CVS - The Virtuous Cycle

| About: CVS Health (CVS)

Summary

CVS achieves synergies through a strategically constructed collection of complementary healthcare businesses.

These businesses, coupled with scale advantages, create an increasing competitive advantage in a growing and economically resilient industry.

Management plans to leverage these advantages against the backdrop of an aging population and recently expanded access to insurance coverage.

To Your Health

CVS Health (NYSE:CVS) kicked its smoking habit, and along with it about $2 billion of revenue, when it decided to permanently remove cigarettes and tobacco products from its stores in 2014. Since then, it's also changed its name from CVS Caremark to CVS Health to reflect its new strategic direction as an integrated healthcare company with a large footprint in key areas of the industry.

For those unfamiliar with the company, it may be surprising that this operator of their local pharmacy retail store books more annual revenue than e-commerce juggernaut Amazon.com (NASDAQ:AMZN) and more than the combined total of tech giants Microsoft (NASDAQ:MSFT) and Cisco Systems (NASDAQ:CSCO). But it does, and that's due partly to its position as the nation's second-largest pharmacy benefit manager. Along with its PBM operations, CVS retail pharmacy stores, in-store health clinics, and recent strategic acquisitions place it in prime position to benefit from an aging population and recently expanded access to health insurance coverage that promise to bolster industry demand for the foreseeable future.

Past Performance

CVS stock traded at $37 five years ago, $59 three years ago. Today it commands $96 per share, generating 17% and 20% annualized stock price appreciation over the past three- and five-year periods before taking into account dividend payments that have been increased annually since 2004.

CVS Health operates more than 9,000 pharmacy retail stores after its recent acquisition of Target (NYSE:TGT) locations in 2015. Its geographic footprint extends to 49 states and it holds #1 or #2 market share in 93 of its 98 U.S. markets according to its 2015 10-K annual report. Its acquisition of Caremark in 2007 has helped it to achieve the second-largest market share in the PBM industry in the U.S.

PBM Operations

PBMs act as intermediaries between pharmaceutical manufacturers and retail pharmacies, benefit health plans, insurance companies, and end consumers. In their relationship with their clients (health plan sponsors and insurers), PBMs develop an approved list of drugs that will be covered under their clients' health benefits plans, negotiate manufacturer discounts and rebates, and administer claims made by members of insurance plans. PBMs are third-party administrators for health plans, ensuring that claims comply with plan specifications, distributing medications to plan members through mail-order pharmacies, and collecting administration fees from clients. In relationship to retail pharmacies, PBMs establish contracts with the pharmacies, negotiate drug price discounts with manufacturers, and dispense drugs to generate revenue.

The Virtuous Cycle

With a store base approaching 10,000 and leading market share in numerous U.S. markets, CVS is no longer a unit growth story. Instead, the key for the company is to leverage its already large scale into more efficient and profitable operations. PBMs are a key cog in the pharmaceutical industry, and pharmacies and insurers rely on them to negotiate favorable prices to contain the ever-increasing costs of healthcare. Drug manufacturers are willing to make price concessions to PBMs if they can offset the lower revenue per item through higher volume.

PBMs can only achieve favorable discounts and rebates if they have a robust network of client companies and pharmacies to which they can dispense a high volume of drugs. CVS boasts a network of 68,000 retail pharmacies according to its 2015 10-K annual report. This network, along with its PBM clients, enables the company to process approximately 1 billion prescriptions annually. This scale provides the company with significant purchasing power to drive rebates and discounts from manufacturers to ensure favorable pricing for its clients. The company's 97% retention rate announced during its Q1 2016 earnings report indicates that the PBM business continues to show remarkable strength.

The combination of a major retail pharmacy operator and PBM also create natural synergies within the business. The addition of CVS' ~10,000 pharmacies to its PBM's network helps boost CVS' scale and negotiating power with manufacturers. As a combined business, CVS Caremark can authorize client members to pick up orders at CVS Pharmacy stores, rather than just through its mail order pharmacy. This helps improve foot traffic in the retail stores and encourage purchases of higher-margin retail goods.

While the PBM area makes up one core area of the business, there's more to the story. CVS is opening a new avenue for growth through introduction of its MinuteClinic. MinuteClinics are staffed with nurse practitioners and physician assistants capable of diagnosing and treating minor health concerns, administering vaccinations, performing screenings, and monitoring chronic conditions. The concept offers a quality alternative to the high costs and long waits required at more traditional health care providers. MinuteClinics number just 1,135 at year-end 2015, meaning that building out clinics inside a larger portion of its store base is far from complete. The addition of MinuteClinics within its retail stores is another initiative to increase foot traffic and drive sales of higher margin retail products. In 2015, the company also acquired OmniCare, which provides pharmaceutical distribution and other services to long-term care facilities. The acquisition provides CVS further exposure to another important area of the healthcare industry.

Emerging trends favor the company's long-term prospects as well. First, forecasters predict that the population of individuals 65 years and older will increase from 14.5% in 2014 to 21.7% by 2040. Second, expanded insurance coverage to the previously uninsured under the Affordable Care Act likely will have a continued positive impact on CVS' healthcare offerings.

Taken together, CVS Health has achieved a virtuous cycle through a synergetic selection of complementary healthcare businesses that each build off the other's success. Superior past performance coupled with its scale advantages and opportunities to grow and further solidify its business against a backdrop of increasing demand from an aging population and the newly insured mean that CVS is carving out an increasing competitive advantage in a growing and economically resilient industry.

Risks

Two key risks for CVS include the potential loss of a major customer and subpar work culture. The prospect of a combined PBM following the Aetna-Humana merger would cause CVS to lose the prescription volume it currently has with Aetna. CVS is currently contracted with Aetna through 2019, which mitigates the near-term risk to some degree, but it's still a significant concern for investors. Secondly, CVS Health consistently receives low marks from its employees for work culture. Although it has been successful thus far in spite of this fact, the company would be stronger if it could reverse this situation.

Conclusion

CVS represents a high-quality company that could hold a place in a diversified portfolio. An investment in CVS stock provides an opportunity to gain exposure to important demographic trends via a market leading company with strong growth prospects, a strong historical track record, and a management team with an inclination to reward shareholders through stock buybacks and annual dividend increases. All are reasons which make owning CVS shares an attractive choice for long-term investors.

Disclosure: I am/we are long CVS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All investments involve risks. Investors are encouraged to do their own due diligence prior to making buy or sell decisions.