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Investment Overview for CVS Health (NYSE:CVS)

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1. Coronavirus Crisis Impact On CVS Health

The current coronavirus crisis has thus far not impacted health insurance companies or retail pharmacies in any significant way. While there are concerns over supply chain disruptions, the retail stores have seen strong demand, as many people stocked up on consumer healthcare products before lockdowns seen across various cities.

CVS' stock has declined around 7% since early February (through May 8), after the WHO declared a global health emergency. This compares with roughly a 9% decline in the S&P 500 over the same period. CVS Health’s near term performance will be impacted due to its insurance business. CVS Health is waiving cost-sharing for certain Aetna members, who are hospitalized for COVID-19 treatment. This will result in higher Medical Costs expense item.

2. Q1 2020 Earnings

CVS posted revenues of $66.8 billion, up by 8.3% y-o-y. The revenue increase was  primarily driven by higher demand due to COVID-19. The earnings of $1.91 per share on an adjusted basis was 18% higher y-o-y. The company held on to its guidance of $7.04 to $7.17 for the full year 2020.

3. Aetna Acquisition

The Company acquired 100% of the outstanding shares and voting interests of Aetna for a combination of cash and stock. Under the terms of the merger agreement, Aetna shareholders received $145 in cash and 0.8378 CVS Health shares for each Aetna share. The transaction valued Aetna at approximately $212 per share or approximately $70 billion. Including the assumption of Aetna’s debt, the total value of the transaction was approximately $78 billion. The Company financed the cash portion of the purchase price through a combination of cash on hand and by issuing approximately $45 billion of new debt, including senior notes and term loans. Aetna is a health care benefits company that offers a traditional, voluntary, and consumer directed health insurance products and related services. The acquisition of Aetna should improve the consumer health care experience for the company as they will combine Aetna’s health care benefits products and services with CVS Health’s more than 9,900 retail locations, approximately 1,100 walk-in medical clinics and integrated pharmacy capabilities.

4. CVS and its Several Partnerships that Improve Its Performance 

The company has undertaken certain steps to ensure a better growth trajectory in the future. It is focusing on partnering with all payers to boost volumes and capture market share. For example, its partnership with Optum to provide 90-day retail solutions to the latter's ASO clients was launched in July.  A partnership with Cigna Health Works has been announced in June. It has also partnered with Express Scripts' Diabetes Care Value program to be their retail network option. The company is in talks with many such PBM health plans to expand the reach of its network.

CVS Health made another big deal that might help grow its business significantly. Completed in November, the $70 billion acquisition of Aetna by CVS is likely to provide a major boost to CVS's business. CVS and Aetna last month received conditional approval from the Department of Justice on their merger. The combination is expected to provide consumers with a more integrated experience, reduced costs, and improved access to health care experts in homes. This will combine CVS's dense local presence through pharmacies and clinics, with Aetna's health care benefits and services.

CVS's PBM business will get a shot in the arm due to greater negotiating power with the drug companies. The company will also be able to tap into Aetna’s 45 million user base and provide them with its offerings, which include pharmacy benefit management – the negotiation of  drug prices on the behalf of insurance companies - MinuteClinics, home infusion services, and long-term care pharmacies.

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Prescription Drugs

Prescription Drugs EBITDA Margin: We currently forecast CVS Health's EBITDA margin for prescription drugs to increase marginally, from 13.9% at present to approx. 14.9%, over our review period. There could be a 5% upside to the Trefis price estimate if margins improve to 20% by the end of our forecast period.

Pharmacy Benefit Management

PBM EBITDA Margin: We currently forecast EBITDA margins for pharmacy services to remain close to 8% over our review period. There could be a an upside of over 25% to the Trefis price estimate if margins were to increase back to the historical highs of over 11% over our review period. On the other hand, there will be a similar downside if margins come under pressure due to the acquisition of new contracts and other contract renewals.

Capital Expenditure: We currently forecast capital expenditures as a percentage of EBITDA to remain under 20% over our forecast period. There could be an approximate 15% downside to the Trefis price estimate if this figure were to rise to the 2000-09 level of close to 25%, by the end of our forecast period. 

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CVS Health (NYSE: CVS) is the largest pharmacy services provider in the US comprising of the largest network of retail pharmacy stores nationwide along with pharmacy services such as mail-order pharmacy services, prescription plan management and claims processing. CVS fills and manages over 1 billion prescriptions per year through its businesses.

Currently, CVS operates over 9700 Pharmacy stores. The retail business provides health care services through more than 1,100 retail health clinics and MinuteClinics, which are mostly located inside CVS pharmacies and serve to diagnose and treat minor health issues. The retail pharmacy business also includes an online pharmacy, CVS.com. 

CVS retail stores sell prescription drugs and a wide assortment of general merchandise, including over-the-counter (OTC) drugs, beauty products, cosmetics, photo finishing, seasonal merchandise, greeting cards and convenience foods.

In March 2007, CVS merged with Caremark Rx, which brought together the nation’s largest retail pharmacy chain and a leading pharmacy benefit manager. CVS Health's Pharmacy Services business provides a full range of pharmacy benefit management (PBM) services including mail order pharmacy services, specialty pharmacy services, plan design and administration, as well as formulary management and claims processing services. The company's customers are primarily employers, insurance companies, unions, government employee groups, managed care organizations and other sponsors of health benefit plans and individuals throughout the US.

In 2016, the company lost contracts with the Department of Defense and Prime Therapeutics to its rival Walgreens. The new deals came into effect in December 1, 2016 and January 1, 2017, respectively, and slowed down CVS' performance in 2017. The company took several measures to counter the loss of contracts including the expansion of its ongoing partnership with Optum and the offer of bundled service offerings to its customers. It plans to improve its productivity by focusing on store rationalization and optimizing its delivery platform. These measures are expected to bring savings to the tune of $3 billion by the end of 2021.

The company has undertaken certain steps to ensure a better growth trajectory in the future. It is focusing on partnering with all payers to boost volumes and capture market share. For example, its partnership with Optum to provide 90-day retail solutions to the latter's ASO clients was launched in July.  A partnership with Cigna Health Works has been announced in June. It has also partnered with Express Scripts' Diabetes Care Value program to be their retail network option. The company is in talks with many such PBM health plans to expand the reach of its network.

Completed in November 2018, the $70 billion acquisition of Aetna by CVS is likely to provide a major boost to CVS's business. CVS and Aetna last month received conditional approval from the Department of Justice on their merger. The combination is expected to provide consumers with a more integrated experience, reduced costs, and improved access to health care experts in homes. This will combine CVS's dense local presence through pharmacies and clinics, with Aetna's health care benefits and services.

In August 2015, CVS acquired Omnicare broadened the base of pharmacy care to a new dispensing channel, long-term care pharmacy. Omnicare's long-term care (“LTC”) operations include the distribution of pharmaceuticals, related pharmacy consulting and other ancillary services to chronic care facilities and other care settings. Omnicare also provides commercialization services under the name RxCrossroads.

In December 2015, CVS acquired Target Pharmacies, for approximately $1.9 billion. CVS acquired Target’s 1,672 pharmacies which operate in 47 states and will operate them through a store-within-a-store format, branded as CVS Pharmacy. The Company also acquired 79 Target clinic locations which will be re-branded as MinuteClinic. The Company acquired the Target pharmacy and clinic businesses primarily to expand the geographic reach of its retail pharmacy business.

As a pharmacy benefits manager, CVS Health manages the dispensing of pharmaceuticals through its 5 fully automated mail order pharmacies and national network of approximately 68,000 retail pharmacies (which include its own CVS/pharmacy and Longs Drugs® stores) to eligible members in the benefit plans maintained by its clients. It utilizes proprietary information systems to perform safety checks, drug interaction screenings and brand to generic substitutions. 

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Prescription drug sales is a major source of value for CVS Health, accounting for 45% of its total value

Accessibility of stores and convenient shopping experience make CVS an attractive destination for consumers.

CVS has a large network of strategically located retail drugstores across the US. It has around 9,681 pharmacy locations and around 75% of the U.S. population lives within a three mile radius of a CVS store, lower than any of the other drugstore chains in the U.S. (Walgreen claims to have 75% population within five mile radius). This makes CVS stores more accessible to a larger number of consumers than other pharmacies.

CVS employs over 34,000 pharmacists, nurse practitioners and physician assistants (more than Walgreen's number of 17,000) who are responsible for interfacing with patients, advising customers and providing them more personalized attention as compared to other retail pharmacy chains.

CVS has about 1,135 in-store MinuteClinics across 28 states, making it easy to get treatment for common ailments, receiving vaccinations or obtaining health screenings. More than 70% of CVS stores are either open round-the-clock or offer extended hours, and over 60% have drive-thru windows, offering greater convenience to customers.

Pharmacy Benefit Management is a major source of value for CVS Haelth, accounting for almost 40% of its total value

CVS's business strategy centers on providing innovative pharmaceutical solutions and quality client service in order to enhance clinical outcomes for its clients’ health benefit plan members, while assisting its clients and their plan members in better managing overall health care costs. In addition, as a fully integrated pharmacy services company, CVS Health is able to offer its clients and their plan members a variety of programs and plan designs that benefit from its integrated information systems and the ability of its more than 34,000 pharmacists, nurse practitioners and physician assistants to interact personally with the plan members.

Currently, CVS operates 11 specialty mail order pharmacies and a network of 24 retail specialty pharmacy stores, which operate under the CarePlus CVS/pharmacy name in the U.S. The company also maintains a national network of approximately 68,000 retail pharmacies, including CVS/pharmacy stores.

CVS Health's clients are primarily sponsors of health benefit plans (employers, insurance companies, unions, government employee groups and MCOs) and individuals located throughout the U.S. ${header:trends}

Increasing demand and utilization of prescription drugs in the U.S. 

An aging population combined with the fact that older people contribute to a larger proportion of expenditures on drugs will lead to an increase in the prescription drugs market size. An observation from CVS Health's 2009 annual report supports our view:

"Looking at demographics, the number of people in the United States who are 65 or older was roughly 48 million in 2015 and is expected to grow to 55 million by 2020. This age group fills an average of more than 25 prescriptions per person annually – 30% more than people between the ages of 55 and 64. That will increase utilization dramatically for years to come and will help drive the growth of both our PBM and retail businesses." 

The 2010 US health reform legislation is expected to increase prescription drug sales

Approximately 30 million uninsured Americans will gain coverage under the reform legislation and the US government will increase outlay on prescription drugs driven by an expansion of Medicaid and Medicare Part D plans. This will help drive prescription sales going forward.

Accelerating sales of generic drugs and private label goods to positively impact gross profit margins of retail stores. 

Generic drugs offer approximately 50% higher gross margins compared to branded drugs. The total generic dispensing rate, which factors the percentage of generic drugs in a consumer’s prescription, grew to around 85% in 2016 compared to 82% in 2014 and 81% in 2013, respectively. Generic drugs continue to replace branded drugs, albeit at a slower pace. With the expansion of generic drug sales in the U.S. (even if the pace is expected to slow down), each script will bring an incremental $5-7 in profits, allowing up to 10% growth in EBIT margins.

Private labels have grown increasingly popular among US consumers as they offer the same quality as established brands and are priced lower. This offers customers value while providing CVS with significantly higher margins.

Turnaround of the PBM segment

CVS has been aggressively trying to grow its Pharmacy Benefits Management (PBM) business after suffering from some major setbacks in 2009-2010. It has witnessed a dramatic turnaround by winning high profile contracts from CalPERS, Medco Health and Aetna in the last few years.

In July 2010, CVS concluded a $9 billion 12-year agreement to provide health insurance carrier Aetna with a broad range of PBM services. In May 2011, CVS won a 3-year contract worth $3 billion to provide integrated pharmacy services for the Blue Cross and Blue Shield Government Service Benefit Plan or Federal Employee Program (FEP). Contracts with Aetna and FEP have helped arrest the decline in the number of pharmacy claims and provided a much needed upside to CVS Health's pharmacy benefit management business. As a result, the Pharmacy Services revenues have been growing in double digits. Pharmacy benefit management currently contributes over 40% to the company's intrinsic value.

How Does Trefis Modelling Work?

How do we get the historical numbers for this chart?

Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.

Who came up with the Trefis forecast for future years?

The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.

How does my dragging the trendline on the chart impact the stock price?

1. We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.
2. We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.

See more on: DCF Methodology

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