CVS - Earnings Implosion And Opaque Near-Term

The pharmaceutical supply chain cohort is simply unable to obtain firm footing in the backdrop consolidation within the sector, legislative backdrop, drug pricing pressures, rising insurance costs and a market that has lost patience with these stocks. All of these factors culminate into sub-par growth with a level of uncertainty as this sector continues to face headwinds from multiple directions. Many of the stocks that comprised this cohort presented compelling valuations in a very frothy market. CVS Health (CVS) was one stock that stood out as compelling value sitting, near multi-year lows in December of 2018. During the market rebound in January and February, CVS began to appreciate to new highs moving from $63 in mid-January to $70 in mid-February or an 11% move to the upside. Upon the release of its Q4 earnings, the narrative quickly changed as the transition to growth and Aneta integration is proving to be much slower than investors had anticipated, yielding an opaque situation near term for the stock. CVS has a healthy balance sheet and growing its dividend while seizing partnerships and acquisitions to propel growth into the future. It’s no secret that these companies have been faced with several headwinds that have negatively impacted the growth and the changing marketplace conditions have plagued these stocks. Regardless, until growth is restored and Aneta is fully integrated to yield a fully functional bumper-to-bumper healthcare colossus, the stock remains range bound. However, the long-term picture looks rewarding for value investors as growth initiatives and acquisitions bear fruit.

Market Challenges

The political backdrop has been a major headwind for the entire pharmaceutical supply chain (i.e., drug manufacturers, pharmaceutical wholesalers, and pharmacies/pharmacy benefit managers). Exacerbating the political climate, the drug pricing debate continues to rage on throughout political and social media circles weighing on the sector. This backdrop erodes pricing power and margins of drugs that ultimately move from drug manufacturers to patients with insurers and other middlemen playing roles in the supply chain web. In an effort to address these headwinds and restore growth, companies have made bold moves such as CVS acquiring Aetna (AET) to form one of the largest healthcare companies as well as acquiring Target’s (TGT) pharmacies prior to this acquisition. There’s been other consolidation in the marketplace with Cardinal Health (CAH) shelling out $6.1 billion to acquire Medtronic's Patient Care, Deep Vein Thrombosis and Nutritional Insufficiency business. Making bold acquisitions to restore growth may be the most viable means to heed competitive threats (i.e., Amazon with Pill Pack) and feed off headwinds. CVS will play an instrumental role in the future of healthcare and will have a growth platform in front of the company as healthcare spending continues to rise. Recently, it has been projected that healthcare spending will rise 5.5% per year over the next decade, reaching ~$6 trillion by 2027 per the Centers for Medicare and Medicaid Services. Prescription drug and hospital spending are projected to rise by 5.6% per year between 2018 and 2027.

CVS and Aetna Combination

To further boost long-term growth prospects, restore growth and fend off potential competition, CVS acquired Aetna. This creates the first through-in-through healthcare company, combining CVS's pharmacies and PBM platform with Aetna's insurance business. Collectively, the acquisition is valued at $78 billion, and the new CVS will combine its existing pharmacy benefits manager (PBM) and retail pharmacies with the second largest diversified healthcare company. This is a bold and hefty price tag to pay yet may be necessary to compete in the increasingly competitive healthcare space, changing marketplace conditions and political backdrop with drug pricing pressures. CVS is making a defensive yet necessary acquisition before it can go back on the offensive moving into the future.

The acquisition will provide CVS with more scale to negotiate for better prices for the prescription drugs it sells through its PBM business. For Aetna, the deal is a pivot after its attempted merger with Humana was blocked on antitrust grounds. The U.S. Department of Justice signed off on the deal in October contingent on Aetna divesting its private Medicare drug plans. Recently, California Department of Managed Health Care Director Shelley Rouillard approved CVS Health's acquisition of Aetna after agreeing not to increase premiums as a result of the deal and agreeing to invest nearly $240M in the state's healthcare delivery system.

Amazon Threat?

CVS is transitioning and realigning its business to adapt to the changing healthcare landscape such as Amazon’s nascent competitive threat. The PillPack acquisition was the biggest statement yet from Amazon that it intends to enter into this market. However, CVS offers one- and two-day delivery to all of its retail pharmacy customers nationwide and extended its same-day delivery to more cities. CVS already offers similar services and issued a statement.

“We already have the capabilities that PillPack is offering, and we have a scale in the business. Keep in mind, that we have not seen a large shift of patient that are looking for their medications to be delivered versus coming to a retail pharmacy. And for those patients that do desire to transition, we offer the option to ship their prescriptions to their home from our pharmacies or obtain the prescriptions through our Caremark mail facilities.” Taken together, CVS’s acquisition has been issued the green light by federal and California state regulators, and the company is evolving and adapting its business to remain competitive now and into the future.

CVS Q4 Earnings

CVS recently announced earnings that were widely viewed as disappointing, tanking the stock from $70 to $58 in a matter of days post-earnings. CVS beat on EPS but missed on revenue in Q4, coming in at $2.14 and $54.4 billion, respectively. Revenue growth came in at 12.5% year-over-year and was broken out into Services, coming in at $34,890 million (+2.2%) and a strong Retail/LTC segment of $22,029 million (+5.4%) while non-GAAP net income came in at $2,415 million (+23.9%). CVS provided soft 2019 guidance on the earnings announcement which sent shares tumbling as these numbers were at odds with the street’s estimates.

“We achieved strong performance in the fourth quarter, and full-year 2018. And importantly with the completion of our merger with Aetna, we have positioned CVS Health to excel in a market that is undergoing profound and rapid transformation.”

“In recent years, it has become increasingly evident that the path to long-term growth and value creation lies in the establishment of new integrated health care models that provide consumers better care convenience at a lower cost. And since closing the Aetna merger, we are increasingly confident in the synergistic potential of this powerful combination to build and deliver shareholder value.”
Larry Merlo – CEO, CVS Health

With the upcoming enterprise synergies via the Aetna combination, the newly formed CVS will be able to unlock value and growth long-term. This value creation will come through medical cost savings, membership expansion, customer retention, expanded customer value and partnerships (Figure 1). In terms of capital allocation, CVS has been and continues to be shareholder friendly with increasing dividends and expanding share buyback program. Although CVS will dilute the share base and take on debt to fund the Aetna acquisition, over time the share buybacks and value creation via the combined entity will outweigh this temporary share dilution overhang.

Figure 1 – CVS enterprise value creation and growth avenues

Irrelevant Valuation and P/E

CVS had broken out from its all-time lows prior to issuing soft guidance during its Q4 earnings announcement. Despite this double-digit gain in a relatively short period of time heading into Q4 earnings, we can how fast these gains can be erased when guidance misaligns with Wall Street expectations. The P/E ratio still indicates that this stock is undervalued and in combination with a strong balance sheet and growing dividend it would seem like a great long-term buy. Despite this solid backdrop, these metrics are irrelevant until the company can get a handle on the long-term growth picture. Healthcare spending is slated to grow, and with further consolidation with Aetna which leads to cost efficiencies, pricing power, scale, and overall enterprise growth, CVS should be able to unlock value and growth. Until CVS can set the narrative and prove that the company can adapt more quickly to the changing healthcare dynamics, the stock will likely trade range bound, absent of any unforeseen catalyst.

Summary

CVS recently announced earnings that were widely viewed as disappointing as a result of its weak guidance, tanking the stock by 17%. CVS is making a necessary yet defensive move with the acquisition of Aetna to grow its business long-term while expanding its moat to fend off competition. This combined entity will result in medical cost savings, membership expansion, customer retention, expanded customer value, and partnerships to drive growth and value creation. Enterprise synergies over time should unlock bottom line cost efficiencies to augment the aforementioned benefits. Despite this, the benefits of the Aneta integration is proving to be much slower than investors had anticipated, yielding an opaque situation near term for the stock as evidenced by its guidance.

CVS possesses a great balance sheet, growing its dividend, continuing its share buyback program and still posting growth. As healthcare costs and prescription drug costs continue to rise and the population ages with the elderly comprising a larger segment of the overall population CVS is well positioned. Collectively, CVS represents value and long-term growth with a great dividend for value investors with a long-term time horizon despite the opaqueness as of late.

Noah Kiedrowski
INO.com Contributor

Disclosure: The author does currently hold shares of any of the companies mentioned in the article however may engage in options trading with any of the underlying securities discussed in this article. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of stockoptionsdad.com a venue created to share investing ideas and strategies with an emphasis on options trading.