Earnings Notes: CVS Health

I’ve decided to share some of my notes on earnings results of stocks that I either own or are watching.  These notes are typically in bullet format and highlight some of the important points.  I hope that these may be of help to other shareholders or investors interested in the stock.

Today notes are on CVS Health which is in the top 10% cheapest stocks according to my model.  I own the stock and the company has done well over the last 5 years.  However, the operating profits have dropped in the last three quarters, there are fears that Amazon (AMZN) may enter the industry and just recently CVS announced that they will merge with Aetna (AET).  CVS trades at a 12x P/E and 7.5x EV/EBITDA, while AET trades at18x P/E and 12.1x EV/EBITDA.  The combined new entity will most likely still be relatively cheap, depending on the deal details.  CVS investor day is on December 12, 2017.  Below are my notes.

CVS Health (CVS)

• Year-on-year:  Top line +3.5%, operating profit -6.6%, Adj EPS comp -8.5%
• Q3 Adj. EPS $1.50 vs $1.49 Est., Sales $46.2B vs $46.17B Est.
• CVS Narrows, Raises FY17 Adj. EPS Outlook From $5.83-$5.93 To $5.87-$5.91 vs $5.88 Est.
• CVS Sees Q4 Adj. EPS $1.88-$1.92 vs $1.91 Est.
• CVS Reports Q3 Front Store Comps Down 2.8%, Pharmacy Comps Down 3.4%, Retail/LTC Segment Comps Down 3.2%
• Confirmed full year CFO $7.7 to $8.6 billion; FCF $6.0 to $6.4 billion

Operating profit decline was primarily driven by A) previously-announced restricted networks that exclude CVS Pharmacy and B) continued reimbursement pressure in the Retail/LTC Segment, C) price compression in the Pharmacy Services Segment, and D) as expected, the timing of Medicare Part D profits between the third and fourth quarter of 2017. In addition, the Company incurred $55 million in expenses in the three months ended September 30, 2017, predominately in the Retail/LTC Segment, for the three major hurricanes that hit the southern United States and Puerto Rico. These decreases were partially offset by lower acquisition-related integration expenses of $59 million.

A =  CVS Health announced previously that it expects to lose 40 million retail prescriptions next year because of new retail pharmacy networks that don’t include CVS, such as those created by Walgreens’ partnerships.  Walgreens formed partnerships with a number of pharmacy benefit managers, which are companies that manage prescription drug benefits for insurers and employers. Those partnerships make Walgreens a preferred pharmacy for people with certain health insurance plans, meaning medications for those customers are significantly cheaper at Walgreens and other in-network pharmacies than at drugstores that aren’t part of those networks.  NOTE: FROM 10-K:  During the year ended December 31, 2016, our PBM filled or managed approximately 1.2 billion prescriptions (which equates to 1.6 billion prescriptions when counting 90-day prescriptions as three prescriptions).

B = Forbes on reimbursement rates.

• “We signed a five-year agreement with Anthem to provide services to support their new PBM, IngenioRx, beginning in January 2020. As part of the agreement, we’ll manage certain services for IngenioRx, including claims processing and prescription fulfillment through our mail order and specialty pharmacies.
• Additionally, we recently announced the new 30,000-store performance-based pharmacy network that will be anchored by CVS Pharmacy and Walgreens, along with up to 10,000 community-based independently-owned pharmacies. The network is designed not only to deliver unit cost savings, but also to improve clinical outcomes that will help lower overall healthcare costs for clients and their members.  This network is an innovative solution that utilizes a value-based management approach in order to achieve improved outcomes through adherence for five high-impact, highly-utilized drug classes. It also helps to provide cost savings through formulary compliance. So, we’re excited to make this available to our clients for implementation beginning in March of next year
• Retail/Long-Term Care segment, total same-store sales decreased 3.2%, slightly better than expectations, with pharmacy same-store sales down 3.4%. Pharmacy sales comps were negatively impacted by approximately 435 basis points due to recent generic introductions.  Same-store prescription volumes increased 0.3% on a 30-day equivalent basis, slightly ahead of expectations, and the decisions to restrict CVS Pharmacy from participating in the TRICARE and fully-insured prime networks continued to negatively impact pharmacy sales and script comps. The network changes had about a 420 basis point negative impact on volumes. And when adjusting for the network changes, same-store prescription volumes would have been up 4.5% in the quarter, again, on a 30-day equivalent basis.
• …we have generated nearly $7 billion of free cash in the first nine months of the year.  In Q4, we are expecting negative free cash flow for the first time in a long time, as we plan to settle the CMS payable associated with the 2016 plan year that was built up last year. Given this, we are maintaining our prior guidance for the full year and continue to expect to produce free cash of between $6 billion and $6.4 billion in 2017.
• Paid ~ $511 million in dividends in Q3; $1.5 billion year-to-date – 12-month trailing dividend payout ratio of 39.6% (The dividend payout ratio is defined as the sum of the dividends paid for the last four quarters, divided by the sum of net income for the last four quarters. Dividends paid and net income are both included on the consolidated statements of cash flows.) – Ratio is artificially high due to some expenses that are more temporary in nature, as described in our non-GAAP reconciliations on our website – On track to reach 35% targeted payout ratio by the end of 2018.
• In Q3, repurchased 5 million shares for $400 million
  • YTD, repurchased 55 million shares for $4.4 billion, or $78.68 per share
  • YTD, returned ~ $6 billion to shareholders through dividends and share repurchases •
  • In 2017, guidance includes expectation to return more than $7 billion to shareholders through dividends and share repurchases
• We have had 1,600 stores who’ve been doing home delivery for a long time.  So, whether it’s our drive-through locations, it’s our Curbside Pickup, we’ve been actively involved with Instacart, which we’re now delivering from 2,800 stores. We’re pushing the envelope on basically serving the patient wherever she is.

From Morningstar:

• The firm operates more than 9,600 pharmacy retail stores across the United States, with about a third of the stores’ revenue derived from convenience goods. The overall top-line contribution from total nonprescription retail operations is approximately 16%.  
• It announced a major partnership with Walgreens and thousands of other independent pharmacies, that will form a massive value-based retail pharmacy network for 2018. This joint venture will likely be a key component for any PBM retail pharmacy network moving forward and will also protect the participating members from being excluded in the future.
• The true driver of CVS’ moat rests with PBM services. The firm’s 1.3 billion adjusted claims processed annually gives it significant scale advantages and the ability to leverage the asset-light nature of a PBM into solid economic profits. CVS has some of the lowest SG&A costs and highest operating profit per claim, and these metrics have translated into significant economic profits.
• With total adjusted claims at approximately 1.3 billion, the PBM is able to negotiate top-tier drug pricing discounts with suppliers.

Amazon threat overstated?  What AMZN would offer is already offered by CVS:

• Mail order service
• For those with immediate need:
  • Starting next year, nationwide one-day delivery of scripts will be available from our stores
  • In select metro areas, same-day delivery of scripts will be available
  • Beginning December 4th, free same-day delivery of scripts and a curated selection of front store
    products will be available in Manhattan
• Nearly 70% of the U.S. population living within 3 miles of one of CVS stores.
• Retail mobile app already available that helps consumers manage when and how they want to receive their medications, set reminders, and manage medications for their families.
  • To date, the CVS Pharmacy app has been downloaded 21 million times.
  • 50 million people are enrolled in our text message program, which enables them to easily refill their prescriptions through their mobile devices.
    • Refilling is as easy as typing ‘YES’ to a refill reminder.
• Links to app:
  • Google Play Store
  • Apple iTunes
• Link to Q3 Investor presentation

Biggest Concern or Opportunity:  CVS merger with Aetna (AET)

• From the Economist:  It is an example of “vertical integration”, in which separate bits of a supply chain are brought together under one roof. This tie-up would reach across three distinct layers of the health-care industry: the retail pharmacies for which CVS is famous; the pharmacy-benefit managers (PBM), intermediaries which negotiate drug prices on behalf of medical plans and whose number again includes CVS; and the insurers, like Aetna. Supporters of the deal argue that aligning the interests of insurers and pharmacies would reduce costs and improve life for consumers. An insurer that could send patients to walk-in clinics of the sort CVS owns would be better placed to monitor and improve results.
• From the Washington Post:  A successful deal could push millions of Aetna’s members toward CVS’s retail pharmacies, walk-in MinuteClinics and home services for infusion drugs at a time when retail pharmacy companies are facing stiff competition.  It would also give Aetna the ability to move deeper into the lives of the 44.7 million people it serves and manage their health care more efficiently. For example, the insurer might be able to create better coordination of care using insights from CVS’s retail clinics and pharmacies.
• From Bloomberg:
  • Citi, Alvin Concepcion (CVS Neutral, Price Target $87):
  • “We see this potential deal as both evolutionary and revolutionary given the dynamic healthcare environment and push toward consumerism coupled with a challenged retail backdrop and the need to combat a looming Amazon threat. In our opinion, the merits of the deal and potential new model is conceptually compelling, with the biggest questions admittedly, execution, integration, and the structure of the deal. Based on our analysis, we estimate the deal could be 24 cents per share, or 3.7 percent accretive to CVS in year one with greater upside over time if the combined entity successfully manages down healthcare cost.  Could they even do the deal? It’s possible. The reported deal could imply a takeout value of 12.4x trailing 12 months (TTM) Ebitda by our estimate. Based on CVS’ acquisitions of Caremark (in 2006 for 11.8x TTM Ebitda), and Omnicare (in 2015 for 22.0x TTM Ebitda), this deal could be in bounds.”
  • Mizuho, Ann Hynes (CVS Buy, $90 Price Target):
  • “We think a CVS / AET combination makes a lot of sense. We would imagine a scenario that CVS expands its MinuteClinics or creates mini urgent centers in CVS stores to direct patients to these lower cost settings via copay differentials (i.e., zero co-payment if treated at a MinuteClinic versus $500 at the ER). Similar to formulary management in pharmacy, this type of partnership between a retail pharmacy and a managed care company could be the next generation of formulary management in healthcare services. ER expenses are massive for managed care companies and a lot of non-acute cases are treated in this setting unnecessarily.  Assuming the price per share of $200 is both accurate and includes debt, we estimate the 2017 and 2018 enterprise value to Ebitda ratio to be 11.0x and 10.0x consensus estimates, which in our view is reasonable. If we are correct on our thesis in the expansion of MinuteClinics, this valuation does not take into account that investment. We would assume a portion of the deal is paid in stock. Assuming a 50% cash/stock split, we estimate proforma leverage for CVS around ~3.5x.”
  • Leerink, Ana Gupte (Outperform on Anthem, $245 Price Target; market perform on Aetna, PT $150):
  • “We had viewed this combination as less likely after the contract inked by CVS with Anthem last Wednesday, given it is an EITHER/OR for CVS, not an AND. We had seen the Anthem pharmacy benefit manager (PBM) contract offering a stop gap for CVS not just on the slowing PBM revenue growth but also on front store sales as Anthem’s close to 40 million members shop at CVS retail stores through 2024. However, Anthem is not being viewed as the prize by CVS, and the connection and shared vision of an Aetna-CVS combination is likely too juicy to pass up by the two managements. Further, the likely Amazon entry into retail pharmacy is a major threat to CVS, on top of already dwindling front store sales.”
    “The anti-trust challenges look manageable in our view though some Medicare Part D divestiture may be needed to address the combined share and overlap. Anthem will potentially look for another alternative. Maybe resurrect the failed marriage with Express Scripts?? Anything is possible in our view.”
  • Cowen, Charles Rhyee and Christine Arnold (CVS Outperform, $86 Price Target; Aetna Outperform, $170 Price Target):
  • “We see the move into healthcare services as a natural defense against the potential threat of Amazon entering the retail pharmacy market. Our question, however, is why can’t CVS affect the transformation into a healthcare platform on its own? After spending $76 billion for AET, it will have to spend additional capital to transform its retail footprint. Couldn’t CVS effect the changes to its retail footprint and then partner with multiple health plans, including AET, and achieve similar results with less capital? For example, the entire urgent care market is currently $16 billion. CVS could roll up that entire industry and acquire Quest Diagnostics and DaVita for less than the cost of acquiring AET.”
    “We believe the potential sale of Aetna has two potentially negative read-throughs for the managed care sector. First, we do not believe Aetna would be a willing seller, even being valued at a 25 percent plus premium, if it believed it could generate similar, or greater, returns for shareholders via organic growth and/or acquisitions. Second, we believe a takeout premium is currently priced into shares of WellCare, Humana, and to a lesser extent, Centene and Molina, with Aetna and Cigna as the most likely potential buyers.”