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

2023-05-12 13:41:59 ET

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.

Introduction

I have been an investor in CVS Health (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.

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).

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%.

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:

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.

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 ).

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.

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