Description

“If you give the best winemakers shitty grapes, they’re still going to make shitty wine.”

--Fred Schrader, founder of Schrader Cellars (the most 100-point scores received by a U.S. winery)

Thirteen years ago, I wrote up CVS as a long. I was fortunate to exit my investment when I did nearly 10 years ago. Since then, the retail and institutional pharmacy businesses have gone from bad to worse (i.e. the shitty grapes). Personally, I believe CVS’ Pharmacy & Consumer Wellness operations are basically terminal.

I wrote up WBA as a short three years ago. Since then, the stock has declined by ~80%. Nothing has changed regarding the poor fundamentals of the industry. While I don’t think the same level of downside exists for CVS because of the inherent value in its Health Care Benefits (mainly Aetna) and Health Care Services (mainly its PBM, Caremark) segments, I still believe there is 30%+ downside from current levels. For those who like pair trades, you could go long CI (purest comp to CVS ex. Pharmacy & Consumer Wellness) and short CVS to create more of a pure short on the stub of its Pharmacy & Consumer Wellness business.

Recently, an activist investor, Glenview Capital, has reportedly taken a 1% stake in CVS. The stock is up nearly 10% in the past month. Glenview states that it is not pushing CVS to break up. However, in my opinion, that is how CVS would maximize long-term value for shareholders. Specifically, it would make sense for Health Care Benefits and Health Care Services to be together as one company, separate from the Pharmacy & Consumer Wellness segment, which is in secular decline and provides no obvious strategic synergies.

Having all these businesses together under one roof was a failed experiment as there are minimal strategic synergies to help bend the healthcare cost curve. Most healthcare costs are downstream, medical expenses (in the hospital), medications and services to combat expensive chronic conditions (such as diabetes) and end of life care. It was a utopian idea that somehow Aetna would send patients to see nurse practitioners at CVS stores on a regular basis to keep people healthier (and buy more front-end merchandise).

The longer these segments stay together, the more shareholder value will be destroyed, in my opinion. That is because I believe it gives the PBMs/Health Insurers a license to push even harder on further reimbursement rate cuts to pharmacies since there are other profit pools to help cushion the blow from harsher reimbursement rate cuts.

So much about being a successful investor is getting a few key points correct. Within healthcare, like in most businesses, a lot of it comes down to Porter’s Five Forces. Specifically, who is a price taker and who is a price maker.

I’m generalizing here, but big picture this is right:

Health Insurers: consolidated industry nationally (even more so regionally) and therefore more of a price maker than taker (absent the government doing anything material)

PBMs: consolidated industry with three major players (UNH’s Optum, CI’s Evernorth, CVS’ Caremark) and therefore more of a price maker than taker (absent the government doing anyting material)

Hospitals: very fragmented industry and thus largely a price taker (Steward Hospitals, THC, etc.) from health insurers except for strong local/regional players (such as NYU Langone, UCLA, Cedars-Sinai, Mayo Clinic, Cleveland Clinic, HCA in Texas and Florida, etc.)

Retail and Institutional Pharmacies: very fragmented nationally and locally and therefore entirely price takers (at the mercy of PBMs/Health Insurers)

Let’s look at a sum-of-the-parts values (using CI as the closest comp for Health Care Benefits and Services):

CI: currently trades at 8.8x 2024E adjusted operating income of $11.775B with a long-term growth rate of ~6%-9%

• ~40% Health Insurance with a long-term estimated growth rate of 7%-10%
• ~30% PBM with an estimated long-term growth rate of 2%-4%
• ~30% specialty pharmacy and services with an estimated long-term growth rate of 8%-12%

CVS (excluding Pharmacy & Consumer Wellness): 2024E $9.45B-$9.80B with a long-term growth rate of ~3%-6%

• Health Care Benefits: 2024E adjusted operating income of $2.25B-$2.55B (down from prior guidance of $3.6B) due to provisions for incremental Medicare trends and its 2024 Individual Exchange risk adjustment, as well as the impact of acuity and rate dislocation in its Medicaid business
• Health Services (PBM): 2024E adjusted operating income of $7.20-$7.25B
  • Since its mix skews more heavily to the lower growing PBM, it deserves a lower multiple. One could argue that Aetna’s issues are short-term and thus one could add back $1.2B of operating income to value this. Roughly speaking, to be conservative I’d use a higher (~8.0x-8.5x) multiple on 2024E operating income and a lower multiple (~7.0-7.5x) assuming the $1.2B comes back within a couple years. In either case, this should trade at a lower multiple than CI given its 3%+ lower long-term growth rate. Being generous on a relative value basis to CI, I get a range of values of $74.6B-$83.3B. Using a 7x multiple (~20% discount to CI) on $9.625B adj. op. income would equate to ~$67.4B in value.

 CVS: 

• Market Cap: $79.3B
• Net Debt (excluding operating leases): $25.0B
• Operating Leases: $17.4B
• EV: $121.7B

 CVS’ Pharmacy & Consumer Wellness Implied Valuation: $38.5B-$54.4B (6.7x-9.5x 2024E adjusted operating income)

• Here is the adj. operating income decay over the last few years:
  • 2021: $7.26B
  • 2022: $6.53B
  • 2023: $5.96B
  • 2024E: $5.70-$5.75B
    • The front of store revenue continues to decline as well, down 6.2% in Q2’24. The obvious culprit is online retail, namely AMZN, taking further share.

Just like WBA, I think the value of CVS’ Pharmacy & Consumer Wellness business is headed towards zero over time. It is in the best interest of PBMs/Health Insurers to let these pharmacies be “zombie” businesses. This way pharmacies will make just enough money to keep many of their doors open so the government doesn’t pick a fight with the PBMs/Health Insurers. At the same, it allows the PBMs/Health Insurers to continually take down reimbursement rates to juice their own profits.

I like CI as a stand-alone long and CVS as a stand-alone short. Together they’re a good, paired trade. Beethoven did a nice job writing CI up as a long two years ago, which has returned ~25% since then with no multiple expansion. I highly recommend you read that write-up and the Q&A.

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Catalyst

Continued pharmacy reimbursement rate cuts by PBMs/Health Insurers.