CVS: A High Cash Flow Yield, But A Low Return On Capital

Summary

• CVS is undervalued and generates impressive cash flow, but it faces competition, regulatory challenges, and low operating margins, resulting in mediocre returns on capital.
• Before investing, I believe an investor should study the complex operations behind the storefront of CVS before falling for its cash flow yield.
• CVS is a vertically integrated and complex company with a healthcare insurance business, pharmacy benefits manager, primary care provider, and pharmacy/retail operation.

Spencer Platt

Introduction

I have been an investor in CVS Health (NYSE:CVS) a little bit prior to the company's $69 billion acquisition of Aetna in 2018. Since then, I have been fairly confident that I understood the business - especially considering the accessibility of CVS in the consumer's eye. In my original thesis for the company, I was impressed at the fact that 8/10 Americans lived within a ten-mile radius of a CVS store (Yahoo Finance, 2017). Currently, CVS has 47 million unique digital users and an average daily store footprint of 5 million customers (Q4 2022). In short, almost every American has a relationship with CVS and the company's reach is thoroughly impressive.

But, I would suggest that there is much more behind the simple CVS storefront. Just to give some context, CVS dedicated a whopping 11 pages in its annual report to list the names of the subsidiaries within the group (2022 10-K). Furthermore, the business has expanded extensively in the past five years beginning with the acquisition of Aetna followed by the recent acquisitions of Signify Health and Oak Street Health. In this article, I'm going to present each CVS business unit and explain how they operate.

• Health Care Benefits
• Health Services
• Pharmacy and Consumer Wellness

Then, I proceed to compare these businesses with primary competitors such as UnitedHealth Group (UNH), The Cigna Group (CI), Walgreens (WBA), and Rite Aid (RAD).

I find that CVS is a vertically integrated player providing health insurance, pharmacy benefits management, primary care, and operates on the front end selling pharmaceuticals through its retail pharmacies in the U.S. Most players in this industry are vertically integrated to a certain degree (UNH is a healthcare provider as well as a pharmacy benefits manager ('PBM')), but CVS is unique since it has a consumer-facing pharmacy business on top of healthcare and PBM. However, the extensive vertical integration of CVS does not seem to have a positive effect on its operating margins. I agree with several of the previous articles that have been written: CVS is a buy at the current valuation due to its incredible cash flow generation. Here are some recent articles that I can recommend explaining why:

1. CVS Health: Explaining The Guidance Cut And How to Evaluate It After Q1 Earnings Beat
2. CVS Health: Investors Getting a Bellyache
3. CVS Health Stock: Too Cheap to Ignore

The takeaway from my article is that even though CVS is undervalued, remember that CVS is a complex business that is sensitive to healthcare laws, strong pharmaceutical manufacturers that put pressure on margins, and strong competitive pressure in all verticals. Before investing, you need to understand the company's business units and their underlying margin profiles before simply constituting that CVS has a great FCF yield.

Health Care Benefits

This business unit is in essence the Aetna business. Aetna is a large provider of healthcare insurance which they sell through two units: Commercial Medical and Government Medical. The Commercial side offers point-of-service, preferred provider organization ('PPO'), health maintenance organization, and indemnity benefit plans which are sold primarily to large, medium, and small businesses, but also to individuals. The Government side offers Medicare Advantage plans, Medicare Supplement plans, and prescription drug coverage for Medicare beneficiaries, participates in Medicaid, and subsidized Children's Health Insurance Programs ('CHIP'). The government side earns money through bidding on Medicare & Medicaid contracts annually to offer preferred provider and health maintenance plans for individuals eligible for Medicare & Medicaid.

Health Care Benefits Q1 Results (CVS Investor Relations)

This business unit has experienced considerable growth in total revenues compared to last quarter, with adjusted operating margins of 7%. As we can see, the commercial side of the business is the largest with 18 million members while the government side has a member count of 7.5 million. On the government side of the business, the government pays CVS premiums annually based on the number of members. The reimbursements that the company receives from The Center from Medicare & Medicaid ('CMS') are tied to the company's so-called 'star rating' which measures the quality of preventative services, chronic illness management, and customer satisfaction. Unfortunately, the Aetna National PPO business moved from a 4.5 to a 3.5-star rating - and the crutch is that any plan that is rated below 4 stars is not eligible for premium bonuses. The company cites that "Medicare Advantage plans' operating results in 2023 and going forward will be significantly affected by their star ratings." It is almost impossible to assess the company's care quality, on a leading basis, with regard to its government programs as an investor & this star rating decrease is a wake-up call. In 2021, 87% of the company's medicare advantage plans were above a 4-star rating. In 2022, only 21% of plans remain at that level. With this said, though, investors should be optimistic about a new Medicare advantage win by Aetna for 250,000 retirees at the Labor Relations New York City Office. This deal is valued at $15 billion over five years and four months! (CVS Newsroom)

UnitedHealth Group and The Cigna Group are two large competitors of Aetna. This is a comparison of each company's healthcare insurance businesses that sell to similar customers. UNH is undoubtedly the industry leader with 2-3x the revenue of Aetna and Cigna Healthcare while keeping competitive margins at scale (also reflected in its $455 billion market cap).

The Author

Health Services

Now, let's move to the company's largest business unit as measured by revenue. The Health Services Segment is solely made up of CVS's Pharmacy Benefit Management ('PBM') business which has various product offerings within this unit. A PBM essentially processes pharmacy claims, negotiates low drug costs and rebates with pharmaceutical manufacturers, plans design offerings and administration, formulary management, retail pharmacy network management services, and mail-order pharmacy services. This business generated $44.6 billion in revenue Q1 2023, with operating margins of 3.7%.

Health Services Q1 Results (CVS Investor Relations)

The PBM is operated by the CVS Caremark brand and their primary clients are insurance companies, unions, government employee groups, as well as a national network of 66,000 retail pharmacies (including CVS pharmacies). In essence, this side of this business is very data-driven and focused on optimizing the administration, purchasing, and delivery of pharmaceutical drugs between pharmaceutical manufacturers and pharmacies & insurance companies. In its 10-K, CVS claims that its largest competitors in this line of business are Prime Therapeutics and MedImpact, Express Scripts business of Cigna Corporation, and the OptumRx business of UnitedHealth. Shawn Guertin, CVS CFO, said at the recent Bank of America Healthcare Conference that the PBM business margins have changed dramatically over the past 5-10 years. Previously, PBM providers could take a good margin on rebate retention and network spread but this has now decreased dramatically as the company passes "through over 98% of rebates back through to clients", but what has grown is the specialty pharmacy services such as that of specialized administrative services of $340B to providers. The lower rebate retention and network spread contribution margins have decreased in large part due to legislation in D.C. When comparing CVS's PBM business to those owned by UNH and CI, we see the following:

The Author

In this graph we notice, again, that UNH is the sole leader with both higher sales as well as substantially higher operating margins compared to the other two businesses.

Going forward, the Health Services segment will include all contributions from Oak Street Health and Signify Health - these are primary care, and home and health services respectively. Although the quick close of the Oak Street acquisition was the primary driver of the downward EPS revision for FY 2023, the quick integration gives CVS the opportunity to scale the business much more quickly in order to drive even greater synergies and cash flows in the future.

Pharmacy and Consumer Wellness

Finally, this business unit is the one that consumers know and love. The pharmacy and consumer wellness business consists of all CVS pharmacies that have a combined store that sells pharmaceutical drugs as well as food, cosmetics, other supplies, and supplements. Some of the CVS locations also have a MinuteClinic where consumers are provided with various healthcare services - flu shots, COVID vaccines, preventative healthcare & other miscellaneous check-ups. At year-end CVS owned and operated over 9,000 pharmacies/retail stores and 1,100 MinuteClinics and the company filled "26.8% of the total retail pharmacy prescriptions in the United States", which can be equated with its pharmacy market share.

Pharmacy & Consumer Wellness Q1 Results (CVS Investor Relations)

Sales increased QoQ by 7.8%, while adjusted operating income significantly decreased resulting in an operating margin in Q1 2023 of 4.1% compared with 6.1% the year before. The company writes:

"Adjusted operating income decreased 27.9% for the three months ended March 31, 2023 compared to the prior year primarily driven by continued pharmacy reimbursement pressure, decreased COVID-19 vaccinations and diagnostic testing and increased investments in the segment's operations and capabilities."

But, CVS's CFO still claims that the pharmacy business has been very stable when excluding the extraordinary contributions from Covid vaccinations during 2020 and 2021 (BoFa Conference). For comparison, Walgreens cited the exact same pressures as the reason why its adjusted operating income decreased by 32.8% in the prior quarter (Walgreens Press Release).

The Author

CVS is the largest player here, with revenues and margins slightly above those of Walgreens whereas Rite Aid is significantly smaller with negative operating income in the business as a whole. It should be noted that I calculated Walgreens's sales solely for the U.S. business (although it also has international pharmacies) because it offers a direct comparison to CVS.

Conclusion

There is a complex and extensively vertically integrated healthcare company behind the simple CVS storefront. In accordance with earlier articles, I believe CVS has a good margin of safety at its current valuation due to its impressive FCF yield. But, the industry in which CVS operates faces strong competitive pressures, it is sensitive to healthcare regulation, and naturally has low operating margins which all result in mediocre returns on capital of 7.4% for CVS, which I expect to remain constant over time. Although CVS may be a bargain today, monitor this business over the long term closely.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of CVS either through stock ownership, options, or other derivatives. 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.

Comments

[jimidean]

Do you have a source for your "low operating margins which all result in mediocre returns on capital of 7.4% for CVS" Because the M* data i see reports much much worse returns on capital:

Management Effectiveness (TTM)

Return on Assets 1.69%
Return on Equity 5.47%
Return on Inves. Capital 2.44%

[Philip Eriksson]

@jimidean Aha yes, sorry for not including the source. I got it from a ISS EVA research report www.issgovernance.com/... They make research reports and put them up on fidelity (my broker). Also they mention that CVS cost of capital is around 5%. Where did you get your data btw- what is M*?

[jimidean]

@Philip Eriksson hi thanks, M* is short for Morningstar, their amounts were the same as reported by Morgan Stanley

[Philip Eriksson]

@jimidean ahh ok got it! They must be using different capital figures then? This number is generally unclear for CVS since there are many ways to measure it - maybe not the most intuitive performance proxy to use…

[kevn1111]

In their recent conference they expect to earn $9 in 2024. Growth will be slow though. So I wouldn’t put a big multiple on it. A multiple of 9-12 seems reasonable if they can monetize the latest acquisitions. So $81-$108 range, but they have to get to at least $9. They have to monetize the acquisitions. They have to improve star ratings to provide growth in out years. Lots of work to do.

[Philip Eriksson]

@kevn1111 yep, great insight. Growth is going to be one of the largest concerns here.

[khatcher]

As Donald John would say lets see what happens

[Philip Eriksson]

@khatcher hehe, yea it’s going to be exciting!!

[diroha]

They have to get serious about their debt. I know they have a plan but the 2 recent acquisitions resulted in a lot more debt. Investors are not going to pay up for EPS in such a leveraged situation.

[Philip Eriksson]

@diroha yep, it’s really important. I think they took on around $5.7 billion in new debt now to finance these acquisitions.

[Galmo]

@diroha had the same issue with Aetna. They did commit to lowering that debt and hit their goal, so if they commit again I will believe it. Could be a dividend halt though for 2 years...

[Yuval Rotem]

Thank you for referring to my article and for your interesting view as well!
I think UNH's relevant segment margins perfectly reflect the best-case scenario for CVS. At its current price, I think even the base-case scenario will reward shareholders.

On another note, CVS's total assets are inflated with goodwill. But actually, since 2018, the company barely deployed capital that resulted in goodwill. If you adjust for that, then you get to the 16%-18% ROCE range.

[Philip Eriksson]

@Yuval Rotem hey no problem, it’s always a pleasure to read your articles!! And really interesting insight. This makes sense when we think about their business. CVS is not investing in many new stores/pharmacies so PPE assets are actually declining w/ depreciation and Aetna + Caremark are more labor-intensive businesses. One thing I’m wondering about though… is it reasonable to include subtracting Health care costs payable (Current liability for Aetna) when calculating the ROCE?

[Yuval Rotem]

@Philip Eriksson I think the reason you subtract current liabilities is to reflect the capital that isn't being 'employed'. So, for lack of a better way to assess how much capital is paid back to Aetna's beneficiaries, I'd say we do need to subtract these, or else it will be a double count, as the current health care costs payable are expensed in the income statement.

[Philip Eriksson]

@Yuval Rotem ahh ok yep I get your thinking, thanks :)

[Maybenot2023]

In the end all the primary care acquisitions such as Oak Street depend on poorly trained APRNs with little to no oversight. It is an FTE job with a lot of turnover and referrals to the Er for any really sick patient. This will eat into shared risk contract profits quickly. They have very poor integration with large hospital systems and nursing homes. I also am waiting to see routine multimillion dollar judgements for medical malpractice. The formulary management is also at risk when someone brings a law suit for not using best in class drugs and patients end up with bad results. Not to mention CVS having to recall drugs because of carcinogens.

[Philip Eriksson]

@Maybenot2023 these are exactly the type of risks i think investors should know about!! Thanks for describing a more concrete example. And do you mean Oak Street has poor integration with hospitals? - what can we look for to see this is under control, operating margins?

[johngonole]

@Maybenot2023 yea operating doctor's offices might scale poorly cause of deep pocket theory. Sure they carry insurance. But plantiffs will ask for way more than your insurance capacity if you have billions of dollars in cash on your balance sheet. This is where vertically integrating could make things worse maybe there is a law or legal framework that can protect from this. But I doubt it.

[BeaBaggage]

@johngonole this magnified potential 'legal' risk from vertical integration is nonsense-
for decades CVS has been operating in the medical field w registered pharmacists who dispense billions of RX annually- occasionally we hear about pharmacies dispensing the wrong RX to someone but on a corporate scale there are numerous checks and balances in place to thwart the issues.
You are required to sign that you were given the option to discuss your RX and potential interactions etc when you pick up- do you have any questions for the pharmacist? do you decline to discuss with the pharmacist?
I just did this yesterday.
CVS will carry this patient focused concerned culture to the vertical integration into other areas as well. Pharmacists gave out hundreds of millions of vax in the last 3 years..no class action suits, big lawsuits making headlines.

more fear mongering as usual.. professionals are required to carry E&O insurance and even corp employed ones often carry policies on their own; a relative is a hospital pharmacist and their E&O protects her and she carries a 2mil policy as well. Institutions also often employ large reinsurance policies as well.

It would require gross negligence on a corporate level to amount to anything risking the company and I don't see that here at $CVS.

the dearth of PCP MD's is real especially in rural areas and clinical care management thru other sources like insurers, pharmacies and 'clinics' is the future. CVS is prepared to move in this direction.

[MWinMD]

A lot of moving parts, indeed. But the person who knows them best *should* be the CEO, and she recently bought $1 M more worth of it at around $70. FWIW.

[Philip Eriksson]

@MWinMD Aha... interesting insight. I didn't know that, thank you!

[BeaBaggage]

@MWinMD long $CVS recently and adding on these dips..great value for a long term position accumulation. Bea

[Philip Eriksson]

@BeaBaggage agree, this is a great time to be buying if you believe in CVS.

[RWilliam]

Good article, thx! Me too got in at 97 traded around all the way to the 50s, doubled it. Was my first most hated stock second was Viacom. That’s why I sold all over 90. Don’t get married to stocks!

[Philip Eriksson]

@RWilliam Good timing in the short term!

[RWilliam]

@Philip Eriksson very long term hold around same as you. I cut stocks when they seem expensive and don’t fit my core hold. Redeploy the capital.

Too low div too low growth. Unlike AVGO MLPA LYB MO BTI MO QCOM EPD PRU all in my top ten list. MLPA is the only ETF I hold large amounts for tax reasons.
I got have one or the other (growth or income) or a blend. I cut ABBV. We see if I’m right on that one.

[Philip Eriksson]

@RWilliam ok got it. Never get married to stocks, i like that XD. You're right to sell when you don't believe in the investment thesis anymore and thanks for the tips :)

[pmapires]

I rather use market values and FCF for ratios instead of accounting BS. Shareholders perspective: FCF = $13.5 bn | FCF/Mkt Cap = 13.5/88.4 = 15.3%. Including bondholders: Adj FCF = FCF + Interest * (1-tax) = 13.5 + 2.3*(1-.26) = 15.2. Adj FCF / EV = 15.2 / 147.4 = 10.3%. It doesn't look bad to me unless interest rates won't go lower over the next couple of years. That would increase interest expense and reduce FCF to shareholders.

[Philip Eriksson]

@pmapires agree with you there. How many ways can you twist and turn profitability ratios... lol? But one thing that I hold on closely too still is that CVS operates in complex industries without much insight from the investor/consumer side (Aetna's star rating was a surprise & 27% decline in operating margin at pharmacy was as well).

[johnhyunsookim]

Let's look at this in terms of returns using Q1 23 numbers. Working capital (CA-CL) is negative, meaning there is no capital invested there, so ignore for now. Also holding a lot of cash, which one could take some out of CA. Then look at PPE $13B, but few of assets I am not going to count: 1) operating lease asset is just accounting fiction to put store leases on the balance sheet 2) goodwill and intangibles based on deals they have already done. There is $8B of other assets, don't even know what it is. So $13B + 8B in assets = $21B. Annualizing their Q1 NI is about $8.4B. So return on tangible assets is very high at 40%! Now what do you do with goodwill and intangible assets--that has more to do with capital allocation and I have no problem passing judgement on whether doing M&A and/or whether CVS mgmt overpaid for deals. My only point is that the underlying business generates a very high return.

[Ray Merola]

@johnhyunsookim Determining RoIC is part arithmetic and part philosophy.

One could make a good argument that goodwill and intangibles may be excluded from the calculation. However, GW and intangibles is about half total assets. These do reflect real money spent on acquisitive actions; so should not these be included in return-on-invested capital?

Using a down-and-dirty methodology and 1Q2023 input (annualized), I can come up with ~12% RoIC.

Here's the formula:

EBIT (adjusted) / total assets minus current liabilities minus balance sheet cash

[Philip Eriksson]

@johnhyunsookim interesting way to look at it. But I agree with Ray that CVS is especially acquisition happy and has so much goodwill its undeniable! Also, another perspective could be using the net income from pharmacy/store operations divided by the $21 since the majority of fixed assets pertain to this business unit.

[johngonole]

@Ray Merola I've always felt that acquiring. Companies should maximize cash flows by depreciating goodwill.

And to some else's point I don't care for them putting future lease obligations on the balance sheet as assets. It is 't hard usually to subtract the long term debt carries on the liabilities side of the balance sheet but a pain that has to be dealt with when looking at financial metrics.

[Ray Merola]

Thank you for referencing / linking my recent CVS article.

CVS return-on-capital is greater than its WACC, so there is value creation. However, to your point, the RoIC isn't outstanding. It is greater than WBA, though less than CI or UNH. To be fair, none of these companies' business models are an overlay with CVS.

[Philip Eriksson]

@Ray Merola Hey, of course! I enjoyed your article and I have also seen that they have a greater return on capital than their WACC (which is surely positive). But yes, whenever I review CVS I can't get a grip of whether it truly is a great long-term investment considering all the other opportunities that there are. The company is a giant in this industry, like no other!

[Tim Travis]

Good article. I have a tough time understanding the strategic rationale of those recent acquisitions relative to the price paid. Maybe they are right, but that is my biggest struggle with the stock.

[Philip Eriksson]

@Tim Travis Well it seems like management is very optimistic about leveraging their capital position to grow Oak Street. This could be a great acquisition if the profitability of these locations are what management thinks it will be.

[Millennial Investment]

@Philip Eriksson vertical integration. It doesn’t take a rocket scientist to figure this stuff out. Debt is high, but is well covered by FCF. It’s going to be a struggle for the next 2 years imo. But that’s a good time to accumulate shares. 2025 will be a turnaround story (if not sooner)