Is CVS Changing The Healthcare Landscape?

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About: CVS Health Corporation (CVS)
by: Regan Teague
Summary

Concerns around latest guidance and Omnicare write down seem overblown.

Suspending share buybacks and dividend increases until balance sheet is back in order after Aetna purchase is causing short-term price pain but should drive longer-term appreciation.

My bullish investment thesis is still intact and cash flow generation remains strong despite recent debt accumulation for Aetna purchase.

The current stock price is trading at a steep discount to current fundamentals as well as future potential growth from the transforming business model.

Investment Thesis

CVS Health (CVS) is the largest U.S. pharmacy and recently became the largest pharmacy benefit manager (PBM) in the country, with more than 93 million members. On November 28, 2018, CVS also acquired health insurer Aetna. At the most recent J.P. Morgan Healthcare Conference, CEO Larry Merlo anticipated that the merger allows CVS the opportunity to create an integrated healthcare model to decrease healthcare costs and increase consumer satisfaction.

To visualize CVS’s future, it is important to understand its three divisions. The first is its retail storefronts, pharmacy and MinuteClinics we all probably see on a daily basis (Retail/LTC Segment). The second is the PBM business, which you might know as Caremark (Pharmacy Service Segment). The Healthcare Benefits segment is its third division. This arm includes the Aetna business along with its Medicare Part D business, SilverScript.

https://static.seekingalpha.com/uploads/sa_presentations/86/37086/slides/3.jpg?1546974697

Source: J.P. Morgan Healthcare Conference Slideshow

At the J.P. Morgan Healthcare Conference, Merlo noted three challenging, cost-increasing areas in the current healthcare system. “As we look at it first, we see the complexity that exists in the system, the lack of support for patients as they try to navigate to the most high quality and cost effective care settings,” he explained. “Second, we see a healthcare system that was designed for episodic care in a fee for service environment. And to date there has been little incentive to move to a more holistic care model. Third the system remains fragmented with care that often is uncoordinated between various healthcare stakeholders and all too often the patient has to be their quarterback for their own care. Now all of these factors lead to unnecessary, avoidable or wasteful spending.”

He believes that helping individual customers find the right programs and services to achieve their goals is the initial touchpoint needed. Seventy percent of Americans live within three miles of a CVS location, and one out of every three Americans engages with the company which puts them in a good position to be that initial touchpoint. Merlo believes that “by driving consumer engagement we can improve health outcomes, you improve health outcomes we can lower overall healthcare costs. And the end result is a better, more satisfying patient experience, a patient who is healthier and more confident in their action plan to achieve better health in a more efficient healthcare system with a lower cost trajectory.”

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Source: J.P. Morgan Healthcare Conference Slideshow

According to management, CVS’s purpose has always been to help people on their path to better health, and the Aetna acquisition will help with that goal. CVS’s five areas of focus to help increase the patient experience and drive down costs should be, according to Merlo, “improved care management for both common and chronic conditions, preventing hospital readmissions, site of care management, and optimizing primary care.”

https://static.seekingalpha.com/uploads/sa_presentations/86/37086/slides/17.jpg?1546974697

Source: J.P. Morgan Healthcare Conference Slideshow

The majority of chronic diseases (diabetes, cardiovascular diseases, severe asthma attacks) are highly preventable through healthcare coaching. While it doesn’t anticipate solving America’s obesity epidemic, CVS plans to mitigate this and other problems by providing outreach and counseling through its in-store wellness centers and healthcare concierge programs. Aetna members will be the initial focus, but the scope will potentially expand after CVS completes integration.

Another focus is reducing hospital readmissions by setting up a care plan and engaging members as they are discharged from the hospital. CVS believes that this can be achieved through its remaining concentrations, including integrating homecare when possible to avoid costly hospital visits. The company plans on extending care options, care services, and its in-store MinuteClinics. It also plans to educate its members on care options to reduce emergency room visits.

Overall, CVS is trying to build a more inclusive, transparent healthcare ecosystem - starting with current Aetna members and then expanding - that offers more knowledge and non-hospital solutions to the patient. This puts CVS in the vanguard of a much-needed healthcare evolution.

Latest Earnings Call

The Aetna transaction was completed in the fourth quarter of 2018, and all eyes turned to the latest earnings call on February 20, 2019. While operating results came in nearly as expected, forward guidance and a $6.1 billion yearly goodwill impairment charge on the Omnicare acquisition from 2015 caused investor concern. The weaker-than-expected guidance (continued pressure in drug prices) and, now obvious, poor Omnicare investment have only added to the debt concerns around the Aetna purchase. This caused the stock price to spiral down more than -20% since the earnings release.

While these anxieties are not unfounded, I believe the investment thesis is still intact. The healthcare ecosystem CVS is developing through the Aetna deal will drive long-term shareholder value. Management has stated that it has put stock buybacks, capital spending and dividend increases on hold until the balance sheet is in a more manageable position. According to CVS, cash flow from operations is expected to be somewhere between $9.8 and $10.3 billion in 2019. On the low end, this would leave over $5 billion in cash available to pay down the $70 billion Aetna debt after roughly $4.5 billion in capital spending and dividends next year.

Current Balance Sheet

The debt from the Aetna acquisition has definitely stressed CVS’s balance sheet. While the Piotroski F-Score remains stable, the debt has put pressure on the Altman Z-Score. While the debt is a risk, the expected free cash flow going forward should allow management to get the Altman Z-Score back to comfortable levels rather quickly.

Source: GuruFocus

Viewed through an adjusted cash flow lens (see appendix below), the balance sheet confirms there is ample cash to cover operations while paying down debt.

Source: Valens Research

Current Valuation

Even prior to the its post-earnings decline, the stock looked inexpensive by most standard relative (P/E, P/FCF, etc.) valuation measures.

Source: GuruFocus

Those who follow me regularly know that I am a fan of using dividend yield theory as a relative valuation tool. By this theory, a shareholder is getting a good cash return (dividends) for taking on the risk of owning the stock when the dividend yield is on the high end of its normal range. Currently, the dividend yield is at a 15-year high while the payout ratio is at a manageable level.

While relative valuation tools are helpful in the investment analysis process, I like to compliment them with economic value analysis (EVA). This is a form of intrinsic value calculation after making cash flow adjustments to the reported numbers.

Based on these adjustments (see appendix below), the current stock price reflects an expectation that adjusted return on assets (ROA’), similar to margins, will decline from 2019 expectations, and adjusted asset (Asset’) growth, similar to sales, will be relatively low—around +3% going forward—while holding debt levels constant.

Source: Valens Research

In my view, these expectations are too pessimistic given my investment thesis and management’s stated goals around debt levels. I believe management will be able to lower debt levels by $15 billion over the next five years, keep sales/asset’ growth at 5% and maintain adjusted return on assets at 2019 expected levels. If these assumptions hold true, CVS has a fair value of $80-$90 a share. Even if these assumptions prove inaccurate, the current share price still provides a large margin of safety.

Source: Valens Research

Recommendation

While I am bullish on CVS (I bought my first block of shares at $64), I am waiting to see some price stability to add to my position. While I don’t emphasize technical analysis, a lesson I’ve learned over the years is that the market (other people) can act irrationally longer than I can stay solvent.

For those who are comfortable selling cash-secured put options to work into a position, the 18 April 2019 50 strike options look attractive to me. That would give you a 2.43% return over the next 42 days if the stock is not put to you. If the stock price does continue to decline below 50, you would have a cost basis of $48.78 ($50 stock - $1.21 premium) as of the time of this writing. Given that purchase price, you would capture a 4.1% ($2 annual dividend / $48.78 cost basis) dividend yield on your cost basis.

Appendix:

Source: Valens Research

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.