic reimbursement rates and new competition
Specific to CVS are risks to its Retail and PBM businesses from a continued decline in generic reimbursement rates as well as increased competition from GDRX and AMZN. I already discussed the impact of a decline in generic reimbursement rates in my analysis of the Retail/Long-Term Care and Pharmacy Services segments above and believe these trends will continue.
In terms of increased competition in retail pharmacy from GDRX and AMZN, I believe these competitors won’t take any market share from CVS over the next few years but will take market share from the independent and smaller pharmacies which currently make up 40% of the retail pharmacy market. Barclays forecasts that GDRX’s market share will grow from 1.4% in 2020 to 3.1% in 2023, and AMZN’s market share will grow from 0.4% in 2020 to 2.1% in 2023. Barclays assumes a 34% CAGR for prescriptions for GDRX and 75% for AMZN.
Independent pharmacies are expected to experience a decline in market share from 40% to 35.6%, while CVS is expected to increase its market share from 25.5% to 26.3% in 2023. Given the wide range of services CVS offers, which includes prescription delivery, as well as its continued roll out of additional healthcare services, I do not expect CVS to lose any market share in the next few years. However, its clearly worth monitoring the performance of new competitors.
Despite my skepticism around CVS’s integrated healthcare strategy, I believe CVS represents an attractive investment opportunity, with driven by a 9.5% FCF yield and 3% annual FCF growth through 2025. As shown above I have forecasted mid-single digit revenue growth, and significant share repurchases starting in 2022, offset by some margin compression. There is additional upside here if CVS can actualize the benefits of its integrated healthcare offerings, leading to stronger EPS growth and likely multiple expansion as well. For example, if CVS’s forward FCF multiple increased to 13x in 2024 that would result in a 19% IRR over the next 3 years, and a 15x forward FCF multiple in 2024 would lead to a 25% IRR over that time frame. Overall, CVS represents an attractive opportunity as I believe the downside risks are minimal, my base case represents an attractive IRR, and there is meaningful upside beyond the base case.
This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions. You can follow Enlightened Capital on twitter here!