Below is an update on where we stand on CVS, and why the stock has been under pressure recently:
1. Omnicare underperformance: while we were hoping for this turnaround to take place, CVS ended up writing down a big piece of this long-term care business in 4Q18. This puts pressure on CVS to successfully integrate Aetna and execute on their synergies and strategic vision.
2. Democrat’s push for a “Medicare for All Act of 2019” bill that would replace almost all private health insurance. The measure would push all Americans (even under 65) towards a Medicare program within 2 years. Premiums, deductibles and co-pays would disappear, and guarantee a universal health care system. Medicare would dictate doctor’s fees and drug prices. No details on how much this would cost or how it would be funded… CVS’s stock however went down with the news… We think this bill is unlikely to pass.
3. The PBM model is under pressure as new legislations are being discussed:
· The Human Health Services issued a proposed rule to remove the safe harbor for drug rebates (on the government side of the business) currently permitted for Medicare and Medicaid managed care, which would directly impact PBMs. The rule would also create two new safe harbors for (1) discounts provided to the consumer at point-of-sale and (2) flat, fixed service fees paid by manufacturers to PBMs. PBMs have stated in the past that they do not keep any rebates earned under government programs, as this compensation is disclosed to CMS and reflected in plan bids in the form of lower Medicare Advantage and Medicare Part D premiums and lower Medicaid managed care plan bids.
· “The Drug Pricing Transparency Act” would force PBM in the commercial market to pass rebates to the patient directly (point-of-sale rebate). Other proposed changes are included in the bill, such as: utilizing an international pricing index in Part B, direct negotiation of drug prices by Medicare, etc… The details and impact of this bill on the supply chain economic model are still unclear at this time. CVS already offers that option, with increased acceptance in 2019 from the healthcare insurance participants. CVS only kept $300M worth of rebates (less than 3% of its 2018 EBIT).
Rebates have been a great tool used by PBMs to offer an attractive service package to their clients, and recently less of a way to make profits (profit margins are very low vs. pharmacy/managed care profits).
Valuation:
Today’s stock price for CVS reflects the above challenges. Our DCF model shows that today’s price only account for 2 segments out of 3: the retail pharmacy (stores and pharmacy business) and the Aetna segment. Even the recently negotiated 5 year PBM contract with Anthem would disappear. The PBM segment would go to zero in 2020, with the rest of CVS’s business growing at a 1% rate thereafter.
Here’s where we disagree:
· Pharmacy sales continues to grow nicely, not just due to higher drug prices (which has slowed down in 2018), but also due to higher script volume (average growth of 4% in past 7 years).
· PBM segment is unlikely to radically disappear in 2020. We could see margins contract as the government steps in, but levels are already very low (~3.5%). Also we can’t forget the power of lobbyists.
· Rebates profits are small for CVS, and we believe companies like CVS could play a role in regulating pharma prices even more. We think the main issue with drug prices does not lie solely with the PBM model but with a broader patent and FDA laws issue. By allowing Pharma to hold patents for decades, new cheaper alternatives are left out of the market place, allowing them to raise prices without competition. Recently though, Pharma companies have been trying to gain some goodwill by cutting prices or launching new generics.
· Anthem is to provide an estimated $3.8B in sales in 2019 in its first year in place, then $11B in 2020, and $62B in 2021 as the contract matures. Total PBM revenue in 2018 were $134B, so Anthem is not a negligible customer.
So in conclusion, while CVS has been under tremendous pressure, we advocate for remaining patient with this name. We continue to like its long-term thesis of vertical integration and solutions provider to clients, such as its MinuteClinic proposition and new HealthHub store format (see video below).
https://cvshealth.com/thought-leadership/cvs-health-testing-new-healthhub-store-format
$CVS.US
[tag CVS]
Julie S. Praline
Director, Equity Analyst
Direct: 617.226.0025
Fax: 617.523.8118
Crestwood Advisors
One Liberty Square
Suite 500
Boston, MA 02109