Three Factors Which Will Increase Our Valuation For CVS By 30%
Unlike its major competitors, CVS Health (NYSE:CVS) today is largely the same organization as it was a couple of quarters ago. Meanwhile, its peers in the pharmacy retail industry, Walgreens (NASDAQ: WBA) and Rite Aid (NYSE: RAD), have grown much larger in their own ways. Walgreens acquired a 55% stake in Alliance Boots (it already owned the remaining 45%) to become a global pharmacy-led healthcare enterprise, and Rite Aid entered the pharmacy benefits management (PBM) market with the acquisition of EnvisionRx. Even stock prices of these companies have shown a similar pattern so far in 2015 (as of April 30th). While Walgreens and Rite Aid have appreciated by 16% and 9%, respectively, CVS has stayed relatively flat with an increase of just 3%. The PBM market, where CVS earns most of its revenues, has seen some consolidation and is now controlled by fewer (and more powerful) players than before. Both pharmacy and PBM divisions hold importance for CVS Health, as ~60% of its revenues come from PBM and ~50% of its EBITDA comes from pharmacy retail.
In this article, we will analyze how these industry-level changes will impact CVS Health and their implications on the company’s stock price. Note that the potential upside/ downside is indicated in parentheses beside each factor. Our price estimate of $81 for CVS Health is approximately 20% below the current market price.
View our detailed analysis for CVS Health
New And More Expensive Specialty Therapies Can Increase Revenue Per Prescription (+10%)
Specialty drugs treat complex diseases such as multiple sclerosis, rheumatoid arthritis, hepatitis C and cancer, among others. As these drugs are characterized by high cost and high complexity, this holds a lot of growth potential for retailers with the necessary delivery and support systems. To make the most of this booming market, CVS came up with a specialty prescription services program in mid 2014, called Specialty Connect, which is available at all CVS pharmacy locations. [1]
Examples of these therapies include Sovaldi and Harvoni, which were launched in 2014. Sovaldi costs $84,000 for a 12-week course of treatment and the more recently launched Harvoni is even more expensive, listing for $94,500 for 12 weeks of treatment [2]. While the launch of more expensive therapies will drive up revenue per prescription for drug retailers, we believe that the launch of new generic drugs will offset this increase. Therefore, we forecast CVS’ revenue per prescription to remain fairly stable between $47 and $48 over our forecast period.
However, a scenario where prices of new specialty therapies hit new highs cannot be ruled out. In such a situation, low generic prices might not be enough to offset the higher prices of specialty therapies and could drive average drug prices upwards. A 10% increase in the revenue per prescription, i.e. from $48 to about $54, will lead to a similar upside in our current price estimate for CVS.
Payers Design New Formulary Tiers To Ease The Reimbursement Rate Pressure (+10%)
For some time now, both consumers and drug retailers have been plagued by soaring generic drug prices. Flat reimbursement rates meant that retailers received the same amount from payers for higher priced drugs, leading to significant losses for most drug retailers. While CVS is better placed to face these pressures than other drug retailers (due to its PBM arm), these factors still negatively affected the company’s bottom line.
It is necessary to treat each generic drug differently when it comes to reimbursement rates; i.e., all generics cannot be treated equally and reimbursement should be higher for higher priced drugs. To help address this issue, payers are working on creating a tiered pricing system for generic drugs that would require members to pick up more of the cost. While this pricing system is still in its formative stages, when put into effect, it could reduce drug acquisition costs for pharmacy retailers.
We currently expect CVS’ Prescription Drugs EBITDA margin to remain flat at the current level of 16.6% until the end of our forecast period. However, if the proposed new pricing system is brought into effect, it has the potential to push margins up. If margins go up by 2% over the next three fiscal years (FY’16 to FY’18), it will lead to a 10% increase in our valuation for CVS.
The PBM market has seen considerable consolidation in the last few years, with the number companies declining from around 100 in 2008 to just a single digit number. The three key players in the market; namely, CVS, Express Scripts (NASDAQ: ESRX) and UnitedHealth Group (NYSE:UNH), account for almost three-fourths of the market. The recent acquisition of Catamaran Corporation (NASDAQ:CTRX) by UnitedHealth Group (NYSE:UNH) further intensifies competition in the market. While Express Scripts manages about 1.4 billion prescriptions annually, CVS and UnitedHealth manage a billion each (UNH’s figure increased from 600 million pre-merger). An increase in scale for UnitedHealth means greater negotiating power with drug manufacturers and pharmacies and hence more competitive plans for consumers.
Therefore, we believe that it will be increasingly difficult for CVS to increase margins in its PBM business, and forecast CVS’ Pharmacy Services EBITDA margin to remain flat at 5.4% over our review period. However, if CVS is able to increase the number of claims processed, it could lead to higher negotiating power (relative to its peers) and hence better margins. Considering an increase of 1.5% in CVS’ PBM EBITDA margin by the end of our forecast period (from the current level of 5.4% to 6.9%), our valuation for the company will go up by 10%.
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- CVS Caremark Launches Innovative Specialty Connect Program at all CVS/pharmacy Locations, CVS Health Press Releases, May 28, 2014 [↩]
- Abbvie Expects $3B In Hepatitis C Drug Sales And 40% Of Insured Customers, Forbes, January 30, 2015 [↩]