CVS - CVS Health Corporation

[kc3]

I'm still very new to this and haven't had much time to go through the financials heavily however I've noticed that CVS has shown consistent growth over the past ten years as well as increased profit as well as operating expenses that really aren't bad. One thing that does concern me is the cost of revenues but I don't know enough about this. The price/book is at 2.94 and the P/E is 21 which together might be a little high but again I'm fairly new to reading financials. Is there any thoughts? I plan on reading through the latest 10-K and 10-Q and a few other reports when I have some time as well.

[rishig]

I'm still very new to this and haven't had much time to go through the financials heavily however I've noticed that CVS has shown consistent growth over the past ten years as well as increased profit as well as operating expenses that really aren't bad. One thing that does concern me is the cost of revenues but I don't know enough about this. The price/book is at 2.94 and the P/E is 21 which together might be a little high but again I'm fairly new to reading financials. Is there any thoughts? I plan on reading through the latest 10-K and 10-Q and a few other reports when I have some time as well.

 

I owned CVS in the past (in 2011 when it was ~30) and sold it as it ran up. Here is my report from back in 2011. A lot has probably changed and I have not kept up, but you may find the report useful to get background on the industry: https://app.box.com/shared/y3aiym3q14

[kc3]

Sweet, I appreciate that, thank you. I'm also looking into their competitors.

[KCLarkin]

CVS is down 20% since May. Does anyone have a good short thesis at this price?

[kab60]

Nothing solid, but I think people are concerned that PBM's will be targeted politically. It seems there are some perverse incentives with both pharma, PBM's and insurance companies all being interested in rising list prices.

[DooDiligence]

I own NVO (bought more yesterday on the drop) & BBH & XBI & was thinking about something to inverse correlate risk of falling drug prices.

 

CVS still seems a bit pricey & I just can't get comfortable with Express Scripts smarmy management or Athena's either.

 

Seems like anything in this space would be a leap of faith...

[KCLarkin]

Nothing solid, but I think people are concerned that PBM's will be targeted politically. It seems there are some perverse incentives with both pharma, PBM's and insurance companies all being interested in rising list prices.

 

Yes, I'm assuming that's the reason for this weakness. Plus, Clinton's election promises. Plus, general sell-off in health-care. Plus, smaller drug price increases.

 

But these are all perception, which I think is creating the opportunity.

 

Are there any fundamental issues I am missing?

 

--

I agree that the entire pharma/PBM/insurance industry is a cesspool. But I'm doubtful that the next president will get any meaningful reform given the sad state of the U.S. political process.

 

 

[DooDiligence]

Nothing solid, but I think people are concerned that PBM's will be targeted politically. It seems there are some perverse incentives with both pharma, PBM's and insurance companies all being interested in rising list prices.

 

Yes, I'm assuming that's the reason for this weakness. Plus, Clinton's election promises. Plus, general sell-off in health-care. Plus, smaller drug price increases.

 

But these are all perception, which I think is creating the opportunity.

 

Are there any fundamental issues I am missing?

 

--

I agree that the entire pharma/PBM/insurance industry is a cesspool. But I'm doubtful that the next president will get any meaningful reform given the sad state of the U.S. political process.

 

I thought the PBM's/insurers were supposed to help reduce prices & improve outcomes?

 

There goes my theory about reducing the risk of lower margins in biopharma with a corrolary (whew; didn't wanna own one of those anyway...)

[kab60]

Nothing solid, but I think people are concerned that PBM's will be targeted politically. It seems there are some perverse incentives with both pharma, PBM's and insurance companies all being interested in rising list prices.

 

Yes, I'm assuming that's the reason for this weakness. Plus, Clinton's election promises. Plus, general sell-off in health-care. Plus, smaller drug price increases.

 

But these are all perception, which I think is creating the opportunity.

 

Are there any fundamental issues I am missing?

 

--

I agree that the entire pharma/PBM/insurance industry is a cesspool. But I'm doubtful that the next president will get any meaningful reform given the sad state of the U.S. political process.

 

I thought the PBM's/insurers were supposed to help reduce prices & improve outcomes?

 

There goes my theory about reducing the risk of lower margins in biopharma with a corrolary (whew; didn't wanna own one of those anyway...)

I think that was the idea...

 

PBM's negotiate rebates on list prices of medicine and apparently pocket a bit of the rebate themselves, so it seems pharma and PBM has figured higher prices is good for both of them. Cause higher list prices = higher rebates. And insurance companies pass on the bill, so if margins stay the same, and the bill grows, their earnings increase. That's roughly how I've had it explained by industry source, but please correct me if I'm wrong.

 

The losers are obviously patients and employers. I think it's a crazy system but there's a lot of money that wants it to stay this way, so I wouldn't expect it to change (but I do hope it does for my fellow US boardmembers).

[DooDiligence]

Nothing solid, but I think people are concerned that PBM's will be targeted politically. It seems there are some perverse incentives with both pharma, PBM's and insurance companies all being interested in rising list prices.

 

Yes, I'm assuming that's the reason for this weakness. Plus, Clinton's election promises. Plus, general sell-off in health-care. Plus, smaller drug price increases.

 

But these are all perception, which I think is creating the opportunity.

 

Are there any fundamental issues I am missing?

 

--

I agree that the entire pharma/PBM/insurance industry is a cesspool. But I'm doubtful that the next president will get any meaningful reform given the sad state of the U.S. political process.

 

I thought the PBM's/insurers were supposed to help reduce prices & improve outcomes?

 

There goes my theory about reducing the risk of lower margins in biopharma with a corrolary (whew; didn't wanna own one of those anyway...)

I think that was the idea...

 

PBM's negotiate rebates on list prices of medicine and apparently pocket a bit of the rebate themselves, so it seems pharma and PBM has figured higher prices is good for both of them. Cause higher list prices = higher rebates. And insurance companies pass on the bill, so if margins stay the same, and the bill grows, their earnings increase. That's roughly how I've had it explained by industry source, but please correct me if I'm wrong.

 

The losers are obviously patients and employers. I think it's a crazy system but there's a lot of money that wants it to stay this way, so I wouldn't expect it to change (but I do hope it does for my fellow US boardmembers).

 

I never could understand why insurers outsourced the PBM operation.

 

Seems like the goal of reducing prices would be better achieved by keeping it in house (and they could probably improve their margins a point or 2 to boot.)

 

If Athena was allowed to buy Cigna & was then able to do its own PBM in house, do you think the outcome would be good for pricing? (I'm positive it'd be bad for ESRX & it seems the government is in ESRX's corner on this one which indicates to me that the government has no interest in lowering prices...)

 

There may be a bit of fuzzy logic in my last statement.

[fisch777]

My impression is that MCOs originally "carved out" the drug benefit itself from the rest of the main medical plan, as the Rx benefit used to be simply lumped in.  At first, the "carved out" benefit was basically just processing drug claims, which could be done more efficiently/broadly with PBMs, who built networks to process claims at drug stores on behalf of MCO payors.  As Rx claims grew, the pharmacy benefit significantly gained in complexity, and the role of PBMs grew.  As PBMs grew in size, the role expanded beyond a 3rd party processor and they began to leverage their buying power to obtain lower drug pricing, which helped their payor clients (employers, MCOs). 

 

Some PBM activities do appear to be in potential conflict of end patient and/or payor, but PBMs do take cost out of the entire supply chain, so I don't get the argument that they don't add value and shouldn't exist. It is clearly not simple or easy to negotiate with the scale and expertise that these big PBMs operate.  As recently as 2009, Wellpoint (now Anthem) sold NextRx to ESRX for ~$5B.

 

Why is the integrated Rx/PBM model (CVS/Caremark) superior to the standalone (ESRX, recently Catamaran) model?

[DooDiligence]

My impression is that MCOs originally "carved out" the drug benefit itself from the rest of the main medical plan, as the Rx benefit used to be simply lumped in.  At first, the "carved out" benefit was basically just processing drug claims, which could be done more efficiently/broadly with PBMs, who built networks to process claims at drug stores on behalf of MCO payors.  As Rx claims grew, the pharmacy benefit significantly gained in complexity, and the role of PBMs grew.  As PBMs grew in size, the role expanded beyond a 3rd party processor and they began to leverage their buying power to obtain lower drug pricing, which helped their payor clients (employers, MCOs). 

 

Some PBM activities do appear to be in potential conflict of end patient and/or payor, but PBMs do take cost out of the entire supply chain, so I don't get the argument that they don't add value and shouldn't exist. It is clearly not simple or easy to negotiate with the scale and expertise that these big PBMs operate.  As recently as 2009, Wellpoint (now Anthem) sold NextRx to ESRX for ~$5B.

 

Why is the integrated Rx/PBM model (CVS/Caremark) superior to the standalone (ESRX, recently Catamaran) model?

 

Thanks - I didn't realize the history of the PBM (seems like they created a bunch if Frankensteins that got free & ate each other up & now the creators are gobbling up the resultant bigger monsters.)

 

I totally missed the United Health / Catamaran deal (did it go through & did they rename it Optum?)

 

I'm no expert but it seems logical that having PBM in house would be beneficial (albeit not for a pharma manufacturer as Merck found out.)

 

ESRX stands alone (will they eat their maker or be consumed & if so by whom?)

[ABM]

 

 

Why is the integrated Rx/PBM model (CVS/Caremark) superior to the standalone (ESRX, recently Catamaran) model?

 

I am spending a lot of time thinking about this myself. My best guess is that a scaled PBM returns profile is more attractive than the pharmacy business. It is a asset light negative cash conversion cycle business that has very high returns on tangible net assets.  This may explains why CVS entered the vertical which could have also been considered a low cost source of financing for its retail business inventory. I mean the amount of working capital ESRX has released over the past 10 years while growing EBITDA at high teens is astonishing and will be remembered in the same vein as AZO. 

 

Now from the perspective of ESRX, it is more difficult to understand rational incentives.  On the one hand, independent scaled PBM sounds ideal as it can serve multiple customers reinforcing network effect and widening its moat as the low cost producer.  On the other hand, disintermediation remains a threat as pharmaceuticals increase adoption rates of using direct to consumer rebates or "coupons" as they are known.  This is apparently a fast growing but real threat that could one day displace the PBM function as we know it.  So you can see ESRX maybe wanting to partner with a scaled payor to ensure its business remains relevant and well funded to face the shifting challenges of the industry.

 

To the comment earlier about why insurers let the PBMs out of the box to begin with, I believe it was due to the industry structure at the time which was fragmented; as such, a scaled PBM made sense for the benefit of all MCOs.  Now with the consolidated/consolidating MCO industry it likely makes less sense to outsource the PBM function if you underwrite 20% of all scrips int he country like UNH. 

[DooDiligence]

 

 

Why is the integrated Rx/PBM model (CVS/Caremark) superior to the standalone (ESRX, recently Catamaran) model?

 

I am spending a lot of time thinking about this myself. My best guess is that a scaled PBM returns profile is more attractive than the pharmacy business. It is a asset light negative cash conversion cycle business that has very high returns on tangible net assets.  This may explains why CVS entered the vertical which could have also been considered a low cost source of financing for its retail business inventory. I mean the amount of working capital ESRX has released over the past 10 years while growing EBITDA at high teens is astonishing and will be remembered in the same vein as AZO. 

 

Now from the perspective of ESRX, it is more difficult to understand rational incentives.  On the one hand, independent scaled PBM sounds ideal as it can serve multiple customers reinforcing network effect and widening its moat as the low cost producer.  On the other hand, disintermediation remains a threat as pharmaceuticals increase adoption rates of using direct to consumer rebates or "coupons" as they are known.  This is apparently a fast growing but real threat that could one day displace the PBM function as we know it.  So you can see ESRX maybe wanting to partner with a scaled payor to ensure its business remains relevant and well funded to face the shifting challenges of the industry.

 

To the comment earlier about why insurers let the PBMs out of the box to begin with, I believe it was due to the industry structure at the time which was fragmented; as such, a scaled PBM made sense for the benefit of all MCOs.  Now with the consolidated/consolidating MCO industry it likely makes less sense to outsource the PBM function if you underwrite 20% of all scrips int he country like UNH.

 

Nice thought process!

 

I'm looking into this because I own NVO, BBH & XBI & I'd like to have something that will counterbalance the risk of lower drug prices.

 

I like CVS but it seems a bit expensive & I don't like (but don't hate) ESRX & it seems cheap (lots of overhang from potential loss of Anthem contract & the proposed Cigna/Anthem merger, competition from UNH & CVS & the point you raised about possible future irrelevance of ESRX in the whole process...)

[ABM]

Further to my comment above, I found this excerpt from a buyside long report for ESRX posted on Sumzero defending the independent PBM argument

 

"There is in my mind a rational argument that the PBM business should remain independent of the HMO or the Retail pharmacy businesses because their interests are not necessarily aligned. By way of example, it seems to me inconceivable that Anthem would offer their PBM contract to UnitedHealth – there largest competitor. Similarly it seems likely that Walgreens would be more predisposed to dealing with Optum (Untied Health) or Express Scripts – as opposed to CVS (their largest competitor. To this extent and going forward, it seems reasonable that ESRX and United/Optum should have the upper hand over CVS/Caremark, when negotiating with pharmacies such as Walgreen, Target, Walmart, etc. Similarly ESRX and CVS/Caremark should have the upper hand over United/Optum when negotiating with HMO’s such as Anthem."

[KCLarkin]

Down 15% today.

 

http://www.bloomberg.com/news/articles/2016-11-08/cvs-says-slowing-prescriptions-will-hurt-profits-next-year

 

CVS Health Corp. earnings forecasts for 2016 and 2017 came in below analysts’ estimates as more prescriptions are being filled outside of its drugstores, sending the shares plunging Tuesday.

[fisch777]

Appears that most of the issues plaguing CVS today trace back to the PBM having superior leverage in the Rx supply chain, which allows PBM and respective client to steer lives away from specific retail pharmacy networks as it sees fit, to control payor costs.  The same thing happened in 2012 (on an ever larger scale) with ESRX dropping WAG from its network.

 

Again, I ask why is the integrated Rx/PBM model better?

[rogermunibond]

When it was about choice and consumer convenience having retail/PBM made sense.  When it's about cost reduction, well then...  that argument vaporizes.

[DooDiligence]

Appears that most of the issues plaguing CVS today trace back to the PBM having superior leverage in the Rx supply chain, which allows PBM and respective client to steer lives away from specific retail pharmacy networks as it sees fit, to control payor costs.  The same thing happened in 2012 (on an ever larger scale) with ESRX dropping WAG from its network.

 

Again, I ask why is the integrated Rx/PBM model better?

 

Good point...

 

If ESRX manages to stay independent, how do you think it will affect the competitve dynamic if at all?

 

Will politicos continue grinding at pharmas or payers or both?

[KCLarkin]

CVS is down 33% form all-time highs. It is now trading at under 12x FCF. This is remarkable for such a steady growth company when markets are at all time highs.

 

Ignoring the general malaise around drug prices and PBM business models, here is my theory.

 

--

There is an epic battle brewing between Walgreen's and CVS.

 

CVS owns a PBM, pharmacy, clinics, specialty pharmacy, etc. Ultimately, it is hoping that this integrated approach allows it to offer cheaper and better PBM services to payers (employers, insurance companies, government). CVS is also using the PBM to drive traffic to the retail stores. As part of this strategy, CVS is de-emphasizing general merchandise sales. Ending sales of cigarettes, for example. In recent years, this strategy is winning. CVS was winning market share at both pharmacy and PBM.

 

Walgreen's is following a very different strategy. It is using prescription sales to drive traffic to stores, where it hopes to sell very high margin beauty products. Because the goal is to drive traffic, it is willing to sacrifice pharmacy margin to become the "preferred network" for PBMs and payers. Basically, Walgreens offers discounts on drugs and payers steer traffic to Walgreens beauty products.

 

CVS and Walgreen's retail stores are both heavyweights. CVS is slightly larger. But with Walgreen's acquisition of Rite Aid, they are basically the same size with excellent coverage across the U.S. Normally, you would expect CVS to respond aggressively to win its own share of "preferred networks". The negative impact on margins would encourage the duopoly to compete less vigorously.

 

But the brilliant owner of Walgreen's is playing some mean judo. Because PBMs compete with CVS Caremark, they are unlikely to select CVS as a preferred network. So CVS is unable to compete for a large chunk of business. Walgreen's can move aggressively knowing that CVS can't retaliate.

 

Pharmacies have high fixed costs. Any loss of market share has a big impact due to this operating leverage. In the past few years, CVS has been gaining share but now the tides are turning. Even relatively modest share losses could be a big hit to earnings.

 

--

To respond, CVS is hoping to use its integrated model to win even higher share of the PBM business. So there is an interesting dynamic here. CVS retail will lose share of scripts from 3rd party PBMs. But win more share in the PBM business. The PBM business is a better business, so CVS might still grow despite headwinds in the retail business.

 

--

This is an epic showdown worthy of an HBS case study.

 

It is really hard to predict how this battle shakes out. I'm using LEAPs to buy CVS. If CVS can stabilize its retail business, it is worth much more than 12x FCF. But there is also a risk that hyper-competition from Walgreen's could decimate FCF. (There are also regulatory risks that make the protective features of the LEAPs attractive).

 

--

Some articles discussing these dynamics:

http://www.drugchannels.net/2015/04/walgreens-boots-alliance-analysis-of.html

http://www.drugchannels.net/2016/10/walgreens-tricare-win-tracking-wbas.html

http://www.chaindrugreview.com/brindley-walgreens-is-reinventing-beauty/

 

[fisch777]

As an anecdote, I just got letter from my PBM (Prime via BCBS) stating that I can no longer use the CVS I've been using for 6 years and must switch all Rx to a "preferred" pharmacy (i.e., in network), which includes a tiny neighborhood pharmacy (zero scale/negotiating power) and, you guessed it, Walgreens.

[KCLarkin]

CVS returns fire:

http://www.unitedhealthgroup.com/Newsroom/Articles/Feed/Optum/2016/1129CVSPharmacy.aspx

 

Looks like this allows OptumRX patients to get their 90-day prescriptions filled at CVS retail pharmacies. On the one hand, this looks to negate the advantage that WBA gained in its own deal with OptumRX. On the other hand, it negates slightly the advantage that CVS Caremark has with it's Maintenance Choice program.

 

Interesting times...

 

H/T @bluegrasscap

[ABM]

Good points KC. 

 

I have been hearing from some industry people that payors and by extension their PBMs may be pushing pharmacies to turn increasingly to the old fee-for-service revenue model rather than the prevailing mark up model.  The current structure is a mix between fee-for-service and a mark-up from the perspective of the pharmacy. 

 

CVS in their most recent Q discloses this trend in a muddled way but it is there.  Payors/PBMs are after the spread the retailers earn on the drugs dispensed, especially on generic, which if this catches steam it could be a big challenge for CVS & WBA. 

 

 

As MCOs & PBMs have scaled, in the face of runaway growth in drug spend, they are increasingly searching for innovative ways to minimize spend.  We all know about the rise in mail prescription fills that has been successful in recent years.  ESRX is now filling 28% of all scrips by mail.  This bypasses the pharmacy channel and lowers overall costs in the transaction chain for payors and consumers .  Curiously, CVS's Caremark, only fills 18% of its scrips through the mail despite rivaling ESRX in scale. 

 

There is also the movement to the "90 day" fill but of course even though it is good for Caremark is is bad for CVS retail as it reduces foot traffic that is critical to support the "front store" retail.  The inherent conflict of interests are growing and their counterparts including competitors and customers know this.

 

Given the scaled customer concentration and bargaining advantage this delivers, WBA may realize that it is futile to resist this trend and is proactively ceding margin to secure exclusive access to these networks which will provide guaranteed traffic levels to its front store operations.  In other words, being a first mover hoping to reap the benefits while CVS is tied up trying to figure out how they can optimize the relationship between their PBM & retail operations to better appease customers.  I do not expect Caremark  to lobby on behalf of clients to follow the emerging trend as it may prove catastrophic for the CVS retail side.  I am aware of the ABC/WBA tieup and this will not happen over night night but it is important to note that ABC is the largest specialty distributor in the game and the supply chain operates largely outside the traditional channels. 

 

I haven't even touched specialty which we can leave for the next post but there is one more thing worth mentioning.

 

There is increasing activity by payors/PBMs to buy direct from producers.  This has the potential to disrupt the wholesaler business as they are forced to accept another fee-for-service arrangement.  Put simply, the PBM will buy the drug from Pfizer pay CAH to deliver it to the pharmacy where the pBM will pay the pharmacy a dispensing fee for the service. 

 

This is not mumbo jumbo as I have heard as much from some of the big players in the ecosystem and they are all trying to protect their profit pool but it is hard when you are up against the Goliaths of the world and battling on a sinking ships of sorts. 

 

MCK went through this transition in the mid 2000's (on its own volition) after a period flat to falling drug prices causing losses on inventory balances held.  At the time, they decided to shift to a fee-for-service model that while deliver lower overall margins required much less capital investment ultimately driving higher overall capital returns. Unfortunately, CVS has a ball & chain in the way of its brick & mortar retail business and so may not be as flexible as MCK was at the time. 

 

Btw, the Citi Analyst predicted much of this conundrum back in 2014 as detailed in the WBA initiation report.  Great primer on the retail sector.  I will post it if anyone's interested. 

 

Bonus read for those that want a helpful primer on pharma supply chain [url=http://www.americanhealthpolicy.org/Content/documents/resources/December%202015_AHPI%20Study_Understanding_the_Pharma_Black_Box.pdf]http://www.americanhealthpolicy.org/Content/documents/resources/December%202015_AHPI%20Study_Understanding_the_Pharma_Black_Box.pdf]http://www.americanhealthpolicy.org/Content/documents/resources/December%202015_AHPI%20Study_Understanding_the_Pharma_Black_Box.pdf]http://www.americanhealthpolicy.org/Content/documents/resources/December%202015_AHPI%20Study_Understanding_the_Pharma_Black_Box.pdf]http://www.americanhealthpolicy.org/Content/documents/resources/December%202015_AHPI%20Study_Understanding_the_Pharma_Black_Box.pdf]http://www.americanhealthpolicy.org/Content/documents/resources/December%202015_AHPI%20Study_Understanding_the_Pharma_Black_Box.pdf

[KCLarkin]

I have been hearing from some industry people that payors and by extension their PBMs may be pushing pharmacies to turn increasingly to the old fee-for-service revenue model rather than the prevailing mark up model.  The current structure is a mix between fee-for-service and a mark-up from the perspective of the pharmacy.

 

Thanks for the great details.

 

The interesting dynamic is that this needs the cooperation of either CVS or Walgreen's. I don't think any PBM can compete without at least one of the national chains.

 

Walgreen's needs the retail pharmacy margin. So from a Game Theory perspective, Walgreen's was unlikely to blink first.

 

CVS owns a major PBM so it can be agnostic to whether the profit goes to the PBM or the pharmacy. But it didn't have an incentive to move aggressively.

 

But with the new "Boots" beauty strategy, Walgreen's has a new strategic option. It can trade pharmacy profit for beauty profit. So the PBM's now have more leverage.

 

For CVS, the disaster scenario would be both lost market share and compressed margins. This happens if CVS is unable or unwilling to bid aggressively for preferred networks.

 

The likely outcome is that CVS will respond aggressively. Market share will stabilize and retail pharmacy margins will fall. In this scenario, Walgreen's makes up for lost margin with it's beauty products and CVS compensates with its PBM. The OptumRX deal suggests that CVS plans to fight back.

 

--

Some more background on the OptumRX deal (h/t @bluegrasscap)

http://www.drugchannels.net/2016/11/cvs-changes-direction-with-surprise.html?m=1

 

[ABM]

I think of WBA as a bit more aggressive in their strategy to play disruptor and may be willing to adapt full fee for service model while wagering that its front store business is strong enough to carry off the business in the US.  I believe CVS is telling us that any compression on retail margins or loss of customer traffic could have an outsized impact on retail segment as the pharmacy is a critical driver of store traffic that generates front store sales. 

 

On your point about profits just being shifted between segments, I would disagree to an extent as the return profiles are very different in the PBM business vs. the retail given the retails capital intensity. They need a certain level of margin output to support those capital dollars invested in working capital and fixed assets.  If they were to sacrifice margin dollars in lieu of producing them at the PBM I am not sure how positive that can be for overall company capital returns. 

 

Further, WBA is run by an owner operator with billions at stake while CVS CEO owns a neglible amount of stock. 

 

Did you guys see the near $200 million open market purchase by WBA CEO a couple of weeks back?

 

https://www.sec.gov/Archives/edgar/data/1618921/000155468716000006/xslF345X03/primary_doc.xml

 

I have followed and owned CVS for years but I am quickly becoming a fan of the man that runs WBA.