CVS Health Is In A Great Position To Excel

| About: CVS Health (CVS)

Summary

CVS Health’s current stock performance due to two events in 2016.

Neither event significantly affects CVS Health’s revenues.

CVS Health continues to be the market leader holding great value for investors.

Why has CVS Health's stock been down?

As we all know, the entire health care industry was hit hard last year, nearly 35% in the second half of the year, due to uncertainty surrounding health care reform and recent changes regarding pharmacy networks. CVS Health (CVS) was especially punished, given its 23.4% downturn during a 12-week period from late August to early November. I'd argue that the two main events that fueled the downward spiral of CVS' stock were:

  1. Walgreens (NASDAQ:WBA) announcing its deal with Prime Therapeutics
  2. CVS leaving the Tricare Network

Despite negative reactions to the news over anticipated health care reform, CVS has continued to outperform the market in their sales producing over 58% more in consolidated revenues over a three-year period than its closest competitor. Given CVS Health's expected growth following major acquisitions in 2015 and surpassing expectations in Q2 of 2017, I am here to say that CVS Health is being unnecessarily reprimanded by the market and should not be overlooked. In the following sections, I will support my claim by explaining why 2016's events will not significantly affect CVS' top or bottom lines and finally by giving an overview of what investors should expect from CVS in the coming quarters.

Walgreens deal with Prime Therapeutics

On August 29th, 2016, Walgreens announced a strategic alliance* with Prime Therapeutics, the 4th largest Pharmacy Benefit Manager (PBM) in the nation. This 10-year agreement includes two parts that first makes Walgreens the core retail network for Prime and secondly creates AllianceRx Walgreens Prime. This alliance now allows Walgreens to offer a combined specialty pharmacy and mail order services such as what CVS Health's PBM CVS Caremark has been offering since its acquisition in 2007. Will this merger significantly impact CVS Health's revenue from its subsidiary CVS Caremark? Chances are it will not. CVS Caremark services nearly 90 million PBM plan members through more than 2,000 healthcare plan sponsors while Prime Therapeutics services just 22 million members including those contracts with Blue Cross and Blue Shield health plans. Just in numbers, CVS Caremark is still a much larger PBM servicing a larger portion of the market in specialty pharmacy services and continuing to save drug costs for its clients. In fact, CVS Caremark is the number one specialty pharmacy in the nation and continues to outpace industry growth in specialty services. Despite Prime Therapeutics being owned by 14 Blue Cross and Blue Shield health plans, CVS Health holds a contract with the Blue Cross and Blue Shield Federal Employee Program (FEP) to provide specialty pharmacy services expected to generate revenues of $2.8 billion for CVS in 2017. Given that the contract ends at the end of 2017, CVS will continue to provide integrated PBM services and clinical care programs to the FEP's more than 5.4 million federal employees, retirees, and dependents under separate contracts through 2018. Meanwhile, Walgreens is simply playing catch up with CVS and will continue to do so.

CVS leaving Tricare Network

On September 30, 2016, Tricare, the health care program for uniformed service members and their families, announced through its PBM, Express Scripts, that it would be advising its members filling prescriptions at CVS stores to switch to Walgreens pharmacies or pay a full price for prescription drugs. A spokeswoman for Express Scripts stated:

We always seek ways to help clients, including the Department of Defense, lower drug costs while maintaining access to the pharmacy care their beneficiaries need and deserve. Our new agreement with Walgreens secures competitive rates while offering quality, convenient pharmacy choices nationwide.

Express Scripts is currently the number one PBM in the country and is rightfully threatened by CVS Caremark's success. Such competition may have been the leading factor that moved Express Scripts into allowing Walgreens back into its network following their fallout in 2011. Tricare currently serves 9.4 million members of active-duty and retired military personnel and their families. Although the loss is not a good look for CVS, it is not a materially catastrophic event that will affect revenues in a significant way.

Outlook for CVS

CVS made some great decisions in 2015 which are now materializing in terms of revenue growth. In 2015, CVS Health acquired Omnicare, the nation's leading provider of pharmacy services to long-term care (LTC) facilities. Omnicare distributes prescription drugs and offers pharmacy consultations to chronic care facilities for more than 100 million patients. CVS Health has invested the time and capital required to ensure the right technology and processes are in place in order to differentiate their offering for their clients and the residents at these LTC facilities. Management notes expectations of significant growth in the Omnicare business in 2018.

Additionally, CVS completed a deal with Target (NYSE:TGT) acquiring its nearly 1,700 pharmacies and 80 retail clinics now rebranded as MinuteClinic health care clinics. These MinuteClinic health clinics are staffed by nurse practitioners and physician assistants who diagnose and treat minor health conditions, perform health screenings, monitor chronic conditions and deliver vaccinations. With seven new locations in 2016 and growth in sales of 8% in Q2 2017, these convenient locations are contributing to the improvement of member health, lowering costs for clients, and boosting revenues for CVS Pharmacy.

Valuation

I used a Discounted Cash Flow (DCF) Model using Free Cash Flow to estimate the intrinsic value of CVS Health's stock price. Using a WACC of 6.12% and terminal growth rate of 3%, I estimated the intrinsic value of CVS to be $116.32. Given today's closing price of $80.07, this intrinsic value means the company has a projected upside of 45.3%. With conservative sales growth assumptions of 5.5% - 7.5%, I project CVS Health's net income to grow between 2.5% - 6.2% YoY through 2023.

What this means for investors

Given that health care spending and prescription drug spending are expected to grow 5.6% and 6.3% respectively from 2016 to 2025, CVS Health is in a great position to excel. The market has overlooked CVS Health's accomplishments and its expected growth due to the overshadowing of 2016's events. CVS Health is still the leader in drug stores, specialty pharmacy and long-term care to name a few. Despite the mistakes CVS Health made in 2016 by allowing its competitor to take over some existing contracts, CVS made many great decisions that set the company up for success in the long-term. The company's acquisition of Omnicare and Target Pharmacies, as well as its advancement in technological services such as CVS Pay and Mobile Prescription Pickup, largely play into the expected performance of the company.

*Note - This article has been corrected to reflect that Walgreens and Prime Therapeutics created a strategic alliance, not a merger as previously described. The contents of the alliance remain the same, including its creation of Alliance RX Walgreens Prime and Walgreens becoming the core retail network for Prime.

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.

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