Amazingly, CVS Health (CVS) has lost 50% of its value since trading above $110 all the way back in 2015. The pharmacy company just completed a major merger with Aetna fueled by debt and to no surprise the stock is hitting new multi-year lows. Large debt loads and a confusing business model lays the foundation for opportunity in a beaten down stock.
Image Source: CVS Health website
Hard To Manage
While CVS Health can promote the integrated health solutions from the addition of the healthcare benefits business from Aetna, the company can’t change the massive scale of a business that now has $250 billion in annual revenues. The new business includes a massive retail operation that includes 10,000 pharmacies, a Pharmacy Benefits Manager in Caremark and a Health Benefits Manager in Aetna.
The addition of substantial debt loads makes for little room for error in a complex business to navigate, especially with the government expanding efforts to reduce drug pricing. The company is uniquely positioned to address medical cost savings opportunities, but CVS Health doesn’t necessarily appear to benefit from that scenario as the government wants some of the middlemen to take the hit in providing savings to the industry.
Source: CVS Health Q4’18 presentation
So on one hand, the company sounds like the leader of the future in healthcare providing improvements in health outcomes at lower costs. Per CEO Larry Merlo on the Q4 earnings call:
CVS Health is in a superior position to lead the change needed in the fragmented U.S. Healthcare System with our compelling fully integrated healthcare offerings, our unmatched local community assets, proven pharmacy care leadership and a commitment to collaborating with healthcare providers to achieve the very best outcomes for the patients and clients we serve.
On the other hand, the company isn’t seeing any of the benefits as a lot of people want to see the $15 billion in operating income from CVS Health redistributed to other people in the healthcare system including primarily savings for the patients. As such the company listed the following reasons for an EPS hit in 2019:
- Declining benefit of generics.
- Lower brand drug inflation.
- Ongoing questions around drug rebates.
- CVS-specific challenges in the long-term care space.
The end result is the previous CVS units are forecasting operating income declines. The Retail business forecasts a 10% decline to ~$6.65 billion and the Pharmacy Services group forecasts a low-single digits decline to ~$4.88 billion.
The end result is a mega merger that isn’t seeing the projected outcomes as either the company used the purchase of Aetna to hide weakness in legacy businesses or CVS Health lost focus on those businesses during the merger.
Keep It Simple
Where the stock gets interesting is the company keeping the game plan going forward simple. CVS Health has substantially expanded debt levels in the last few years with net debt now at nearly $67 billion and costing the company over $3 billion in annual interest costs.
The company forecasts about $15 billion in operating income in 2019 so the debt level isn’t a leverage issue, but rather a strategy nightmare for a company that can’t hit financial targets from the massive business.
Simply, CVS Health needs to repay debt and prove out the model where offering more primary care services at retail locations via the MinuteClinic is a winning strategy. Based on these early results, the biggest concern is that the main customers utilizing such services are the cost conscious ones looking for a good deal. A big difference exists between being the company offering the healthcare solutions patients want and offering profitable services that these patients need.
The company forecasts 2019 free cash flow in the $7.5 billion range with the extra cash after paying about $2 billion in annual dividends to repay debt. CVS Health has a ton of near-term debt maturities that aren’t a major concern with this cash flow business, but the company still needs to eliminate the risk via debt repayments and refinancing other maturities.
The unknown here is where EPS estimates bottom out. The trend remains highly negative leading the stock into a value trap scenario until the management team can get a handle on the massive business.
The key investor takeaway is that CVS Health is a clear value stock trading at 8.3x ’19 EPS estimates of $6.78. The company has to prove that a hard to manage business is actually manageable while repaying substantial debt levels.
More patience is needed before rushing into this potential value trap. Once the negative EPS trend reverses, the stock will be a buy.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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