CVS: Aetna Acquisition A Big Offset To Margin Pressures

May 03, 2019 6:27 AM ETCVS Health Corporation (CVS)38 Comments

Summary

  • CVS Health Corporation reported Q1-2019 results that were better than the market expected.
  • Revenue and EPS beat expectations; however, there are still significant margin pressures.
  • The current leverage needs to be worked down quickly to restore flexibility.
  • Valuation is well compressed here and provides a good risk reward.
  • This idea was discussed in more depth with members of my private investing community, The Wheel of FORTUNE. Start your free trial today »

When we last covered CVS Health Corporation (NYSE:CVS) we left with the message that the Aetna acquisition was exceptionally expensive but we could still find some value in the stock.

CVS accountants have found that they overpaid for Omnicare. That was a $12.7 billion acquisition. Aetna was purchased at almost 6X that cost. Did CVS overpay for Aetna? Absolutely. The chances that CVS did not overpay when purchasing a company whose chart looks like this, is zero.

Source: Netcials

This has now become a "show me" case and CVS will have to work through some rather challenging integration. We think it can be done and we are optimistic about the long term here, even taking into account that CVS probably paid $20 billion more than it should have.

Source: Good Will Hunting: CVS Decline Explained

Thursday morning CVS reported Q1-2019 earnings and the initial market reaction was positive. We took a closer look at the numbers to see if this warranted a stronger buy recommendation.

Q1-2019

CVS beat on their adjusted EPS and raised guidance for the year.

Source: CVS Q1-2019 Presentation

The midpoint of that range is now finally above the consensus estimates. We should note that CVS had disappointed so badly in Q4-2018 that the consensus had fallen rather rapidly in the last 90 days.

Source: Yahoo Finance

The beat and guidance raise were driven by strong volume growth in the pharmacy side along with faster-than-expected realized synergies.

Source: CVS Q1-2019 Presentation

Retail Pharmacy & Long-Term Care Segments

It speaks to the challenges in this segment when CVS had an almost 19% drop in operating income as revenues went up by 3.3%.

Source: CVS Q1-2019 Presentation

While CVS' higher paid labor had been somewhat behind the curve as far as demanding wage hikes, we are starting to see this come through now. It is rather a big issue for CVS as the company is facing pressures on expenses and reimbursement revenues at the same time.

Another area where CVS had been struggling is front store sales and we were pleased to see a positive number here.

Source: CVS Q1-2019 Presentation

Overall, the numbers were in line with CVS' guidance from Q4-2018. CVS synergies are having to work overtime to offset the margin pressures and execution will be key in the coming quarters.

PBM Segment

The Pharmacy Services segment also showed the same trend, albeit to a smaller extent. Revenues moved up 3.1% while operating income was lower by 4.2%.

Source: CVS Q1-2019 Presentation

The competition for dollars in this sector continues to be fierce and CVS is feeling the impact.

Source: CVS Q1-2019 Presentation

Aetna Segment

The one bright spot for CVS was paradoxically their expensive acquisition segment. Growth here was strong and the low medical benefits ratio improved operating income substantially.

CVS did not show comparatives as Aetna was not part of CVS in Q1-2018, but we were able to dig up the numbers from Aetna's Q1-2018. The overall year-on-year numbers do look incredibly positive.

Source: Aetna Q1-2018 results

Dividend safety, cash flow and debt

CVS guided for close to $10 billion in cash flow for the year. This leaves the company about $4.2 to $4.6 billion to pay off debt.

Source: CVS Q1-2019 Presentation

While that may sound like a lot, it is barely about 6.5% of their total long-term debt which bordered on $68 billion at the end of the quarter.

At the other side of the equation for uses of cash is the dividend. While CVS dividend yield is not high, the dividend still consumes more than $2.4 billion a year from CVS coffers. CVS currently seems comfortable with this payout and we see no risk to this in the next 12 months. Further out, if CVS can deliver the synergies they promised, it would improve the dividend safety even more. Even capex should trend down next year as Aetna is fully integrated allowing more than $5 billion of debt repayment in 2020. The one risk though is the wall of debt maturities in 2021.

Source: CVS Q1-2019 Presentation

A severe credit market freeze-up alongside continuing reimbursement pressures could put the dividend at risk, but we consider that a low probability at present. We put the 12-month outlook for a dividend cut on our proprietary, Kenny Loggins scale as follows:

The future

CVS even made the rather bold claim Thursday morning that they can deliver an additional $1.5-2.0 billion of savings in the longer run above synergy targets.

Source: CVS Q1-2019 Presentation

If CVS can deliver those numbers, and we are skeptical at this point, it would substantially reduce the estimated overpayment for Aetna in our opinion.

Conclusion

CVS successfully lowered expectations so that they could beat them and raise guidance for the year. We still consider our fair value for this stock to be $72 with reimbursement pressures being offset by a good performance from Aetna. Assuming the former stabilizes here, we see fair value rising by about 10% a year as debt repayment flows to our equity valuation of the company with a 1.5X multiplier.


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