2023-06-15 12:28:51 ET
Summary
- CVS has had a rough 2023.
- Some of the drop was deserved on the back of floundering earnings estimates.
- More downgrades are likely in the medium term, and we won't see growth next year.
- Valuation is a saving grace.
When we last covered CVS Health Corporation ( CVS ) we gave it a buy rating on the back of solid cash flow and consistent deleveraging. The stock initially outperformed the S&P 500 ( SPY ) and even in the healthcare select sector SPDR ETF ( XLV ) from there. At one point it was up nearly 90% leading both SPY and XLV by over 50%. But has lost considerable ground in the last few months and giving up all that outperformance.
What's Going On?
Investors must be wondering where did all those gains go. Well, in our last article, there was one paragraph that has some bearing on the current setup.
Interestingly, instead of hurting CVS, the pandemic helped it as it had a very low benefit payout ratio on the insurance side. This was driven by deferral of many procedures during the peak of the lockdown and, on the flip side, will likely also reduce earnings to some extent in the coming quarters.
Source: A Look Under The Medical Hood
While the "coming quarters" portion did not play out exactly, the big expected increase in procedures deferred during the pandemic might be coming to haunt the company. While CVS had gently guided estimates lower at the end of 2022 and after Q1-2023, the sudden pressure came from UnitedHealth Group Incorporated ( UNH ) scaring the managed care sector yesterday.
UNH scared investors at its Goldman Sachs investor conference. The CFO predicted that the medical care ratio will likely exceed the upper end of its full year range of 82.6%. Interestingly, the comments seemed to be specific for Q2-2023. The additional comments provided suggest that the annual numbers are likely to still be within that range. Nonetheless, the managed care sector did an epic swan dive.
Our Outlook
While we did not cover this stock for over two years, we have been following the trends in this sector. Our take is that the deferrals in elective procedures and even routine care were quite severe during 2020 and 2021. 2022 was sort of a normalization year. 2023 is payback time. The industry is possibly underestimating the catch-up in 2023 and beyond. There is also a potential blowback as we treat more severe forms of disease later as we missed catching these earlier.
Specifically, when excluding care directly related to Covid-19, the volume of primary care visits was down 10.3% in 2021 compared to 2019, suggesting consumers won't be using primary care more now to make up for the care they missed out on during the pandemic. Some of this is to be expected: a person who did not see a physician for diagnosis and treatment of the flu does not need to "make up" for not seeking that care. But delayed or forgone visits for routine screening for heart disease, diabetes, cancer, and other conditions, or for other preventive care, will inevitably result in delays in treating serious diseases that might have been prevented, or at least diagnosed earlier.
Source: Stat News
You could see spiked medical cost ratios all across the industry in 2023 to 2025. Extending this to CVS, we can see that analysts were already lowering their estimates for the last few months.
As seen above, the consensus was more revenues and less EPS. This was partially related to the massive Oak Street Health acquisition, which will close a bit earlier than expected.
We successfully closed the acquisitions of Signify Health and Oak Street Health and are updating our projections to include the financial impact of both transactions. We are revising our full year 2023 adjusted EPS guidance through a range of $8.50 to $8.70, reflecting the positive contribution of our strong underlying results and the impact of the Signify Health transaction, which enables us to partially offset the dilution from the early close of Oak Street and the financing costs for both transactions.
Source: CVS Website
We don't think an elevated cost ratio is priced in into CVS' estimates. For 2023 and 2024, we would look a bit lower than the low end of estimates.
That would mean contracting EPS for two straight years, something growth investors might have a hard time digesting.
Valuation & Verdict
Investors have appreciated CVS' free cash flow yields several times in the past. Each time they thought they would get to enjoy those in shareholders returns, and each time CVS did an acquisition.
Pharmacy benefit manager Caremark came in 2007. Insurance provider Aetna, which we wrote about at the time, came in 2018 and now with substantial deleveraging complete, we got Signify Health and Oak Street Health. While one can be critical of these purchases, CVS sees the bigger risk here as one where they don't integrate the entire healthcare chain and become a company that is at the mercy of larger players. Oak Street Health was particularly telling, and CVS paid about 5X trailing revenue and 3.5X forward revenues. We wish we could add some profitability metric here, but Oak Street will be losing money even on the most generous of metrics, adjusted EBITDA.
Oak Street Health January 2023 Presentation
Sure, when CVS bought it, they did throw this lollipop for the investors.
Oak Street specializes in treating Medicare Advantage patients and its network of clinics is expected to grow to over 300 centers by 2026, with each offering $7 million in potential embedded earnings before interest, taxes, depreciation and amortization, according to the company. CVS expects the merger to drive more than $500 million in synergy potential over time, bolstering its long-term growth goals.
That is $2.6 billion total of potential EBITDA, which makes the $10.6 billion acquisition sound very palatable. But the ball is now back in CVS' court to make even this acquisition work, just as they finished proving themselves on Aetna.
On the plus side, CVS is trading at less than 8X (non-GAAP) earnings and at a similar free cash flow yield. Credit rating agencies were not too enthused with the purchase, and Moody's ( MCO ) even commented on the extremely rich price for Oak Street Health.
Tempering these strengths, CVS faces execution risk as it rapidly expands its primary care business, involving the acquisitions of physician-led centers (Oak Street Health) and integrated virtual and home healthcare assets (Signify Health). Absent other large acquisitions, we anticipate lease-adjusted gross debt/EBITDA of 3.5x - 3.75x over the next 12 to 18 months, including an adjustment for opioid liabilities. CVS faces intense competition, reimbursement rate pressure, and regulatory uncertainty, especially pertaining to drug pricing and PBM business practices.
Source: Moody's.
But the debt rating was maintained, as CVS has shown a great history of prompt paydowns. Overall, CVS likely makes this work, even though we don't think that $2.6 billion of adjusted EBITDA target from Oak Street Health will be met. Over the next three years, look for a focus on deleveraging and some increasing pressures on the cost side. Overall, we would not be surprised to see 2025 earnings per share under $9.00. So while it is a great value play here, we don't see material upside while the company is focused on deleveraging. We think the stock will be range bound between the $60 on the low side and $80 on the high side in the next 18 months. This gets us to a hold rating but considering the compelling valuation, cash secured puts would be an attractive choice for investors looking for income.
Author's App
The January 2024 $65's looks great, with the net price coming to the low end of our potential trading range.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
For further details see:
CVS Health: More Earnings Downgrades Coming But Stock Reaching Compelling Valuation