CVS Health: A Complicated Business Adapting to Healthcare Changes

CVS Health (CVS) was founded in 1963 with three Consumer Value Stores located in Lowell, Massachusetts. It has grown into the second largest drugstore company in the US with close to 10,000 retail locations.
CVS is also one of the nation’s largest pharmacy benefit managers and health insurance providers, positioning itself as a uniquely diversified and vertically integrated player in the health care industry.
CVS organizes itself into three business segments:
  • Pharmacy Services (56% of revenue, 40% of profits): as one of the largest pharmacy benefits managers  (PBM) in the nation, CVS provides services to employers and insurance companies by determining which drugs are covered for patients and negotiating rebates from drug makers and discounts from drug stores.

  • Retail Pharmacy / Long-term Care (35% of revenue, 53% of profits): CVS's retail drugstore business derives about three-fourths of its revenue from prescription drug sales, with a wide assortment of merchandise (over-the-counter drugs, beauty products, cosmetics, personal care products, etc) and walk-in medical clinics accounting for the remainder. 

  • Health Care Benefits (9% of revenue, 7% of profits): consists of Aetna's health insurance business, which CVS acquired for $78 billion in 2018. Aetna makes money from the premiums charged on its insurance plans, as well as fees from co-payments, claim processing, and other member services.
CVS has paid uninterrupted dividends since 1997 and increased its dividend each year for more than a decade through 2017. However, following the Aetna acquisition, management announced it would freeze the dividend until CVS achieved its deleveraging targets. As a result, the firm's 14-year dividend growth streak came to an end in 2018.
Business Analysis
Pharmacy retail (about half of CVS's income) is a tough industry characterized by fierce price competition and little differentiation. There are few noticeable differences between a CVS or Walgreens store and many grocery chains and big box retailers operate pharmacies within their stores as well. 

Driven by acquisitions of other pharmacies, CVS's historical success largely is largely due to the convenience of its nearly 10,000 retail outlets which are located within 5 miles of 75% of the nation's population.

About half of Americans take at least one prescription drug, and odds are a CVS or Walgreens store (or their mail order services) provides the most convenient pick-up location for many people.

After all, CVS and Walgreens together control at least 50% of the market share in 70 of the 100 largest metro-areas in America, according to a 2015 report from Barclay's. (Consolidation has only increased since then.)

Pharmacy benefit managers and insurers want their plan members to have convenient and affordable access to necessary medications. They decide which pharmacies are included in their retail pharmacy networks for their prescription-filling members.

CVS's scale (better able to negotiate lower drug prices with distributors) and nationwide reach make it an essential partner in many cases. This gives CVS relatively more bargaining power compared to smaller pharmacies when negotiating drug reimbursement rates with PBMs and insurers, helping protect its profitability. 

Meanwhile, the essential nature of prescription drug purchases guarantees consistent foot traffic into CVS's stores. This creates opportunity for CVS to sell high-margin consumer merchandise in the front of its stores. 

With America's population aging and spending more on health care, CVS's retail pharmacies have long enjoyed steady growth and healthy margins.

CVS's PBM business (about 40% of profits) has served as an important driver, too. This  industry also benefits from a consolidated market, with the top three players processing nearly 80% of all prescription claims

Many employers and insurers outsource activities related to prescription drug coverage for their members due to the complexities of health care and their limited scale; aggregating their purchasing under a large PBM maximizes purchasing power to help keep costs low. 

As the largest PBM, CVS's handling of substantial prescription claims provides it with more power to achieve bigger rebates from drug manufacturers. Coupled with its own retail pharmacy network (one less middleman to pay in the prescription drug chain), CVS is positioned to help keep drug costs low for health insurers and their members.

However, the health care sector is evolving as it looks to reduce costs, including efforts to make prescription drugs more affordable. This has created growth challenges for CVS (more on that in the Key Risks section).

Management has responded in a big way, buying up health insurer Aetna in a nearly $80 billion deal in 2018 that represents CVS's largest ever acquisition. By combining drug stores, PBM services, and insurance operations, CVS envisions a future where it can drive down medical costs and make quality care more convenient for customers.

For example, Aetna was a customer of CVS's PBM, providing opportunity to take out costs. Additionally, rather than direct members to in-network doctors, Aetna can now offer medical care directly to consumers via CVS's medical staff and pharmacists, cutting out more middlemen along the way.

CVS is turning more of its stores into health care hubs to meet this need with hopes of bringing additional customers into its retail shops. This would potentially increase CVS's medical services revenue, result in more prescriptions being filled, and lift sales of consumer merchandise to improve its long-term growth outlook.

However, change never comes easy in the health care space, and CVS limited its financial flexibility after buying Aetna due to the high debt load it took on. 

In fact, management suspended share repurchases and froze CVS's dividend with hopes of deleveraging to its target goals by 2022, at which point dividend growth may resume if all goes according to plan.

Several challenges stand in the way, though.
Key Risks
CVS operates in a complex sector in three highly regulated and risk-prone industries (drug distribution, PBMs, and health insurance).

According to a recent report from the Centers for Medicare and Medicaid Services, U.S. health care spending is expected to rise from 17.7% of GDP in 2018 to 19.4% by 2027.

While rising health care spending is a growth opportunity for some companies, it's also a double-edged sword because it leads to calls from private and public payers (like Medicare and insurance companies) to slash costs in industries where margins can be thin already.

Numerous health care laws and regulations to address drug costs are under consideration at the federal and state level with the potential to adversely impact profits in all three of CVS business segments: PBM, retail drug sales, and health care benefits.

With over half of CVS's profits coming from retail pharmacy, the firm's margins could face pressure if drug prices do not decline enough to offset increasing downward pressure on insurers' reimbursement rates. CVS's ownership of its own PBM provide some cushion, but this industry trend seems likely to continue.

Additionally, retail sales of personal health care products are under pressure from e-commerce. The convenience of click-to-order and free next-day delivery is hard to beat. Amazon's recently acquired virtual pharmacy, PillPack, now a licensed pharmacy in 49 out of 50 states, has begun selling directly to insurance companies, too. 

CVS has responded with its own e-commerce and delivery programs, yet reducing foot traffic into its retail stores is not to its advantage if front-end merchandise sales fall. The company could become increasingly dependent on its Health Care Hub strategy to drive retail traffic growth, for better or worse. 

Meanwhile, although PBMs are supposed to reduce drug costs for consumers, the opaque and complex issue of rebate money has instead contributed to increased costs for consumers and insurance companies.

Congress is investigating pharmaceutical companies' business practices and the role of PBM-negotiated rebates in drug costs and profits, which could pressure the profitability of this division.

In response to these challenges, the health care industry is undergoing consolidation as exemplified by CVS's acquisition of Aetna. Management has bet big on a model of integrated delivery of its services and took on a heavy debt load in the process.  
Overall, CVS's long-term growth seems to depend on a variety of factors that are outside management’s control. Laws and rules governing CVS’s core businesses continue to expand, are becoming more restrictive, and are subject to frequent change. 
Anyone considering CVS needs to fully understand these highly complex and ever-changing political and regulatory risks, which make forecasting how quickly CVS can deleverage and return to dividend growth a difficult task.   

Closing Thoughts on CVS Health
It’s hard to grasp all the changes happening across the health care industry. From increased drug price scrutiny to reimbursement rate pressures and the potential for PBM business models to change in ways that would harm CVS’s profitability, there are a number of concerns that make it difficult to predict CVS’s long-term earning power. 

Historically, CVS has been very good at adapting to fast-changing and challenging industry conditions. CVS has so far made good strides integrating Aetna into its business and all three business segments are showing growth, allowing the company to pay down debt as planned.

CVS's business transformation has solid upside potential if it works, but conservative dividend growth investors considering the stock need to be comfortable with the firm's elevated leverage profile and any of the pitfalls that could trip up CVS in the future.

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