CVS Health Corporation (NYSE:CVS) is a vertically integrated healthcare corporation in the United States. The company owns a leading healthcare benefits provider, a leading pharmacy benefits manager (PBM), and one of the largest retail pharmacy chains in the country. As an integrated healthcare service provider, CVS plays a significant role in the U.S. healthcare system. Recently, CVS has faced a number of challenges, which led to the appointment of a new CEO and four new Board members. Amid these challenges, CVS's stock price declined by more than 40 percent in 2024. After a prolonged decline, the stock is trading at less than 10 times trailing-twelve-month earnings and less than 9 times estimated 2025 earnings. Meanwhile, the company continues to generate substantial cash flow. I believe CVS represents a great value opportunity at its current price.
Business description and market dynamics
CVS Health is one of the oldest healthcare companies in the United States. The company's legacy business, CVS Pharmacy, can be traced back to 1821 when the first store was founded by Charles Valentine Storey in Newport, Rhode Island. It was called Storey's Apothecary. Storey's Apothecary was renamed Storey's Pharmacy in 1879. In 1963, the pharmacy chain was acquired by Stanley Goldstein, Sidney Goldstein, and Ralph Hoagland and was renamed Consumer Value Stores (NYSE:CVS).Over the past six decades, through organic growth and acquisition, CVS has become a vertically integrated healthcare company in the U.S. In 2017, the company spent $77 billion to acquire Aetna, one of the top health benefit plan operators in the country. In 2023, CVS made two other sizable acquisitions: Signify Health ($8 billion) and Oak Street Health ($10.6 billion). Signify Health provides home health assessment and nursing services, while Oak Street Health offers primary medical services for older people.
According to CVS's most recent annual report, the company has four reportable segments: Health Care Benefits, Health Services, Pharmacy & Consumer Wellness and Corporate/Other.
The Health Care Benefits segment includes Aetna and other health insurance businesses. CVS acquired Aetna in 2017. In 2023, CVS's Health Care Benefits segment operates as one of the largest diversified health care benefits providers, serving more than 35 million people. This segment accounts for approximately 30% of the consolidated revenue.
The Health Services segment includes the Caremark PBM business, as well as primary care services such as Signify Health and Oak Street Health. Caremark negotiates drug discounts with drug manufacturers on behalf of insurance plans, formulates the lists of drugs covered by the insurance formularies, and reimburses pharmacies for prescription costs. The Health Services segment is the largest segment and accounts for almost 50% of the consolidated revenue.
The Pharmacy & Consumer Wellness segment includes pharmacies, MinuteClinic, and HealthHub stores. CVS operates more than 9,000 pharmacy locations, some of which are located within grocery stores such as Target (NYSE:TGT) and Schnucks. Besides pharmacies, CVS has more than 1,100 MinuteClinics across the nation. The company is upgrading some of the walk-in clinics into HealthHUBs equipped with testing equipment and health management services.
Financial analysis and recent challenges
While CVS has grown its revenue from $268.7 billion to $358 billion between 2020 and 2023, its gross margin and operating margin both declined. The gross margin declined from 18.25% to 14.20% (trailing twelve-month), and the operating margin declined from 5.18% to 2.90% (trailing twelve-months).CVS has faced several challenges across all segments. First of all, the Health Care Benefits Business has faced the unfortunate combination of rising costs and the loss of members. The cost pressure is due to increasing medical utilization rate, growing severity of patients' conditions in the Medicaid program and the increasing benefits offered to members in order to gain market share. The medical loss ratio (MLR) for the Health Care Benefits segment reached 95.2%, a 950-basis-point increase compared to the same period last year. As a comparison, the MLR between FY2021-2023 is 84.8%?83.8% and 86.2%, respectively.
Secondly, CVS is also facing tremendous challenges in its PBM business. Start-up companies with new PBM models have taken significant market shares from the incumbent PBM players such as CVS's Caremark. For instance, In August 2023, Blue Shield of California, one of the largest insurance companies in California, announced that it would terminate its 15-year partnership with CVS Health and chose Mark Cuban's Cost Plus Drug Company and Amazon (NASDAQ:AMZN) Pharmacy to save drug costs for its nearly 5 million members. Furthermore, the PBM business has also faced increasing regulatory scrutiny, particularly by the Federal Trade Commission (FTC). Specifically, the FTC has raised concerns about the largest PBM's market power, especially for PBMs with the vertical integration of mail-order pharmacies such as CVS Health.
In the pharmacy business, CVS Health has agreed to a $5 billion settlement related to the opioid lawsuits. In addition, CVS is transitioning into a cost-plus model with a small markup and administration fee in order to reduce the proportion of loss-generating prescriptions. Negotiations are still ongoing with major non-Caremark PBMs. The transition may lead to further margin decline in the short term for the the Pharmacy & Consumer Wellness segment.
In response to the significant business challenges, CVS has made major changes to its management team. The company appointed David Joyner as the President and Chief Executive Officer and Prem Shah as Group President, and added four new board members. While investors are encouraged by the management change, it will take some time for the new leadership team to turn around the business.
Valuation and risk analysis
Due to the low predictability of CVS's business, I will use the Shiller P/E ratio as the primary valuation metric. Compared with the regular PE Ratio, the Shiller PE Ratio smoothed out the fluctuations in profit margins during business cycles. Over the past 10 years, CVS Health's Schiller P/E ratio has been oscillating between 8 and 30 times with a median of 18 times. Currently, CVS is trading at less than 8.5 times Schiller P/E ratio, well below its historical average.For FY2025, among the 23 analysts covering CVS Health, the most pessimistic analyst estimates that CVS Health can achieve an adjusted EPS of $5.26. If the stock can re-rate to the historic median Schiller P/E multiple of 18 times, the stock can be worth $95 per share, which is significantly higher than the current price.
Although CVS Health's stock appears to be cheap, the upside comes with significant risks and uncertainties. First of all, the ongoing antitrust investigations may result in potential legal challenges. The company may face severe consequences such as big fines, business restrictions, or even divestitures of either the PBM business or the insurance business, which would have a substantial negative impact on its operations. Secondly, the competitive landscape has become unfavourable across CVS Health's three businesses, especially for the PBM and the health insurance business. Whether the company can balance pricing, benefits, and membership retention will be crucial for FY2025 and beyond. Lastly, CVS Health's balance sheet has deteriorated after big acquisitions made by its previous CEO Karen Lynch. While the company still generates very strong cash flow, the higher-than-normal leverage ratio leaves the management team less room for mistakes.
Conclusion
CVS Health has faced a number of significant challenges in recent years. In the near term, cost pressures, competitive threats, and regulatory uncertainties are all headwinds that may last for a while. Going forward, investors should monitor key metrics such as membership trends, MLR trends, the outcome of PBM negotiations, and the progress of the regulatory investigation. However, the stock price has likely priced in much pessimism. CVS Health has significant upside If the new management team can successfully execute its strategic pivots. Meanwhile, CVS's vertically-integrated business model provides the company with more downside protection compared to a standalone healthcare business. At the current price, the risk-reward profile for CVS Health seems to be very favourable for investors.This content was originally published on Gurufocus.com
