Originally published in partnership with INO.com
CVS Health (NYSE: CVS) has been struck in a sideways trend since selling off over 24% from August through November 2016. CVS fell from an all-time high of ~$112 per share in 2015 to ~$70 in November of 2016 wiping out 38% of its enterprise value. Since its high of $112 in 2015, a slew of issues negatively impacting its growth and marketplace have plagued the stock. Firstly, the political backdrop was a major headwind for the entire pharmaceutical supply chain from drug manufacturers to pharmacies/pharmacy benefit mangers (i.e. CVS and Walgreens) and the drug wholesalers in-between (i.e. McKesson and Cardinal Health). Secondly, recent marketplace trends forced CVS to cut guidance for Q4 2016 and the full-year 2017 numbers. CVS stated that “unexpected marketplace actions that will have a negative impact on our Q4 2016 results and a more meaningful impact on our outlook for 2017”. Thirdly, CVS lost a contract with the Department of Defense which carries tens of millions of prescriptions on an annual basis. A new restricted network relationship between Prime Therapeutics and Walgreens impacts CVS Pharmacy’s participation in selected fully-insured networks in several key states and in many cases make CVS Pharmacy a non-preferred provider for Medicare Part D as well. These prescriptions trend to be the most profitable prescriptions as well. Lastly, Amazon’s purchase of Whole Foods has incited rumors that Amazon is looking to gain entry into the pharmacy space via leveraging the Whole Foods physical foot print od store fronts. I’ve written several articles contenting that CVS presents a compelling investment opportunity in the ever expanding healthcare space. My investment thesis was based on proposed sector consolidation (Rite Aid and Walgreens), aging population and growth in long-term care facilities and the pharmacy benefit management segment. All of this in a backdrop of CVS being highly acquisitive, continuing to deliver robust earnings growth, revenue growth, growing dividends and has an aggressive share buyback program in place. It’s a matter of time before CVS will trend higher and in the meantime investors will be paid to wait via dividends and share buybacks. The wildcard may be the Amazon threat with its first real pivot after acquiring Whole Foods with subsequent potential in entering the pharmacy space as well.
The Amazon Effect
With its past acquisitions of Target’s pharmacies and Omnicare, these proactive measures significantly expanded its presence and ability to dispense prescriptions to the general public and in long-term care facilities. As healthcare costs and prescription drug costs continue to rise and the population continues to age with the elderly comprising a larger segment of the overall population, CVS still looks poised to benefit. CVS has strong fundamentals and growth and I feel the long-term narrative still remains intact. Since the large sell-off after Q3 2016 were announced, Q4 2016 and Q1 2017 numbers have been released and the share price has retraced the low $80 range and appeared to be consolidating for another move up. That was until Amazon entered the retail space with its acquisition of Whole Foods for $13.7 billion.
There’s a lot of speculation that Amazon will disrupt the entire grocery space as it has successfully done to some retail brick and motor businesses. An extension of that thesis threatens ancillary retail companies such as CVS considering CVS operates store fronts. It has been theorized that Amazon will leverage the Whole Foods store fronts as a means to enter the pharmacy business. It has been reported that Amazon is hiring a business lead to figure out how the company can break into the pharmacy market. This new hire was Mark Lyons from Premera Blue Cross to build an internal pharmacy benefits manager for its employees. Amazon has also started selling medical supplies and equipment in the U.S. Ostensibly, Amazon is inching its way towards the pharmacy space with its first pivot via the Whole Foods acquisition however I don’t feel that this space is nearly as easy of a target as it bread and butter consumer goods success.
Q1 2017 Numbers
CVS reported solid earnings for Q1 2017, beating on EPS and revenue posting EPS of $1.17 on $44.51 billion in revenue (+3.0% year-over-year). Same store sales fell however this fall in sales beat estimates, coming in at a 4.9% drop verses a consensus expectation of a 6% drop. Revenue in the pharmacy services segment increased 8.5% year-over-year with a 10% increase in network claims processed. Free cash flow was $3.1 billion, an increase of 67% year-over-year. CVS maintained prior guidance for 2017 EPS of $5.77 to $5.93 (Figure 1).
Figure 1 – Q1 2017 earnings highlights
During the Q3 earnings call, CVS issued a guidance that scared investors for both the full-year 2016 numbers and the preliminary 2017 full-year numbers. CVS stated that the numbers were lowered due to “competitor actions restricting us from pharmacy networks as well as current trends in the retail business”. CVS stated that there’s slowing prescription growth in the overall market and a soft seasonal business affecting the pharmacy and the store front. During the Q4 call, CVS presented actions on returning to healthy growth. This included partnering more broadly, new PBM products, enterprise streamlining initiatives and returning value to shareholders. Despite this narrative, CVS posted robust earnings for Q1 2017 and we’ll see how these initiatives continue to bear fruit in the ensuing quarters to come.
Returning Value and Evolving to Marketplace Trends
CVS has been doubly rewarding investors via growing dividends and share repurchases. In Q1, CVS bought back 36 million shares for $3.6 billion as part of an Accelerated Stock Repurchase (ASR) program. In total, the ASR totaled 46 million shares at an average price of $78.74. There’s $14.6 billion remaining in share repurchase authorizations and the company expects to repurchase another $5 billion in shares in 2017. The dividend currently sits at $0.50 per quarter or 2.6% annual yield to further return value to the shareholder base.
“CVS Health can pivot to address policy changes, help reduce health care costs, and bring meaningful solutions to the marketplace”. The interplay between pharmacy benefit managers, insurance companies, pharmacies, drug manufactures, wholesalers is not trivial and another layer of complexity is added when dealing with rebates, discounts and chargebacks. CVS contends that “any suggestion that PBMs are causing drug prices to rise is erroneous”. They went further and added “A recent industry study showed that every dollar invested in PBM services returned $6 in savings for our clients and members”. Recent marketplace trends forced CVS to cut guidance for Q4 2016 and the full-year 2017 numbers. CVS stated that “unexpected marketplace actions that will have a negative impact on our Q4 2016 results and a more meaningful impact on our outlook for 2017”. These network actions will result in more than 40 million retail prescriptions shifting out of stores on an annualized basis. CVS lost a contract with the Department of Defense to Walgreens which carries tens of millions of prescriptions on an annual basis. New restricted network relationship between Prime Therapeutics and Walgreens impacts CVS Pharmacy’s participation in selected fully-insured networks in several key states and in many cases make CVS Pharmacy a non-preferred provider for Medicare Part D as well. To add insult to injury, these prescriptions trend to be the most profitable prescriptions. The PBM segment remains a positive for the company with specialty expected to deliver strong growth. The Retail segment is expected to see a significant headwind of more than 40 million prescriptions from network changes and year-over-year growth acceleration from Omnicare and Target slightly slower than anticipated. Thus far CVS has been able to contend with and evolve to marketplace challenges as seen from Q1 2017 results. If these initiatives and adoption to marketplace challenges continue then CVS will weather the short term storm while the long term thesis remains well intact.
Recent marketplace trends have forced CVS to cut guidance for Q4 2016 and the full-year 2017 numbers. With Q4 2016 and Q1 2017 numbers out, the negative narrative has been priced into the stock in my opinion. Growth is still being forecasted for full-year 2017 numbers albeit slower growth than past years. There’s a lot of speculation that Amazon will disrupt the entire grocery space as it has successfully done to some retail brick and motor businesses. An extension of that thesis threatens ancillary retail companies such as CVS considering CVS operates store fronts. Amazon has hired a business lead to figure out how the company can break into the pharmacy market. I don’t feel that the pharmacy space is nearly as easy of a target as its bread and butter consumer goods success. With moderate growth across the enterprise and $14.6 billion earmarked for share repurchases along with a $2.00 per share in dividends moving forward, CVS remain a buy at these levels. CVS has been highly acquisitive, growing dividends over time and buying back its shares to drive shareholder value. I think CVS has guided conservatively and will make the appropriate adjustments to mitigate potential headwinds. The new administration will likely bode well for the entire healthcare cohort in terms of taxes, mergers and acquisitions and deregulation which may allow further marketplace easing. I remain long CVS, particularly at the sub $80 level.
Disclosure: The author currently holds shares of CVS and the author is long CVS. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com a venue created to share investing ideas and strategies with an emphasis on options trading.