Description

Summary:  BUY

CVS is down 33% since it was last written up on VIC (1/8/2018) due to a number of temporary as well as long-term issues/concerns, and we now have the opportunity to buy a high-quality vertically-integrated business at a substantial discount to intrinsic value.  CVS is now trading at <8x 2019E and ~7x 2020E ADJ EPS. We believe some of the 2019 issues should subside (prove to be a trough year) and should improve performance in 2020 and beyond. At 10.5-12.0x 2020E EPS it would be worth $78-90 = 50-70% upside.

Thesis/Summary:

• CVS' acquisition of Aetna was completed on November 28, 2018 (though still needs DC Judge Richard Leon's final approval; the US DOJ approved the deal on 11/28/2018 and on 2/25/2019 requested for the judge to approve the merger officially.  He hasn't given his approval yet and hasn't allowed them to fully integrate which has likely weighed on margins and delayed synergies). Aetna was acquired for $70B ($78B including assumed debt); $47B in cash and remainder in stock. They acquired Aetna for ~11.7x TTM EV/EBITDA, ~12.6x EV/EBIT, and ~19x TTM Adj PE and guided to $750M of synergies within 2 years and $300-350M in 2019 (Aetna had overhead of ~$500M).
• CVS’ 2019 guidance provided on 2/20 was weaker than expected and the stock has traded down substantially.  It was a significant guide-down from consensus expectations and numbers from the S-4 (provided for the merger; usually optimistic), but it is likely kitchen-sinked and 2020 should show significant improvements as some headwinds subside, and is cheap even on (what should be) trough earnings.
• Consensus had been for $19B of EBITDA in 2019 and $20B in 2020 (in early 2018 CVS standalone was expected to achieve $13B of EBITDA in 2019 and $13.5B in 2020 and AETNA $6.2B in 2019 and $7B in 2020 and then guided to achieve $750M of synergies 2 years post merger). 
• Following the Q4 2018 call, earnings guidance is now at $17B of EBITDA in 2019 and consensus is for $18B in 2020, so a $2B reduction in EBITDA for 2019 from original expectation.
• Even on significantly guided-down (what should be trough) 2019 numbers they are trading at <8x Adj. EPS (adding back amortization and Aetna acquisition costs) and should be ~7x 2020 Adj EPS.
• Leverage is fairly high post-acquisition at 4.4x Debt/2019E EBITDA (4.1x Net Debt/EBITDA), which is concerning to some, but the debt is termed-out, primarily fixed-rate and low-cost, the business is highly cash generative and recurring (medium-term contracts in PBM, high-quality Health Insurance (Aetna) business (though retail pharmacy results should continue to struggle despite growing share and doing well relatively) so quite likely that can get to mid-to-low 3's leverage by YE 2020 and should have outsized equity return as they de-lever.
• $70.5B of Net Debt and 4.1x Net Debt/EBITDA on Guided 2019E EBITDA.
• Only $1.175B of Debt matures in 2019; $5.75B in 2020; $10.4B in 2021; $4.15B in 2022; $8.55B in 2023.
• Company has guided to $7.5B of FCF in 2019 and should be able to generate $9-10B in 2020 and beyond.
• FCF Estimate:  $17B of 2019E EBITDA in 2019 minus $3B of Interest Expense minus $2.4B of Taxes minus $2.5B of Capex = $9B of FCF before Changes in WC or One-Time expenses.  Company guided to $550M of Acquisition Related expenses in 2019, which is a hit to FCF in 2019, but should go away in 2020; should experience benefit in 2020 from the ~$750M of total estimated synergies; EBITDA is expected to increase by $1B; interest expense should decline over time as they use most FCF ex dividend for debt paydown.
• Currently paying $2.6B ($2.00/share) in dividends; the company plans to use the remainder for Debt paydowns until <3.5x Debt/EBITDA (no buybacks).
• We estimate getting to <3.5x Net Debt/EBITDA by 9/30/2020.
• Risk:  $8.2B of what was Aetna debt would come due and payable if CVS were to get downgraded to below investment grade (due to the change of control); currently 2 notches above non-investment-grade.
• Certain issues  impacting 2019, such as Pharmacy Reimbursement Pressure, Lower Brand Inflation, weak Long-Term-Care (Omnicare) and Front-of-Store will likely continue long-term and unlikely to get the large offsetting boost from generics as in the past few years, but a number of 2019 headwinds should be temporary and subside (Rebate Guarantees in PBM contracts, Incremental Investments, integration costs, Anthem start-up costs) and Health Care Benefits (AETNA) should continue to perform well.  They are also expected to realize $750M in synergies over the next 2 years ($300-350M in 2019) which should lead to improved results in 2020.
• Retail (due to front-of-store and pharmacy reimbursement) will struggle just to maintain 2019 guided profitability (guided to be down 10% from 2018) in future years.
• PBM (guided to be down LSD in 2018) should have positive growth in 2020 as a number of 2019 headwinds should subside, as the rebate guarantees impacting PBM should roll off in 2019 & 2020 (3Y contracts), and additional investments in 2019, such as Anthem start-up costs and investments for new growth initiatives, should subside.  Legislation eliminating rebates could get passed; CVS currently makes around $300M from rebates (2% of Operating Income and 6% of PBM operating income) and is already working on models which eliminate rebates. Additionally, they could lose PBM business as a result of the merger with Aetna; so far have had 98% renewal in 2019 excluding the loss of Centene (in-sourcing), which will transition over the next couple years.
• HCB (AETNA):  Should continue to perform well despite recent headlines.  Medicare for All legislation was introduced on 2/27/2019 by Democrats which has pressured UNH, CI, CVS and other health insurers.  The legislation would do away with private insurance, deductibles and out-of-pocket payments.  I think this is very unlikely to get passed though; need Democrats to win presidency in 2020, maintain House, and increase senate from 47 to 60 votes.
• Risks from Amazon ramping up online pharmacy (acquired Pillpack online pharmacy in June 2018, has 5 distribution centers, and are adding licenses at each facility to many additional states) as well as the Amazon/JPMorgan/Berkshire partnership (entering health insurance) will remain.
• Valuation:  CVS should be worth $78-90/share at 10.5-12.0x 2020E EPS = 50-70% upside, and get there in the next year or so as some of the headwinds subside and they guide for a stronger 2020 (and provide LT details at Analyst Day on 6/4/19).
• Current Valuation:
• 7.7x 2019E Adj PE (adds back amortization and Aetna acquisition costs; 7.1x 2020E); 9.2x 2019E FCF (6.6x 2020E); 8.2x 2019E EV/EBITDA (7.8x 2020E); 9.3x 2019E EV/EBITA (8.9x 2020E).
• 2019 is guided to be below previous expectations (and 2018 Pro-Forma).  2020 should show improvements and could prove to be better than currently expected.
• Target Price:  $78-90+ = 50-70% upside
• CVS should be worth $78-90/share at 10.5-12.0x 2020E EPS = 50-70% upside, and get there in the next year or so as some of the temporary headwinds subside and they provide 2020 guidance at YE (and LT details at Analyst Day on 6/4/19) which give confidence in their future trajectory.
• Retail&PBM (2/3rds of operating income) should be worth 8-10x PE and HCB(Aetna = 1/3rd of operating income) should be worth Mid-Teens+ PE.
• Thoughts:
  • There are a significant number of headwinds/risks with the stock, but the current price seems to be assuming the downside case; the headwinds will all continue on, and the company is permanently in decline.  2019 should be a trough year and should show improvement in 2020 as some of the headwinds subside. A combined vertically integrated CVS/Aetna should help them combat some of the pressures in the business and they should be able to develop a model that allows them to maintain/grow their profitability from 2019.
• Share Repurchases:  They won't do any share repurchases until leverage is below 3.5x (so 2H 2020 at the earliest).  They repurchased $13.9B in 2015-2017 (suspended the repurchases once they agreed to acquire Aetna) but will likely continue large repurchases once debt is below their target
• Dividend: They currently pay $2.00/share = 3.8%.
• Insider Buying:  2 Directors, Edward Ludwig and Fernando Aguirre, bought 4.0K and 3.41K respective on 3/1/2019 totaling $432K at $58.

Causes of Lower than Expected 2019 Guidance:

• Recurring industry headwinds such as pharmacy reimbursement pressure, lower brand inflation and challenges within long-term care (Omnicare) are the primary reasons for the shortfall. The company will also be affected by rebate guarantees and fewer generics.
• Pharmacy Reimbursement Pressure:  Ongoing industry issue on retail side; reimbursement rates continue to decline.  This had previously been offset by wave of generics and brand inflation but much lower tailwind from this currently.
• Fewer Generics & Single-Source Generics:  Historically, generics have been a huge tailwind to help CVS offset the impacts of reimbursement pressure.  2019 is expected to be a weaker year from a break-open generics perspective; lower value of break-open products and some delays in launches, such as with Advair. They maximize generic profitability during the break-open period with multiple manufacturers in the marketplace.
• Lower Brand Inflation/Rebate Guarantees:  Brand inflation has moderated and is expected to be mid-single-digits in 2019; this compares to low-double-digit teens if you go back a few years.  PBM contracts have a 3 year cycle and some of the contracts have guaranteed rebates. These will roll off over 3 years but in the meantime will pressure profits in 2019 and 2020, while new contracts will be structured differently.
• Long-term Care (Omnicare):  Has been weaker than expected the past couple years.  Took a large goodwill impairment ($2.2B) in Q4 and will continue to be weak.  The challenges have been related to skilled nursing facilities, which have been worse than expected.
• Incremental Investment Spending:  The company guided to $325 - $350M of incremental investment spending in 2019, which almost entirely offsets expected synergies of $300 - $350M in 2019 ($750M total synergies expected by company within 2 years). The 2 buckets of spending are 1) Supporting transformation and includes investments in our clinical platform to more effectively engage members, our chronic care initiative and other initiatives aimed at improving outcomes and lowering cost. 2) Investment in digital and improving the digital and mobile experience for members and customers across all of our businesses and in their health cloud software platform.
• Acquisition Related Expenses:  $550M of Acquisition-related expenses (for Aetna) are excluded from Adj. EBITDA, Adj Operating Income and Adj EPS, but causes a reduction in their OCF and FCF as well as GAAP numbers.
• Issues By Segment:
• Retail/LTC:  Guided to $6.6-6.7B in Adj Operating Income in 2019
• Retail segment operating income is expected to be down ~10% yoy. CVS said that Long Term Care (Omnicare) and the lapping of tax reform investment are expected to contribute to nearly half of the segment contraction; the other half is driven by continued reimbursement pressure and a declining benefit from generics.
• 2018:  Adjusted operating income declined by 1.2%, driven by their decision to invest a portion of the benefits they realized from tax reform into wages and benefits. Additionally, they continued to experience underperformance in the Long-Term Care Pharmacy business. Excluding those 2 items, stand-alone Retail Pharmacy adjusted operating income grew by about 5% over full year 2017.  Their market-leading script growth increased our Pharmacy market share to a record 26% in December.
• HCB (Aetna): Guided to $5.1-5.2B in Adj Operating Income in 2019
• Guidance was below expectations. Company said they expect it to be up modestly (excluding certain items below) from 2018 but appears to be down LSD overall.
• "A handful of other dynamics will impact HCB results, including: year 1 deal synergies will disproportionately benefit the HCB segment. Second, incremental investments will be deployed in 2019 to accelerate growth, enhance infrastructure and drive market differentiation. Third, the suspension of the health insurer fee in 2019 will impact certain operating ratios, while the after-tax impact of this suspension versus 2018 is immaterial. And finally, certain onetime benefits realized by Aetna in 2018 are not expected to repeat in 2019, and the HCB segment will be negatively affected by the segment movements discussed earlier. Excluding the segment move, the incremental investments we're making in 2019 to accelerate growth and the impact of the HIF suspension, HCB operating income is expected to grow modestly."
• PBM: Guided to $4.8-4.9B in Adj Operating Income in 2019
• PBM segment operating income is expected to decline LSD in the year, although down MSD on like for like basis.
• The main issue for 2019 is lower Brand Inflation combined with Rebate Guarantees.  Brand inflation has moderated and is expected to be mid-single-digits in 2019; this compares to low-double-digit teens if you go back a few years.  PBM contracts have a 3 year cycle and some of the contracts have guaranteed rebates. These will roll off over 3 years but in the meantime will pressure profits in 2019 and 2020, while new contracts will be structured differently.
• Centene: Centene has notified CVS that they will move their business to their recently acquired PBM partner, RxAdvance (a small tech-enabled PBM that they made an investment in last year). This transition is expected to begin in 2019; there is no exact timeline but will start in 2019, peak in 2020 and residual in 2021.
• Anthem Start-Up Costs:  "Anthem to remain as strong a headwind, given the investments required to onboard the business on its accelerated time line. The onboarding is expected to begin in the second quarter of this year."
• Management expects a number of the headwinds to subside by YE 2020. 

Risks/Concerns:

• Medicare-for-All (or similar):
  • Medicare for All legislation was introduced by Democrats on 2/27 which has pressured UNH and other health insurers.  The legislation would do away with private insurance, deductibles and out-of-pocket payments.  I think this is extremely unlikely to get passed though.  Democrats would need to win the presidency in 2020, maintain the House, and increase Senate seats from 47 to 60 (they only have a 40% odds currently to even get to 50; there is ~0% chance of getting to 60 in 2020 and minimal in 2022).  So while this will continue to grab headlines through 2020, there's likely minimal actual risk.
• PBM/Rebates:
• PBM has always been a black box in terms of the cut of drug spend they are taking, and has been under increasing pressure to eliminate rebate model, including new Rebate Rule proposed by HHS.  CVS says they created a new Guaranteed Net Cost pricing in which clients will receive 100% of rebates.
• CVS currently makes about $300M net from rebates (Cigna/ESRX = $400M).  They are currently changing their pricing model and should be able to maintain a substantial portion of this, but $300M is fairly small (2% of overall Operating Income and 6% of PBM operating income) versus $17B in EBITDA, $15B of Adj  Operating Income, and $8.8B of Adj Net Income guided in 2019. Management said that branded pharma would be the winner of the controversial rebate-rule proposed by HHS. Meanwhile, beneficiaries would face higher premiums (+52% by some reports), and taxpayers would foot a $200B bill.  CVS reiterated that Part D premiums are already 100% rebated to Part D customers, while overall rebate exposure remains at 2-3% of EPS.
• PBM Business Attrition:
• Centene:  Centene has notified CVS that they will move their business to their recently acquired PBM partner, RxAdvance (a small tech-enabled PBM that they made an investment in last year). This transition is expected to begin in 2019; likely to peak in 2020 and remainder in 2021.  CENTENE is an MCO for >12M members in govt-sponsored healthcare programs. RBC estimates Centene is one of Caremark’s largest PBM customers with ~$9B in revenue (7% of PBM revenue). Assuming OP margins of ~1.5% (vs. PBM average of 3.5%, lower because big customer/Medicaid margins are lower than rest of commercial book), we estimate CVS derives ~$135mm of Operating Profit (~1% of total OP and 3% of PBM).
• Other PBM business could be lost as a result of Aetna acquisition:  They've had 98% renewal excluding Centene. Express Scripts combined with Cigna so now there are no independent PBM's; this should limit some of the attrition.  GS estimated recently that up to ~30% of their PBM book could be at risk but this seems unlikely.   
• Fairly High Leverage and risk if downgraded to below-investment-grade:
• CVS is at 4.4x Debt/EBITDA and 4.1x Net Debt/EBITDA on guided 2019E (4.0 and 3.8x on PF 2018).
• Their plan is to get to mid-3's within 2 years after closing.
• At YE 2020E they should be at 3.5x Debt/TTM EBITDA and 3.3x Net Debt/TTM EBITDA.
• Debt is termed out.  $68.5B of $74.3B of Debt is Fixed.  Only $5.7B is floating. All debt maturing after 2021 is Fixed.  They should generate FCF well in excess of the debt maturities.
• Risk:  If AETNA bonds were to be downgraded to Below Investment Grade (combined with recent Change of Control) there is $8.2B of bonds that could become due and payable (at 101) and likely would require higher rate debt to replace.  These bonds have 3.9% interest rate and recent CVS overall is at 4.0%. But issuing at below investment grade the rate would likely be significantly higher. Bonds are currently rated Baa2 by Moody's and BBB by S&P which is 2 notches above non-investment grade. They could pre-pay some Aetna-issued bonds with excess cash flow to reduce this risk.
• Amazon/JPMorgan/Berkshire Partnership (Haven):
  • Announced partnership on 1/30/2018 to reduce healthcare costs (create their own health insurer, initially for their own employees).  I'd put low odds of this partnership doing anything that puts a significant dent in CVS but they have deep pockets and the possibility of this entrance will remain an overhang on the stock.  They hired Dr. Atul Gawande as CEO in June and recently poached an executive from UNH Optum (PBM); UNH attempted to block the hire (due to his intricate knowledge of their PBM practices) but failed.
• Amazon:
• Amazon entered online pharmacy through Pillpack acquisition in June 2018.   Risk that Amazon will roll out a full online pharmacy offering once its distribution capabilities are sufficiently scaled.  Currently have 5 distribution centers (Manchester, NH; Austin, TX; Miami, FL; Phoenix, AZ; Brooklyn, NY); they continue to apply for additional licenses for each center to ship to additional states; eventually they'll apply for all centers to ship to each state, but will need to add additional distribution center before they have nationwide distribution coverage at scale.  CVS has 26 facilities; Optum has 18; Express Scripts has 15.
• Continued pressure on front of store in retail segment from e-commerce (primarily Amazon).  0.5% SSS in front-of-store in 2018 (but required significant discounting according to WBA which impacted margins).  -2.6% SSS in front-of-store in 2017; -1.5% in 2016. Expected to continue low single-digit declines. Amazon launched a line of OTC health products in February 2018 which will hurt front of store further. 

Catalysts:  There are no real catalysts upcoming, which is likely one of the main reasons for the continued selloff the past couple weeks in the face of weak guidance and headline risks.  But the following should drive the stock substantially higher over the next 1-2 years:

• Investor Day on 6/4/2019:  Should provide LT guidance post-acquisition of Aetna (and perhaps for 2020) and provide a detailed roadmap and additional visibility into their combined business.
• Improved Performance/2020 Guidance:  2019 will be a transition year for CVS; there are risks/costs from integrating Aetna as well as other headwinds (some temporary, some long-term).  Additionally, headline risks such as "Medicare for All", which have little chance of passage, have caused declines in the MCO's. Once some of the temporary headwinds (and headline risks) subside, performance improves, and they provide positive guidance for 2020 and beyond they should get a significantly higher valuation.
• Continued Debt Paydown:  One of the concerns weighing on the valuation is CVS' fairly high leverage (4.1x Net Debt/EBITDA) post-Aetna acquisition.  The debt is almost entirely fixed though, is termed out, CVS generates high FCF ($7.5B in 2019 and likely $9B+ in 2020), and will use almost all FCF after dividend for debt paydown.  They should get leverage to <3.5x in ~1.5Y and should get higher valuation as debt is paid down.
• Share Repurchases:  They are unlikely to do share repurchases the next 1.5 years but once leverage is <3.5x will likely use significant FCF for repurchases.  They bought back $13.9B in shares from 2015-2017.

2019 Guidance:

Catalyst

Investor Day in June:  LT Guidance/roadmap/visibility into business.

Improved Performance/2020 Guidance

Continued Debt Paydown