Last October I wrote about the just-leaked CVS Health (CVS) bid for health insurance giant Aetna (AET) and tried to convey the notion that the move was about far more than just diversifying away from retail pharmacies for fear Amazon might compress margins in that industry. Interestingly, CVS’s stock price was $69.05 when I published that note, and today it closed at $69.05. So almost 10 months later and all investors have earned from the shares is the not-too-shabby 3% annual dividend.
CVS reported a solid second quarter this week and is on pace to book nearly $7 of free cash flow per share in 2018 ($6.88 in my internal model), which puts the stock at 10 times free cash flow, a price normally reserved for melting ice cube businesses. And there are plenty of people who see CVS (incorrectly) as just a bricks and mortar pharmacy company destined to be disrupted by some trillion dollar market value tech darling. Others acknowledge their huge pharmacy benefits management business (Caremark), but believe the thesis that those firms are actually robbing their commercial clients blind and helping boost drug prices, when the opposite is actually true (and hence why their clients don’t fire them). If both of those notions turn out to be correct, CVS will not be a good investment over the next 5 or 10 years, but I am taking the opposite view.
In fact, the story will get even better when the Aetna deal closes (CVS management indicated on their quarterly conference call this week that September or October is the most likely timeframe for closure). Essentially, CVS is building a healthcare services juggernaut, it seems to me anyway, and will be able to use a vertically integrated business model to offer consumers numerous options and generate efficiencies in an otherwise complex healthcare system. Bears on the company seem to fail to realize that a network of drugstores and in-store clinics, coupled with pharmacy plan management, assisting living and nursing home drug distribution, and insurance plans is an all-encompassing system that can be designed and integrated in such a way as to drive convenient usage from customers of all shapes and sizes, which in turn should bring down costs as scale is leveraged.
Now, there is no guarantee that the company will figure out the best way to harness this potential, but the goods news is that the stock is pricing in failure already at 10x free cash flow. Nothing positive is being considered by most investors and many of them figure the 3% dividend will be immaterial once Amazon announces 2-hour prescription fills delivered by drone starting in 2022 (that is merely speculation on my part — no announcements have been made). However, when you look at the breadth of CVS’s offerings it seems to me that this company is more than just a bricks and mortar retailer selling a commodity at a higher margin than Jeff Bezos would. It does not seem like something the tech giants could duplicate successfully.
As for the PBM side of the business, a lot has been made about pharmaceutical rebates and how they may be encouraging drug prices to remain high on a gross basis. The anti-Caremark thinking assumes that drug markers are giving the PBM rebates on drugs and those payments are juicing the profits of the PBM while patients pay huge out of pocket costs. CVS told investors this week, however, that they keep just $300 million of rebates annually, and pass the rest (roughly 97-98% of the total collected) back to their clients in one form or another (different clients choose different structures). That $300 million figure represents just 4% of the company’s annual free cash flow.
Put another way, in a world where PBM plans are restructured so that no rebates are kept by the plan manager, CVS’s free cash flow would drop from $6.88 to $6.59 per share. Not only is that hardly enough reason for the stock to be trading where it has been for the last year, but it is unlikely that Caremark would have to give up that $300 million at all. Rather, the PBM contracts would likely be changed to move away from rebates at all, and be underwritten in other ways such that certain folks would no longer insist rebates were the problem. Given that PBM clients are renewing their contracts in the high 90 percents every year, providers like Caremark would likely have no trouble keeping their existing business relationships, at the same underlying profit margins, even if they changed how the reimbursement of negotiated drug savings were handled.
As an investor in CVS Health, I am intrigued to see what the company can do with Aetna added to the mix. Since I don’t expect their business to begin a slow decay over the next few years, I am sticking with the shares, despite them merely treading water lately, as I firmly believe the business is far more resilient and value-providing than the bears are giving it credit for. Even at 15x annual free cash flow, still a material discount to the S&P 500 index (remember when consumer staples used to trade at a premium?), CVS stock would trade north of $100 per share. Call me crazy, but I think we will get there sometime within the next 2-3 years. Add in a 3% dividend while we wait and the upside potential is impressive, especially given how negative sentiment is today (which limits further downside to some extent).