CVS’s (NYSE:CVS) share price tanked last week, after it was announced that the health insurer Blue Shield of California is set to drop the healthcare giant’s Pharmacy Benefit Manager (“PBM”), Caremark, after a 15-year association, and team up with Amazon (AMZN), Mark Cuban’s Cost Plus Drug Company, and three other companies instead.
Even if CVS was quick to communicate with shareholders, and state that the loss would not impact revenue guidance, shared when Q2 2023 earnings were announced in early August, and that the long term impact on the company’s revenues would be “immaterial”, it is another significant blow for the PBM division, after Centene (CNC) announced it would be taking its $35bn business elsewhere in November last year.
These feel like strange times for CVS, a business built on its “Consumer Value Stores” (selling health and beauty products) empire, which had grown in size to very nearly 10k stores by the end of 2021, but which has also taken in the $24bn acquisition of Caremark in 2007, giving the company a significant share of the murky PBM drug pricing market, and the $78bn acquisition of health insurance giant Aetna in 2018.
Nobody could accuse CVS of lacking ambition, but the reality for shareholders has been bleak. CVS stock has only traded consistently >$100 per share twice in its lifetime, once in 2015, and again in January 2022, but the vertigo proved too much on both occasions. By 2019, shares had fallen in value to ~$55 per share, and after the COVID-related surge in value that nearly lasted into 2023, the stock price is now tanking again, reaching a low of $66, its lowest price since October 2021.
CVS is busy trying to reinvent itself under its new leader, Karen Lynch – formerly President of Aetna – who was appointed in February 2021, replacing Larry Menlo, a 40-year CVS veteran who led CVS for more than decade. In a press release in December 2021, Lynch commented:
“Now is the time to undertake our next major evolution and capitalize on our role as the leading health solutions company in America. By leaning into our high-growth foundational businesses and expanding our reach in areas like health services and primary care, we have an opportunity to shift care to be more centered around the consumer while capturing a meaningfully greater portion of health care spend.
Ultimately, this plan is only possible with our unique combination of assets which will allow us to lower costs, increase access to quality care and improve health outcomes for consumers, patients and members – while delivering superior results for shareholders.”
Although CVS’ business is still rooted in its Brick and Mortar stores, it’s clear that Lynch is plotting a different path to growth, and in fairness, this may be the right strategy, as for all Menlo’s expertise and good stewardship, the former CEO failed to get the share price moving.
Under Lynch, inevitably the pendulum is likely to swing away from its 9k retail locations, and >1k walk-in-clinics, and towards concepts such as holistic healthcare, value based care, online services, and Medicare Advantage Healthcare plans. As per a statement in the company’s 2022 annual report:
The Company seeks to reimagine the consumer healthcare experience to make it easier and more affordable to live a healthier life. This means delivering solutions that are more personalized, simpler to use, and increasingly digital so that consumers can receive care when, where and how they desire.
CVS Health is also shifting from transaction-based care to addressing holistic health – physical, emotional, social, economic – which will lead to higher quality care and lower medical costs. The Company is a leader in key segments of health care through its foundational businesses and is seeking to create new sources of value by expanding into next generation care delivery and health services, with a goal of improving satisfaction levels for both providers and consumers. The Company believes its consumer-centric strategy will drive sustainable long-term growth and deliver value for all stakeholders.
Inevitably, under new leadership and attempting to reimagine not only how the company operates, but how the entire healthcare system works, there are going to be teething problems and setbacks, but now there is no going back, particularly after new CEO Lynch authorised the buyout’s of both Oak Street Health and Signify Health, providers of primary care and home based care respectively, for a combined $20bn late last year.
I have shared my thoughts on these deals, and tried to paint a picture of what CVS might look like in five years, in previous notes on CVS for Seeking Alpha in March and June, but after the events of the past few weeks this feels like a good time to update on the company, and whether the new direction CVS is heading in will be good news for shareholders, or bad.
CVS Health – Q2 2023 Earnings Review
On the face of it, CVS delivered an upbeat set of earnings that beat analysts’ estimates on non-GAAP earnings per share (“EPS”), and revenues – by $0.09, and a healthy $2.4bn, respectively. Lurking behind these headline figures however are some troubling issues that may take years to resolve, and for which arguably CVS does not yet have a concrete resolution.
Total revenues were $88.9bn – up 10.3% year-on-year, but GAAP earnings per share (“EPS”) fell over 35% year-on-year, to $1.48 per share, and non-GAAP adjusted EPS fell 13%, to $2.21 per share. On a more positive note, cash flow from operations rose 9% to $5.9bn – for a company undergoing significant change, CVS will likely need all the cash it can get its hands on.
It is a similar story when it comes to FY23 guidance. The company upgraded its total revenue expectations for the year to $350.5bn – $356.3bn – a less than 1% uplift at the midpoint from the guidance provided in Q1 2023 – but downgraded GAAP EPS from $6.90-$7.12, to $6.53-$6.75, keeping non-GAAP EPS the same at $8.50-$8.70. Expected cash flow from operations also remained at $12.5bn-$13.5bn.
Looking further ahead to 2024, the news gets worse, as CVS’ Chief Financial Officer Shawn Guertin told analysts on the Q2 2023 earnings call that:
Given the emergence of multiple potential headwinds across our diverse set of assets, including uncertainty in Medicare Advantage, the potential for a weakening consumer environment and reduced retail contributions from COVID, combined with our plans to accelerate Oak Street clinic growth, our 2024 adjusted EPS target of $9 is no longer a reasonable starting point for our guidance range.
Given the more challenging outlook for 2024 and our desire to set guidance that is achievable with opportunities to outperform, we now believe investors should anchor their initial expectations for our 2024 adjusted EPS to $8.50 to $8.70, essentially flat to our existing 2023 guidance range.
The fact that CVS will be no more profitable in 2024 than it was in 2023 – which in turn is expected to be less profitable than 2022 – means shareholders looking for near term share price growth are likely to be disappointed. In fairness, that will be nothing new for long term holders of CVS stock, and there is a reasonably generous dividend of $2.42 per annum to fall back on, which currently yields 3.64%.
Escalating Business Transformation and Medicare Costs Create Longer Term Issues For CVS To Solve
CVS admits that it had not expected Medicare Advantage costs to rise as much as they did in Q2 2023. CEO Lynch told analysts on the earnings call that these additional costs “became apparent in the latter part of the quarter”, and were due to “greater than expected utilization in outpatient settings”.
One inference that can be drawn from these statements is that Medicare Advantage is a great business for CVS to be in, so long as members do not take “Advantage” of the services provided by this popular alternative to traditional medicare!
Clearly it will take some time – and some expense – before Signify Health and Oak Street Health are fully integrated into the CVS business model, although as I have noted in previous posts, these two companies made heavy losses before they were bought out – of $(780m) and $(500m) respectively in 2022, so the value proposition here remains unclear.
CVS has previously said it believes Oak Street can drive $2bn in embedded adjusted EBITDA by 2026, and unlock $500m in synergies. Oak Street provides primary care to Medicare Advantage members – of which CVS has ~3.4m – a figure that is expected to grow by 12% before the end of this year – making it a good fit for the business, that may help to reduce costs of administering care locally. Signify health provides home based care, another valuable way of administering “value based” (as opposed to fee-for-service) care, that ought to reduce costs, as well as being beneficial to members.
Another potential advantage is that the two companies can help CVS increase the star ratings of its plans – higher rated plans receive additional bonus payments from the Centers for Medicaid and Medicare (“CMS”) – by providing better standards of care – CVS low plan ratings will result in an estimated $1bn hit to revenues in 2024, the company believes.
The current reality however is that Oak Street Health and Signify Health are likely significant contributors to the company’s rising costs, although CFO Guertin had some positive updates to share on the earnings call:
Signify completed 673,000 in-home evaluations in the quarter, an increase of 16% versus the same period last year, and generated revenue growth of 19%. Oak Street ended the quarter with 177 centers and 181,000 at-risk lives, increases over the same period last year of approximately 23% and 35% respectively. Oak Street also significantly increased revenue in the quarter, growing 43% compared to the same quarter last year.
Perhaps tellingly, however, Guertin chose not to discuss how profitable these business were in Q2 2023 – my guess would be they continue to be heavily loss making, creating more short-term headwinds for CVS to deal with.
Looking Ahead – Will Shareholders See A Benefit From The Business Transformation?
In my June note on CVS I quoted from the company’s 2022 annual report, which discussed CVS’ debt, recently downgraded by Moody’s from “positive”, to “stable”, noting that:
Although the Company currently believes its long-term debt ratings will remain investment grade, it cannot guarantee the future actions of Moody’s and/or S&P. The Company’s debt ratings have a direct impact on its future borrowing costs, access to capital markets and new store operating lease costs.
Were CVS to lose its investment grade credit debt rating it would spell serious trouble for the company and its new management – which may be behind CVS’ decision to let go of as many as 5k staff – admittedly a drop in the ocean, given the company has 300k employees.
CVS is closing stores also, having announced in 2021 that it intended to close 900 stores in three years. The Pharmacy business was certainly not immune to cost pressures in Q2 2023 – apparently, despite revenues growing to $28.8 billion, an increase of nearly 8% versus the prior year, operating income fell 17% year-on-year, to $1.4bn.
Although the business may generate record revenues in 2023, it is also possible to identify flaws in all three of CVS core businesses. Brick and mortar stores are being closed, the PBM business has lost two major clients in the past eight months, and Medicare Advantage costs are higher than expected, damaging the health insurance business.
Although it would be tempting to argue that CVS shareholders have nothing to lose, given the company has been mostly stagnant for a decade or more, the corollary to that thesis is that CVS shareholders have potentially 50% of their initial investment to lose if CVS’ gamble on holistic, value based care does not work out. The share price could fall below $50 in my view, if by the end of 2023 the company is unable to show its plan is working.
With all that said, even though I have been skeptical about CVS in the past, giving the company bearish ratings, when almost no other commentators were prepared to do so, and ultimately being proven right, my current sense is that, given enough time, management can make this business model work.
The ballast of having 9k physical stores that have generated profits for CVS for more than 50 years can support the push into new ways of administering healthcare, and eventually, buzzwords such as value based care, holistic healthcare and dealing with “customers”, rather than “patients” will become more concrete business pillars.
In my view, CVS categorically does not need to invest any more funds in M&A – management now needs to focus on creating synergies, and making sure the incredible momentum and profitability generated by Medicare Advantage is sustained.
I would stop short of stating that CVS’ valuation – which implies an unusually low price to sales ratio of 0.2x (a more usual figure might be 3-5x), and a low forward price to earnings ratio of ~9x – is set to grow, but I’d be relatively confident CVS can overcome its cost issues and achieve the necessary synergies to make a success out of its new business model.
In 5 years, given the challenges that lie ahead, I would therefore be tempted to speculate that CVS may well trade at the same price that it does today.
Meet the new boss. Same as the old boss.