CVS Health

Summary

• CVS Health (CVS) along with its recent acquisition of Aetna, will have huge amount of pricing power within the pharmaceutical supply chain for the foreseeable future.
• While the Aetna Acquisition has left the company extremely leveraged, they have made a consistent and concerted effort to pay down their debts and this trend will most likely continue.
• Overall, this CVS is a well run company with good long term prospects selling at a very low price.

Overview

CVS Health Corporation provides health services in the United States. They currently are made up of 3 primary segments. 

Farmacy Services

• The company's Pharmacy Services segment offers pharmacy benefit management solutions.
• It serves employers, insurance companies, unions, government employee groups, health plans, prescription drug plans (PDPs), Medicaid managed care plans, plans offered on public health insurance and private health insurance exchanges, other sponsors of health benefit plans, and individuals
• Plan design and administration ,formulary management, mail order pharmacy, specialty pharmacy and infusion, clinical, and disease and medical spend management services.
• This segment operates retail specialty pharmacy stores; and specialty mail order, mail order dispensing, and compounding pharmacies, as well as branches for infusion and enteral nutrition services.

Retail/LTC

• Sells prescription and over-the-counter drugs, beauty and personal care products, and cosmetics; and provides health care services through its MinuteClinic walk-in medical clinics.
• Distributes prescription drugs; and provides related pharmacy consulting and other ancillary services to chronic care facilities and other care settings
• As of December 31, 2019, it operated approximately 9,900 retail locations and 1,100 MinuteClinic locations, as well as online retail pharmacy websites, LTC pharmacies, and onsite pharmacies.

Health Care Benefits

• Offers traditional, voluntary, and consumer-directed health insurance products and related services.
•  It serves employer groups, individuals, college students, part-time and hourly workers, health plans, health care providers, governmental units, government-sponsored plans, labor groups, and expatriates.

I think one of the main reasons why the stock price has been so low lately is because many people are lumping CVS in with the rest of the Retail industry that is suffering both because of COVID and because of disrupters increased competitionlike Amazon (AMZN). Looking at their last annual report, we see that the retail segment was affected. However, "Total revenues increased $11.9 billion or 4.6% in 2020 compared to 2019. The increase in total revenues was primarily driven by growth in the Health Care Benefits and Retail/LTC segments." 

Acquisition of Aetna

 From CVS's 2019 financial statement -

• The transaction valued Aetna at approximately $212 per share or approximately $70 billion.
• Including the assumption of Aetna’s debt, the total value of the transaction was approximately $78 billion.
• The Company financed the cash portion of the purchase price through a combination of cash on hand and by issuing approximately $45.0 billion of new debt

To truly understand why CVS most likely considered such a huge amount of leverage to be worth the risk, we need to look at the pharmaceutical industry and and the various players in it make money. 

I would highly recommend this paper, by USC Schaffer which describe the relatively complicated supply chain involved in getting a drug from a manufacturer to a client. 

While pharmaceutical industry is too complicated to summarize here, one of the main take-aways I have found from my research is that several middle-men stand between the drug manufacturer's list price and the patient's copay. Below is a great representation of the profits that are skimmed in each step of the supply chain. 

Broken down in to more specific numbers, we can see that on average, the insurer, the pharmacy benefit manager , and the pharmacy combined absorb about 48% of the cost of a drug, and keep 9.3% as a net profit.

With the acquisition of Aetna, CVS (CVS) will have a presence in all three of these links. 

I have not been able to find any other example of a company that will have as much combined bargaining power as CVS will going forward. The value of the acquisition is already beginning to show. From the most recent financial statement:

Net cash provided by operating activities increased by $3.0 billion in 2020 compared to 2019 due primarily to higher operating income in the Health Care Benefits segment and the deferral of approximately $670 million of certain payroll tax payments to future years, as permitted in response to the COVID-19 pandemic.

Data by YCharts

In 2020, Moody's affirmed Aetna's credit rating to 'stable', stating:

Beyond consolidated financial flexibility, Aetna's rating reflects its large scale with over 20 million members and leading positions in commercial and Medicare Advantage.

High Leverage

CVS Health's (CVS) leveraged position is far and away the greatest risk to the companies' long-term prospects. In order to pay off it's debt, CVS has suspended its dividend. According to Moody's, "CVS has repaid $13.8 billion of debt and Moody's expects it to repay in excess of $5 billion of debt over the next twelve months." So by the end of 2021, CVS will have paid off about $19 Billion of its $45 Billion (42%) total debt from the Aetna acquisition. Realistically, it may be another few years before we see another dividend increase. However, barring any major political changes that will disrupt the company' profits, I feel fairly confident that they will eventually pay down their debt and continue with their otherwise steady dividend growth.

Data by YCharts

In addition to their dividend suspension, they will also need to redirect a portion of their revenue toward amortization, which means that future headwinds will be more likely to result in low, or even negative earnings in the near future. 

Data by YCharts

However, as a long-term investor I view the the current price of the stock to be an opportunity, and I am inclined to aggrege with Moody's when they say

CVS continues to prioritize debt reduction since its acquisition of Aetna with no share repurchases or increases in dividends and we expect this trend to continue....Despite headwinds due to the coronavirus pandemic CVS's cash flow generation has been robust and the company's scale and diversified revenue base will be a competitive advantage going forward -Moody's Investors service 

Management

As president of Aetna, Karen Lynch led a very profitable business. As stated on Aetna's balance sheet from 2018, their assets were more than 8 times their liabilities, which is pretty rare from what I have seen in my research. 

Aetna's cashflow was positive until it had to pay Humana a $1 billion after their merger was blocked by a federal court. 

She has more than 30 years of experience in the healthcare sector. She previously held executive positions at Cigna and Magellan Health Services.

She personally owns 94,370 shares in CVS, which is lower that what I would like to see from a CEO. She has sold most of the shares that she has been awarded since 2018. Regarding her overall compensation, "A regulatory filing late Friday shows as CEO Lynch will be paid an annual salary of $1.45 million. In addition, Lynch qualifies for a potential annual cash bonus of 200% of her salary. In 2021, her “target” annual equity award compensation will be $11 million, with 75% performance stock units and 25% stock options." Considering the company's size, I would actually consider this to be pretty reasonable.

Value 

With it's current P/E ratio at the lowest it's been in the last 10 years, this is probably one of the best deals you will find in the current market.  My DCF Analysis also confirms a pretty gosh-darn good value.  

Data by YCharts

Conclusion. 

I believe that while CVS is currently in a very leveraged position, and while short term growth may be stunted by this fact, their presence in the pharmaceutical supply chain, competent management, and brand-name recognition will serve them well in the long term. I believe that this investment is as worst safe, and at best an opportunity for substantial growth.