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CVS Health: A Complicated Business and Frozen Dividend

CVS Health (CVS) is one of America’s most dominant healthcare players. The company operates the nation’s second-largest pharmacy chain with over 9,900 retail locations and is the biggest U.S. pharmacy based on total prescription revenue. 

CVS is also one of the nation’s largest pharmacy benefits managers (PBMs), having acquired Caremark RX for $21 billion in 2006 to become the second biggest PBM. In 2018 CVS closed on another large deal to acquire health insurance giant Aetna for $78 billion, creating one of the world's largest vertically integrated health giants.

The PBM business provides vital services to employers and insurance companies by determining which drugs are covered for patients and negotiating price discounts with drugmakers. By integrating Aetna's health insurance business, CVS believes it will be able to further enhance economies of scale as well as derive significant cost synergies that will eventually result in stronger long-term sales, earnings, and dividend growth. 

Following the addition of Aetna, CVS added a third reporting segment, Health Care Benefits, to its existing Pharmacy Services and Retail/Long-Term Care segments. 

  • Pharmacy Services: 56% of revenue, 40% of profits
  • Retail Pharmacy / Long-term Care: 35% of revenue, 53% of profits
  • Health Care Benefits: 9% of revenue, 7% of profits

While pharmacy services still account for the majority of sales, approximately 60% of CVS's adjusted operating profits come from its higher-margin retail pharmacy, long-term care, and health care benefits businesses.

CVS has paid uninterrupted dividends for over 20 consecutive years and increased its dividend each year for more than a decade through 2017. However, the Aetna acquisition required the company to take on so much debt that management announced it would freeze the dividend until CVS achieved its long-term deleveraging targets. As a result, the firm's 14-year dividend growth streak came to an end in 2018.

Business Analysis
CVS's legacy retail pharmacy business has historically grown through industry consolidation, allowing it to create a massive nationwide store network on par with Walgreens Boots Alliance (WBA). Offering customers convenience and leveraging its scale to keep prices affordable proved to be an effective strategy.

However, CVS management recognized years ago that rising healthcare costs would increasingly put pressure on every aspect of the medical sector to cut costs, which is why it bought Caremark RX for $21 billion in 2006.

This acquisition made CVS the second largest PBM in the country. By becoming more vertically integrated and achieving greater economies of scale, CVS was able to generate very impressive earnings, cash flow, and dividend growth over the past decade.

Why was the PBM segment such a boon to CVS? Mainly because, as rising costs and increased regulatory complexities under the Affordable Care Act (i.e. ObamaCare) set in, many organizations, including health insurance companies such as Aetna (AET), were willing to outsource the nitty-gritty logistical details of managing various health programs to PBMs such as CVS.

This is because PBM’s are responsible for saving their clients as much money as possible, through actions like negotiating price breaks with pharmaceutical companies and medical component makers.

And better yet they are willing to sign long-term contracts, like the 12-year deal that Aetna inked with CVS back in 2010, which gives management a lot of future cash flow predictability with which to plan its growth efforts.

In other words, CVS has evolved beyond just a chain of pharmacies and stores, turning into one of the most important names across the U.S. healthcare chain. Thanks to the continued expansion of its PBM business (and now health insurance itself), CVS is able to generate large economies of scale, resulting in some of the lowest per claim costs in the industry. That helps CVS maintain market share which only further grows its moat and helps maintain high retention rates (98% in 2018) with PBM customers.

In 2015 the company doubled down on scale by acquiring 1,667 of Target’s (TGT) in-store pharmacies and 79 clinics for $1.9 billion. That year CVS also made its $12.7 billion purchase of PBM company Omnicare, further expanding that part of its empire as well.

Why did CVS then make such a bold deal to acquire Aetna and break into yet another new industry (health insurance)? Several reasons, the biggest of which is that as U.S. healthcare expenditures continue to rise, companies/payers are becoming increasingly desperate to cut costs out of the system at every level.

Thus scale is even more critical to being able to retain pricing power, while also squeezing price breaks out of suppliers. CVS now locks in Aetna's large base of insured customers for its PBM business and retail drugstores. Simply put, the Aetna merger has truly made CVS a healthcare giant with an impressive scale and reach in U.S. healthcare.

For example, in 2019 management expects to generate over $250 billion in sales, which would have put CVS as No. 2 on Fortune’s 500 list in terms of companies with the highest annual 2018 revenues.

The company also enjoys No. 1 or No. 2 market share positions in all of its core businesses, which form a network that one third of all Americans interact with in some way at least once per year. That's largely thanks to CVS's nearly 10,000 retail outlets that are located within 5 miles of 75% of the nation's population.
Source: CVS Fact Sheet
The Aetna deal is designed to increase CVS's scale even further so the firm can help deliver significant cost savings to the U.S. healthcare system (be part of the solution) while also hopefully boosting its own profits by taking a small cut of those savings.
Source: CVS Investor Presentation
The first step will be trying to achieve over $750 million in cost synergies through the end of 2020. Savings will come from the elimination of overlapping administrative functions as well as simplifying its drug formularies and streamlining the health plans offered by Aetna (simpler and less costly to run).
Source: CVS Investor Presentation
CVS also hopes to evolve its store locations to be able to provide more types of medical care for patients, which could reduce costs and make it an even more attractive PBM partner for large employers. 

Over the long term CVS hopes to convert most of its retail locations into what it calls "health hubs" in which 20% of the retail space is converted to MinuteClinic-like customer care space. Aetna customers can then use these areas to get low complexity health care at cheaper costs while lifting CVS's retail revenues and profits. 

CVS's MinuteClinic revenue was up about 10% in 2018, indicating that its low cost and convenient way of dispensing less complex healthcare is showing some traction with consumers and insurance companies.
Source: CVS Investor Presentation
While all of that sounds good in theory, and CVS has a decent track record of making strategic shifts in its business model via M&A, we can't forget that the Aetna purchase required taking on $40 billion in debt, which led to a credit rating downgrade from Moody's (to BBB+ equivalent with a negative outlook, meaning a cut to BBB is possible). S&P also downgraded CVS to a BBB credit rating.

This is where management's announcement of a dividend freeze and suspension of its buyback program comes in. Debt is paid down out of retained free cash flow (free cash flow minus dividends), so keeping the dividend stable rather than growing it maximizes the amount of cash flow available for deleveraging.
Source: CVS Investor Presentation
Management expects to pay out $2.6 billion in dividends this year, while free cash flow is expected to be about $7.6 billion, leaving around $5 billion for debt reduction. That would be enough to pay off 12.5% of the debt CVS took on to finance the Aetna deal.

Over the next three years CVS has about $18 billion in debt maturing. Assuming the company manages to keep growing its free cash flow (driven largely by achieving cost synergies), then it should be able to fund nearly all of the debt coming due with retained free cash flow.

In other words, CVS's deleveraging plan, which is critical to eventually returning to safe and steady dividend growth, appears reasonable.
Source: CVS Investor Presentation
Once deleveraging efforts are complete, analysts believe CVS can deliver high single-digit annual EPS growth in the years ahead. That's roughly in line with the company's recent growth rates and seems like a sensible forecast. If the future plays out as expected, CVS will grow into an even safer balance sheet and hopefully return to mid to high single-digit dividend growth in the long term. 

However, as with many medical companies, especially one that is now digesting the largest acquisition in its history, there are plenty of risks to keep in mind. 

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

As the company grows and diversifies via M&A this creates a greater risk of something going wrong, which is what appears to have happened with its $12.7 billion acquisition of Omnicare in 2015. 

In 2018 CVS took two write-downs on this business that equaled about half the value of the original acquisition. Omnicom provided pharmacy services to long-term care facilities, expanding CVS's ability to dispense prescriptions in the assisted living market. However, Medicaid and Medicare began making changes to reimbursement policies in 2011, resulting in challenging operating conditions. 

Here's what CVS had to say about Omnicare's troubles in its fourth-quarter 2018 earnings release:

"The [long-term care] business has continued to experience industry-wide challenges that have impacted our ability to grow the business at the rate that was originally estimated when the company acquired Omnicare in 2015. These challenges include lower occupancy rates in skilled nursing facilities, significant deterioration in the financial health of numerous skilled nursing facility customers which resulted in a number of customer bankruptcies in 2018, and continued facility reimbursement pressures."

While those policy changes have slowed down in recent years, CVS expects that in 2019 its Retail Pharmacy / Long-term Care segment (53% of profits in 2018) will see a 10% decline in operating earnings due to continued challenges in skilled nursing facilities. 

Combined with a higher share count due to the Aetna merger, this is expected to drive adjusted EPS down about 4%, which is a big reason why CVS shares crashed after its fourth-quarter 2018 earnings and guidance for 2019 were released. 

The good news is that CVS's free cash flow, which funds the firm's dividend and is needed to repay debt, is expected to rise more than 10% compared to 2018. However, the point is that one of CVS's large strategic acquisitions is now failing to live up to expectations. 

This highlights the major challenges for transformative M&A, including breaking into new industries that can provide a new growth runway but also add new complexities. As a result, deals can end up being much less profitable than management initially expected, especially if a company overpays for a buyout target as some analysts fear CVS did with Aetna.

While M&A success is far from guaranteed, the threat from a high debt load is more certain. For example, while most of CVS's business model generates predictable cash flow regardless of the economy's health, it's high debt load does expose the company more to a recession. Should the company fail to achieve its expected free cash flow over the next few years, it may have to refinance a substantial amount of debt.

The company's BBB credit rating is still strong, but bond yields can be highly volatile, especially during times of financial market uncertainty. Should a recession occur within the next few years and the Aetna merger not go as well as planned, CVS might be facing much higher refinancing costs during a bear market.

This seems unlikely to threaten the company's dividend since CVS has a low payout ratio and could even afford another credit rating downgrade before reaching junk status. However, the dividend could remain frozen longer than income investors hoped as management works to protect the balance sheet. 

Finally, it's worth emphasizing that all of CVS's business are highly exposed to political and regulatory risks, specifically tied to the rising cost of healthcare.

According to a recent report from the Centers for Medicare and Medicaid Services, U.S. healthcare spending is expected to rise by 5.5% annually over the next decade, hitting about $6 trillion by 2027.

While rising healthcare spending is a big 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.

CVS bought Aetna to achieve dominant scale, but consolidation in healthcare has been a long-term trend and many of its customers are also getting larger and putting pricing pressure on it.

The company admits as much to investors saying that fewer new generic drug launches in 2019 (87% of its pharmacy sales are generics) plus rising reimbursement pressures across the board will hurt pricing power ("brand inflation").
Source: CVS Investor Presentation
And pricing pressure is not likely to end anytime soon. On January 31, 2019, the U.S. Department of Health and Human Services proposed a new rule banning backdoor drug rebates between drug companies and pharmacy benefit managers (PBMs), Part D plans, and Medicaid managed care organizations.

While it's far from certain that this rule will actually go into effect, and it might take several years to do so, here's what Morningstar equity analyst Jake Strole had to say about that proposed rule change:

"We expect the PBM industry to be the loudest critic of this policy. A transition to a rebate-less system would be difficult and uncertain, with many unintended consequences associated with replacing a nationwide pricing system." – Jake Strole, Morningstar

As drug prices come under greater pressure, the PBM business model seems likely to come under increased scrutiny. PBMs are supposed to lower prices for consumers, but the industry remains quite opaque with where and how profits are moving around. The article linked to above provides a great look at PBMs’ unique risks.

Finally, we can't forget one of the biggest risks of all to CVS's business model which is the proposal by many Democratic presidential hopefuls to adopt Bernie Sander's "Medicare-for-All" single-payer healthcare system. 

While talk is cheap and such potential legislation seems unlikely to pass through the Senate, should the U.S. ever adopt some form of single-payer healthcare, then the private health insurance industry could be wiped out in America, or at least limited to non-covered expenses (premium services). 

In such a worst-case scenario, Aetna's value could eventually go to zero (or close to it), wasting the $78 billion CVS spent on the deal. 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
Historically, CVS has been very good at adapting to fast-changing and challenging industry conditions. The company's skilled management team has proven itself to be very shareholder-friendly, especially in regards to it long track record of fast dividend growth. 

However, in recent years margin pressures caused by a large-scale pushback against rising medical costs have squeezed all medical companies and necessitated major (and sometimes highly questionable) M&A activity. 

That certainly applies to CVS's game-changing acquisition of Aetna, which has large risks associated with it. It will take years for investors to know whether or not this was a smart capital allocation decision, but what is certain, at least for now, is that CVS is no longer a dividend growth stock. 

At the end of the day, it’s just really hard to grasp all of the changes happening across the entire healthcare value chain. From increased drug price scrutiny to reimbursement rate pressures and the potential for PBM business models to structurally change in ways that would harm CVS’s long-term profitability, there are a number of concerns bubbling up that make it difficult to gain conviction in CVS’s long-term earning power.

Combined with all of the uncertainties surrounding potential changes in health insurance policy at the Federal level, conservative dividend growth investors might want to avoid CVS, or at the very least own just a small position to limit their risk in case any of the numerous pitfalls that could trip up CVS in the future materialize.

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