If you have a theoretical $250 with which to add to your healthcare stock portfolio, would you be better off buying a single UnitedHealth (UNH) share or for roughly the same price, 5 shares of CVS (CVS)?
Both companies would appear an attractive buy at current prices. In my view, CVS presents a more compelling, albeit riskier case for share price growth over the next 12 months, whilst UnitedHealth remains a solid bet that possibly has a more diversified, and therefore less risky portfolio of businesses.
Both companies are arguably undervalued at present, due to concerns about the future direction of the US healthcare market.
Medicare For All campaigning has begun in earnest ahead of the 2020 election, whilst there are bipartisan efforts afoot to try to curb the influence of Pharmacy Benefit Managers on drug pricing, and to pass more of the negotiated price reductions onto Medicare customers. Both UnitedHealth and CVS, especially since its mega-money acquisition of Aetna, rely upon PBMs for a significant portion of their revenues.
Whilst we can expect there to be change within the healthcare industry, in my view, companies like CVS and UnitedHealth are more likely to lead the change than be dictated to. The current processes and procedures, after all, exist for a reason; it's possible they are not quite as unfair or even corrupt as the public is being informed they are by vote-seeking political figures.
In the course of this article I will look at both CVS and UnitedHealth from numerous angles and try to determine where the smart money should go. But in reality, it is my belief that both companies represent good value at current prices, and personally, I am long both.
Business Models and Q1 Results - CVS
CVS as a business is divided into 4 major reporting sectors, which I have broken down in the diagram below, with the data extracted from the company's most recent 10K filing for FY 2018.
Source: my table with data sourced from CVS Health 10K filing
Although most people know CVS for its physical retail stores, it may be interesting to note that a larger proportion of revenues (60%) comes from its Pharmacy Services sector. Of course, neither segment can really exist without the other, but the success of pharmacy services perhaps provides encouragement for investors who see the future of healthcare as online, rather than in store, and may be concerned about companies such as Amazon (NASDAQ:AMZN), which recently acquired online drug delivery service Pill Pack for around $750m, taking market share away from CVS by undermining its brick-and-mortar stores.
That said, CVS’ revenues from its 10,000+ retail stores were up 3.8% year on year in Q119, so there is no reason to panic, or necessarily to believe that the average American has any issue with sourcing their medications at a physical store rather than via home delivery (although CVS has that particular business covered too).
Additionally, CVS says that the launch of its HealthHUBs and Minute Clinics - in-store health diagnostics centres - will provide synergies with newly acquired Aetna, helping to identify patients with chronic diseases who would benefit from an Aetna healthcare plan.
Aetna, acquired for a whopping $69bn, is America’s third-largest health insurer with 22m customers, who will begin to fill their prescriptions using CVS’ drug plans going forward. Despite the phenomenally high price that CVS paid for Aetna, many observers believe that it is a win-win for both companies, and the early results have certainly been promising. CVS reported revenues of $61.65bn in Q1 - a 35% yoy increase, largely thanks to the Aetna factor.
By acquiring Aetna, CVS has created a healthcare monster, that will be hard to stop or compete with, but the acquisition does leave CVS with a mountain of debt to pay off - around $64bn net.
Business Models and Q1 Results - UnitedHealth
If anything, UnitedHealth has a more diversified portfolio of businesses than CVS, as we can see from the chart below, which I have created, using United’s most recent 10K submission, for FY ‘18.
Source: my table with data taken from UnitedHealth 10K submission FY2018
UnitedHealth is divided into 2 separate entities, Optum and United Healthcare, which are in turn divided into 3 and 4 reporting segments, respectively. United Healthcare is mainly concerned with healthcare plans, which command a significant portion of company-wide revenues: Employer and Individual (19%), Medicare & Retirement (26%), Community & State (15%) and Global (3.5%).
On the Optum side, UnitedHealth has its own Pharmacy Benefit Manager, Optum RX, Population health programs through Optum Health, and an analytics and insight segment, Optum Insight that, in my view, is highly geared towards the personalised and precision, big data inspired approach to healthcare that we will see more and more of as digitalised, AI driven “healthtech” services become more and the norm. UnitedHealth’s Rally Health initiative, which was piloted with 1 million members last year, is a great example of this. United’s belief is that, as CEO David Wichmann put it in the Q119 earnings call:
Nearly 80% of what influences the person's health relates to non-traditional medical and behavioural issues such as food, housing, transportation, and health care finances.”
United’s Q119 results were solid overall, with revenues up 9%, EPS 23%, and return on equity an impressive 27%. The overall tone of the earnings call was positive, and it seems clear that UnitedHealth is embracing the challenge of making cost savings by adjusting its Medicare plans to each individual, thereby eliminating waste and, the company says, achieving cost savings of $300 per patient, per plan.
That said, UnitedHealth does have a major exposure to the government's war on rebates, which it is insisting companies like United pass on wholesale to the consumer, which will squeeze margins. United’s response, to use innovative technology to streamline its service offerings and save on costs, could be a more than adequate, not to mention necessary, response in the long term.
As I mentioned earlier, both CVS and UnitedHealth have revised their FY 2019 estimates upwards after a positive set of Q1 results, although in CVS' case it is worth noting that the company had revised its estimates downwards in Q418, so the progress is perhaps less impressive.
I have created the table below in order to make a more direct comparison between the company’s respective performances:
Source: my table with data taken from UNH and CVS 10K submissions, Q119 Earnings releases and financial projections for FY19
What jumps out to me when I look at the table is that CVS looks the more attractive buy.
As we can see, there is little to choose between the companies in terms of revenues (CVS $195bn, UnitedHealth’s $226bn), and forward earnings statements (CVS $15.1bn, United $17.55bn). But bear in mind that, with our notional $250 of investment money, we can either buy 1 share of UnitedHealth, or 5 of CVS. CVS pays a dividend of $2 compared to UnitedHealth’s $3.45, but multiply $2 x 5 and you have $10 dividend.
Look at the forward EPS guidance, and whilst UnitedHealth offers $14.6, CVS is offering $6.8, x 5, which adds up to more than double United’s. Granted, there are elements of CVS financials that look a little ugly. The negative EPS, the negative net income and the huge debt pile. But bear in mind these figures are clouded by the Aetna acquisition, and going forward the company ought to be on a much healthier footing, with Aetna providing cost synergies of potentially $750m plus, CVS estimate. A Q119 MBR of 84% also looks attractive, albeit similar to United’s 81.6.
What also jumps out at me as I look at the table above is that UnitedHealth looks the less risky purchase. CVS has a job on its hands to convert Aetna’s massive potential into tangible results and provide the much vaunted synergies. UnitedHealth’s portfolio of businesses is easier to manage and adjust, and as I have mentioned before, I am impressed by the innovative ways it is using technology and data-driven insights to create cost savings and increase margins.
UnitedHealth also has significantly less debt than CVS, and has consistently delivered the more steady results.
But the big risk factors here affect both companies equally, in my view, and possibly CVS, via the Aetna acquisition, has done more to ward off the threat of squeezed PBM margins and their possibly dwindling influence than UnitedHealth. CVS almost looks “too big to fail,” with a 26% share of the pharmacy retail market and the addition of America’s third-largest health insurer. Surely, were Medicare for All to be implemented, it would be hard for the government to ignore 10,000 brick-and-mortar stores.
That said, UnitedHealth has a 25% share of the exponentially growing and increasingly lucrative Medicare Advantage market. According to the Henry J Kaiser Family Foundation:
For the second year in a row, enrollment in UnitedHealth’s plans grew more than any other firm, increasing by almost 600,000 beneficiaries between March 2017 and March 2018; Aetna had the second largest growth in Medicare Advantage enrollment, increasing by about 280,000 beneficiaries between March 2017 and March 2018.”
Neither company will be easy to ignore, and the likelihood is that both will continue to be dominant players within the healthcare sector whatever the outcome of the Medicare For All debate. But when we consider both companies' recent share price performance, a government and public backlash against health insurers and the way they are perceived to manipulate pricing of drugs and health plans would appear to be each company's biggest risk factor.
Share price growth potential
As the chart below demonstrates, whilst it has been a bad year for the healthcare sector, with the S&P Healthcare Index losing 5% between May 20, 2018, and 2019, compared to the overall S&P’s 3.6% gain, it has been significantly worse for UnitedHealth stock, losing 7%, and disastrous for CVS, whose stock has lost 27% over the last year.
Clearly, the market feels that CVS overpaid for Aetna, but over time, the acquisition may start to make more and more sense, and if the synergies are realised, CVS stock could bounce back significantly. Management simply has to prove that it did not make a wrongheaded decision.
Where UnitedHealth is concerned, it is harder to find reasons why the stock has underperformed, but again, we can come back to doubts around the future of the PBM, and the threat to private health insurers from Medicare For All. UnitedHealth is more reliant on its health insurance business than CVS.
Therefore, I would conclude that if it is a potential gain of anything up to $30 per share that you are looking for, CVS looks capable of delivering. And of course, we can multiply that gain by 5 as compared against UnitedHealth’s potential price gain, because CVS stock is nearly 5x cheaper. CVS’ forward P/E of just 7.75x indicates the company is good value: there could be significantly more gain to be realised, but we should temper that with the observation that things could also get worse and losses can also be multiplied by 5.
If it’s a more steady growth stock that you are after, United fits the bill. The company’s results have been well received and the stock is already on an upward trend, with plenty more upside to realise, potentially. A forward P/E of 16.5 is attractive, but the stock price could suffer up to, and perhaps beyond, the Presidential campaign in 2020.
Healthcare stocks are traditionally strong performers, but have recently experienced a wobble. Investing in the sector now is akin to following Warren Buffett's advice to be “fearful when others are greedy, and greedy when others are fearful.”
Disclosure: I am/we are long UNH, 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.