WBA - CVS Health Earnings And 2023 Outlook: Bearish On Oak Street Buyout

Summary

• CVS Health Corporation reported FY22 earnings this week. The company grew revenues by >10% and on an adjusted basis at least, EPS grew slightly.
• Performance across all 3 business segments - healthcare benefits, retail, and pharmacy benefits - was solid and the outlook for 2023 is OK.
• Not everything is functioning as it should be, however. Medicare Advantage plans are losing their 4+ star ratings, and arguably the PBM business is underperforming.
• CVS has spent nearly $20bn on Signify Health and Oak Street Health in order to build out its Primary Care presence. This strategy may be flawed, however.
• CVS remains a solid blue chip paying a decent dividend but I am not anticipating the company share price to perform well in 2023. CVS would have been better off paying down debt than making unnecessary acquisitions.

Investment Overview

CVS Health Corporation ( CVS ) reported its FY22 earnings earlier this week - let's quickly familiarize ourselves with the headline figures.

In FY22 CVS increased revenues by 10.4% year-on-year to $322.5bn. The company delivered GAAP diluted earnings per share ("EPS") of $3.14 and adjusted EPS of $8.69, down by 47% and up by 3.5% year-on-year, respectively. Cash flow from operations was $16.2bn, versus $18.3bn in FY21.

Adjusted operating income was broadly flat year-on-year at $17.5bn, versus $17.3bn in 2021. The operating income margin in FY22 was 5.4% versus 5.9% in the prior year.

Non-adjusted operating income was down by 41% for the year - from $13.1bn, to $7.7bn which CVS reports is due to:

$5.8 billion of opioid litigation charges and a $2.5 billion loss on assets held for sale related to the write-down of the Company’s Omnicare long-term care business...partially offset by the absence of the store impairment charge of approximately $1.4 billion

By Division

Across CVS' 3 major divisions, the Health Care benefits segment drove $91.4bn of revenues, up 11% year-on-year, and operating margin was 6.5%.

Pharmacy Services segment drove $169.2bn of revenues, which was an increase of 10.6% year-on-year, and operating margin was 4.3%.

The Retail / Long Term Care ("LTC") segment drove $106.6bn of revenues, which is an increase of 6.5% year-on-year, and operating margin was 6.3%.

Eagle-eyed readers may have noticed that the 3 divisions add up to more than the stated overall revenue reported figure of $322.5bn. This is due to the different divisions' occasionally accounting for the same revenues, e.g., when a Pharmacy Services client opts to pick up a prescription in-store, which results in Pharmacy Services and Retail claiming the same revenue.

The revenues split between the 3 divisions is roughly 25% for Health Care Benefits, 46% for Pharmacy Services and 29% for Retail / LTC.

Balance Sheet / Debt Leverage / Dividends & Repurchases

CVS reported (via its 10K submission ) a cash position of $12.95bn as of FY22, and total current assets of $65.7bn, with long-term investments of $21bn. Current liabilities were reported as $69.7bn, with long-term debt being $50.5bn, and operating lease liabilities of $17bn.

In terms of debt ratings, in its 10K CVS states:

As of December 31, 2022, the Company’s long-term debt was rated “Baa2” by Moody’s Investors Service, Inc. (“Moody’s”) and “BBB” by Standard & Poor’s Financial Services LLC (“S&P”), and its commercial paper program was rated “P-2” by Moody’s and “A-2” by S&P. The outlook on the Company’s long-term debt is “Stable” by Moody’s. In December 2022, S&P changed the outlook on the Company’s long-term debt from “Positive” to “Stable.”

CVS says it has repaid $25.2bn of long-term debt since making its ~$70bn acquisition of health insurance giant Aetna in 2018, and Chief Financial Officer Shawn Guertin told analysts on the Q422 earnings call that:

adjusted net debt to EBITDA is about 2.9x. Excluding the adjustment for cash at the parent or unrestricted subsidiaries, our adjusted debt-to-EBITDA is approximately 3.1x.

CVS also notes in its earnings presentation that it returned $2.9bn in shareholder dividends, announced a 10% increase in the dividend payout - which now stands at $0.605 per quarter and yields ~2.75% at current traded share price - and that it repurchased $3.5bn of common stock in 2022, with a further $2bn accelerated share repurchase effective January 3rd, 2023.

Looking Ahead - FY23 Guidance

CVS provides guidance for all 3 business segments, but collectively it has guided for total revenues of $332.7 - $338.5bn in 2023, and adjusted operating income of $17.32bn - $17.67bn, with GAAP EPS of $7.73 - $7.93 and adjusted EPS of $8.7 - $8.9, and cash flow from operations $12.5bn - $13.5bn.

That translates to a year-on-year revenue uplift of 3-5%, and adjusted EPS growth of 5-8%.

Healthcare benefits revenues are expected to grow by 11-13% to $101.4bn - $102.9bn, with adjusted operating income $6.11bn - $6.24bn - up 2-4%, Pharmacy Services revenues by 1-2% to $170.2bn - $172.7bn, with operating income up 4%-5% to $7.62bn - $7.74bn, and Retail Services to $108bn - $109.7bn, up 1-3%, with operating income of $5.95 - $6.05, down by (11%) - (10%).

Interest expense is expected to be ~$2.23bn, and adjusted tax rate ~25.5%, whilst share float is forecast to be 1.298bn.

M&A / Business Development

In September 2022, CVS announced that it would acquire home healthcare agency Signify Health ( SGFY ) for $30.5 per share in cash, which values the deal at ~$8bn. The transaction is expected by CVS to close in the second quarter of this year, management told analysts on the Q422 earnings call, although the Department of Justice ("DoJ") has been investigating the deal on antitrust grounds.

At the same time as announcing its Q422 results, CVS announced a second major acquisition, of Chicago based value-based primary care provider Oak Street Health ( OSH ) in a deal worth $10.6bn, or $39 per share. CVS is keen to build out its primary care business, and management believes that Oak Street meets its requirements, although, as with the Signify deal, this purchase may be subject to further regulatory scrutiny.

CFO Guertin told analysts on the earnings call that:

Within the 169 clinics Oak Street has today, we have high visibility into embedded adjusted EBITDA of over $1 billion.

We also recognize the tremendous opportunity to scale Oak Street’s clinics to reach more seniors across the nation. At their current rate of expansion, we expect Oak Street to have over 300 clinics by 2026, at which point we project they will have more than $2 billion of embedded Oak Street adjusted EBITDA.

CVS' business development extends beyond Oak Street and Signify, with the company announcing 3 more investments at the JP Morgan Healthcare Conference last month - a $100m investment in primary and urgent care provider Carbon Health, $25m to behavioral health company Array Behavioural Care, and $375m into polychronic healthcare provider Monogram Health.

Analysis - Frankenstein's Monster Or The Last Word In Holistic Health Care?

CVS Health is generally regarded as a classic "Buy and Hold" dividend paying, >$100bn market cap blue chip, and the company's share price performance over the past 5 years has been broadly satisfactory.

CVS stock has risen in value by 32%, which underperforms the S&P 500 (SP500), which is up +49% over the same period, but is far superior to rivals such as Walgreen Boots Alliance ( WBA ) or Rite Aid Corporation (RAD), whose share performance over the same period is respectively -48% and -91%.

The reason for that is most likely CVS' diversification into health insurance via the Aetna buyout, and going back much further, its $24bn buyout of Pharmacy Benefit Manager ("PBM") Caremark in 2007. These acquisitions have transformed CVS from a drugstore franchise into a holistic healthcare giant that can provide insurance cover, access to medication, and access to physicians who can help reduce the costs of administering healthcare, keeping patients out of the hospital.

CVS is now the 6th largest company listed in the US in terms of revenues generated, although its EBITDA generation is the lowest of the top 6 companies. These are, respectively, Walmart ( WMT ), Amazon ( AMZN ), Exxon Mobil ( XOM ), Apple ( AAPL ), and UnitedHealth Group ( UNH ), and is nearly 2x lower than the the next lowest, Walmart - EBITDA of $32bn (2021 figure). It's price to earnings ratio is the highest, at 28.5x, although its price to sales ratio is the lowest, which hints at an underlying issue at the company - namely, profitability.

Although CVS' cash flow in 2023 is likely to be an impressive ~$13bn, it will nevertheless be substantially down on the figure generated in 2022 - $16.2bn - which itself is less than the figure generated in 2021. There is still a large debt pile to pay down, and CVS needs to make sure it does so in a timely manner in order to make sure its debt continues to be rated as investment grade - a failure to do so would have severe consequences.

That is why I have some doubts about the acquisitions of Signify and Oak Street, and the direction that CVS wants to take going forward. The company is already a three-headed monster with a massive presence in retail, insurance, and pharmacy - did it really need to stitch on 2 more limbs?

Why Oak Street & Signify Deals May Not Add Up To Sum Of Parts

In 2022, according to research , around 24.8m people - or 48% of all eligible Medicare beneficiaries - are enrolled in Medicare Advantage plans. That's nearly twice the number that were enrolled in 2007, and by 2032, it is estimated 61% of all eligible people will be enrolled.

Medicare Advantage is clearly the space that health insurers want to be in and CVS, thanks to its Aetna acquisition, has an ~11% share of the market, with ~3.1m enrollees. UnitedHealth, with 7.9m members and 28% market share, and Humana ( HUM ), with 5m members and 18% market share are the largest incumbents. CVS had the fourth largest growth in plan enrollment in 2022, adding ~282k members.

It hasn't all been plain sailing in the MA space for CVS, however. CVS has seen the star ratings allocated with its plans fall, and by 2024, it is predicted , only 30% of its members will be in 4+ star plans, versus 78% this year. That means missing out on bonuses worth >$1bn, which is going to hurt the segment's profitability.

CVS also lost out on a $35bn contract to manage health insurer Centene's prescription drug contracts last year, with the contract awarded to Express Scripts instead, which is owned by rival Cigna ( CI ). These size of contracts do not come along very often, and the miss is likely to impact its growth prospects. In summary, you could make the case that both CVS' Healthcare Benefits and Pharmacy Services segments are underperforming.

CVS has apparently been looking to acquire a primary care operator as part of its plan to create a vertically integrated business that works for payors, patients, and physicians, finally setting on Oak Street.

Presently, Oak Street operates 169 clinics in 21 states, and by 2026, CVS estimates that figure to reach 300, with each clinic generating ~$7m of EBITDA, which is how CVS believes it will achieve a $2bn annual EBITDA contribution through this $10bn acquisition - which sounds like good business, although rather than investing $10bn to generate $2bn in 3 year's time, CVS could have spent one fifth of that amount paying its interest expense for 2023 off, and reducing its debt burden substantially.

Furthermore, Oak Street is not profitable, despite having borrowed heavily to grow its business. Operating income in 2021 was $(411m), and adjusted EBITDA at the end of 2022 is forecast to be ~$(290m).

Health insurance is not an especially high margin business compared to e.g. Pharmaceuticals, where profit margins are typically >20%. Health insurers generate colossal revenues, but it's rare to see a health insurer with a profit margin >5%.

Oak Street is essentially a "middleman" style business attempting to make a profit by administering care for less than they receive in rebates, but that is also the business model of health insurers and by adding an extra middleman to its layers of business operations, it's tough to see how CVS improves margins.

That is why the likes of Humana, Centene ( CNC ), and Cigna, for example have typically kept these types of operations in-house, and would have been unlikely to move for an Oak Street, or an Apollo Health ( AMEH ). There is no firm evidence that they can help a health insurer become more profitable.

Oak Street claims to streamline healthcare administration by keeping patients healthy and ideally out of the hospital, but even this business model is flawed in a way - incentivizing a business to avoid administering expensive healthcare is not likely to prove popular with buyers, and not likely to improve CVS' star ratings either.

In the case of Signify Health, this company simply does not enough generate revenue to make a significant impact on CVS top line in my view, plus the company reported a net loss of $540m across the first 9m of 2023.

Conclusion - CVS' Desire To Bolster Its Presence In Primary Care Looks Flawed Whilst Underperforming Divisions May Drive Valuation Down In 2023

CVS delivered some broadly positive FY22 earnings, with all 3 of its business segments both profitable, and growing, and that will likely satisfy the majority of the company's shareholders who are holding stock long term and collecting a reasonably generous dividend.

Looking ahead to 2023 and beyond, however, I see a few issues weighing down on the company, and suspect CVS may be pursuing a flawed strategy with its Primary Care ambitions.

Its Medicare Advantage business is going to suffer downgrades to its star ratings, which will hamper its ability to generate meaningful profits over the long term, in what is not typically a high margin business anyway.

This is likely to have an impact on its pharmacy services segment, which is doing ok in terms of revenue growth, but appears to be becoming less profitable, and is arguably - based on the failure to win the Cigna contract - not a top ranked PBM. It may also have a trickle down effect on the Retail segment (remember the overlapping revenues discussed earlier?).

CVS seems to want to solve these issues by becoming a Primary Care pioneer and fundamentally altering the healthcare landscape, and with its acquisitions of Signify and Oak Street it can visit patients at home and bring them medications, help them manage their healthcare needs, and apparently all of this this will add >$2bn to EBITDA by 2026.

To date, however, CVS has spent nearly $20bn on 2 unprofitable companies with unproven business models, that seem to carry a heavy administrative burden and lack the size and scale to compete at the level CVS wants to compete at.

CVS presumably believes it can grow these businesses itself and create a new paradigm in healthcare, but it is worth noting that patients are typically resistant to change in healthcare, liking things as they are. That is why e.g. valuations of telemedicine companies have been decimated in the past couple of years - patients are broadly content with the existing system - and it is also why CVS' retail business continues to thrive.

That is why I think CVS may end up with new businesses that consume lots of cash, and add lots of staff and systems to the company's already creaking operating budgets, that are not strictly necessary - which is the last thing a low margin business like CVS needs.

In my view, CVS - having captured the business it really needed in Aetna already, giving it access to the Medicare Advantage market - would have been better off allocating the $20bn spent on Oak Street and Signify to paying down debt, repurchasing shares, or raising the dividend.

Instead it is preoccupied with building out a loss-making business that neither patients, payors, or physicians really seem to want.

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