Shares of healthcare solutions behemoth CVS Health Corporation (NYSE:CVS) are down some 25% since April 1, 2024, as an abysmal 1Q24 report and downward revised expectations for FY24 weigh. The company is experiencing a higher-than-expected medical benefit ratio in its Medicare Advantage plans, while it is ineligible for full level quality bonuses in FY24 due to fewer 4-star plans. With 87% of its Advantage members expected to return to 4+ star plans (setting up a stronger FY25) and a safe 4.4% dividend yield against net leverage of 4.1, CVS again merited a deeper dive. An analysis follows below.
CVS Health Corporation is a Woonsocket, Rhode Island-based healthcare solutions provider with more than 9,000 retail locations, 1,100 walk-in medical clinics, and 205 primary care clinics. It is also a pharmacy benefits manager with ~90 million plan members and a health insurance provider to ~36 million Americans. With FY23 revenue of $357.8 billion, CVS had the tenth-largest top line globally.
The company was founded in 1963 as Consumer Value Stores, was purchased by Melville Corporation in 1969, and was essentially spun out when Melville completed its last divestiture (of shoe retailer Footstar) in 1996 with its first trade as a standalone entity transacted at $9.56 a share, after giving effect to two 2-for-1 stock splits.
Shares of CVS trade around $60.00 a share now, translating to an approximate market cap of $76 billion. In early 2023, CVS completed the purchase of medical center operator Oak Street Health in its efforts to become a more comprehensive vertically integrated concern. Based on hindsight, it appears CVS overpaid for that acquisition.
Reporting Segments
With the aforementioned acquisition of Oak Street Health (as well as Signify Health) in 2023, the company realigned the composition of its operating segments, rebranding two of the four from which it assesses its performance. The units are now Health Care Benefits (HCB); Health Services (formerly Pharmacy Services); Pharmacy & Consumer Wellness (PCW) (formerly Retail/LTC); and Corporate.
HCB came courtesy of CVS’s acquisition of Aetna Health in 2018 and includes employer healthcare and government plans with a provider network of ~1.7 million healthcare professionals. This segment derives nearly three-quarters of its top line from contracts with the Centers for Medicare & Medicaid Services (CMS) and another 14% from the federal government. HCB generated FY23 Adj. operating income of $5.58 billion on revenue (primarily premiums) of $105.6 billion versus FY22 Adj. operating income of $6.34 billion on revenue of $91.4 billion, down 12% and up 16%, respectively. The decrease at the bottom line was a function of increased utilization in Medicare Advantage, as the overall medical benefit ratio (MBR) increased from 83.8% in FY22 to 86.2% in FY23.
Health Services includes the entire gambit of pharmacy benefit management [PBM] solutions under the CVS Caremark umbrella, including plan design offerings and administration, formulary management, retail pharmacy network management (60% of total segment revenue), and mail order pharmacy (36%). This unit maintains a national network of ~66,000 retail pharmacies and was responsible for filling or managing 2.3 billion prescriptions on a 30-day equivalent basis in FY23. It competes with large independent PBM concerns such as Prime Therapeutics and MedImpact, as well as ones owned by health plans such as Cigna’s (CI) Express Scripts and UnitedHealth’s OptumRx. It also now houses 1,000+ MinuteClinic walk-in medical clinics, value-based care services provided by Oak Street, and in-home evaluations from Signify. Health Services accounted for FY23 Adj. operating income of $7.31 billion on revenue of $186.8 billion versus FY22 Adj. operating income of $6.78 billion on revenue of $169.6 billion, up 8% and 10%, respectively.
In addition to creating a more vertically integrated model, the reason behind onboarding Oak Street was to improve CVS’ Medicare Advantage star rating, which slid precipitously from 78% with four plus stars in FY23 to only 21% in FY24. Established by the Affordable Care Act, the rating program is designed to encourage competition based on quality. Plans with four or more stars receive a 5% quality bonus and the ability to bid against a higher benchmark rate.
Owing to pandemic provisions that phased out in 2023, a decline in star ratings was anticipated in the industry, but CVS’ was particularly severe. That said, the percentage of Aetna Medicare Advantage members in 4+ star plans is expected to return to 87% in 2025, which should provide a ~$700 million tailwind in FY25.
PCW consists of its ~9,400 retail locations – 85% of Americans live within 10 miles of a CVS – and online retail pharmacies, which sell prescription drugs and general merchandise related to health and wellness. This unit dispensed 27% of the total retail pharmacy prescriptions in the U.S. during 2023 and provides ~75% of the segment’s revenue. The retail pharmacy subunit vies for business with Walgreens (WBA), Rite Aid (OTC:RADCQ), Walmart (WMT), and Amazon (AMZN). PCW generated FY23 Adj. operating income of $5.96 billion on revenue of $116.8 billion versus FY22 Adj. operating income of $6.53 billion on revenue of $108.6 billion, representing a decline of 9% and an increase of 8%, respectively. The lower operating line was the result of continued pharmacy reimbursem*nt pressure, more than offsetting a 13.6% pharmacy same store sales increase.
Putting it all together with corporate overhead and intersegment eliminations of $51.9 billion – primarily when certain Pharmacy Service (Maintenance Choice) clients elect to pick up prescriptions at a retail pharmacy instead of through the mail, resulting in double counting – CVS produced FY23 Adj operating income of $17.53 billion and EPS of $8.74 (non-GAAP) on revenue of $357.8 billion versus FY22 Adj. operating income of $18.04 billion and EPS of $9.03 (non-GAAP) on revenue of $322.5 billion, representing 3% declines in the bottom-line metrics and an 11% improvement at the top line. It also generated cash from operations of $13.4 billion, down 17% from $16.2 billion in FY22.
1Q24 Financial and FY24 Outlook
With that as the background entering FY24, CVS produced a clunker of a quarter when it reported financials on May 1, 2024, posting 1Q24 earnings of $1.31 a share (non-GAAP) on revenue of $88.4 billion versus $2.20 a share (non-GAAP) on revenue of $85.3 billion, reflecting a decline of 40% and an increase of 4%, respectively. Cash flow from operations also fell substantially, from $7.4 billion in 1Q23 to $4.9 billion in 1Q24, due to the timing of Medicare payments. Although the Street expected a hit due to the unfavorable impact of the company’s 2024 Medicare Advantage Star ratings, it was not expecting the MBR to soar from 84.6% to 90.4% year-over-year. Also, Health Services lost a “large client,” resulting in a 10% year-over-year drop in revenue to $40.2 billion. Owing to these factors, CVS’s bottom line missed consensus by $0.39, a huge setback for a normally stable business model.
Furthermore, in a change of course, management anticipates its MBR to remain elevated throughout the balance of the year (89.8% versus a previous forecast of 87.7%), compelling it to revise its full-year non-GAAP earnings estimates from at least $8.30 a share to at least $7.00 a share and its cash flow from operations outlook from at least $12.0 billion to at least $10.5 billion. Longer-term, management is still confident it can return to net margins of 4% to 5%. For reference, its new FY24 earnings outlook suggests a net margin of 2.3%.
Not surprisingly, the market reacted severely, sending shares of CVS down 19% in the subsequent trading session, registering its worse one-day performance in over a decade. Combined with disappointing 2025 final rate notice news from CMS concerning Medicare Advantage a month prior, the company’s stock has lost approximately 25% of its value since April Fools’ Day, even with the recent bump up in the equity over the past two weeks or so.
Balance Sheet & Analyst Commentary:
Although “at least $10.5 billion” is down 35% (at the most) from $16.2 billion in FY22, it is still plenty to cover its $0.67 quarterly dividend (of $3.36 billion of annual disbursem*nts), for a current yield of 4.8%. CVS completed a $3 billion repurchase authorization all in 1Q24, buying back 39.7 million shares. Based on its stock’s performance since, it looks as if management should have kept some of its powder dry. It does not plan to repurchase any additional stock in 2024. The company held cash and investments of $37.2 billion versus debt of $64.1 billion on March 31, 2024. Since $24.1 billion of cash and investments is long-term, the company’s net leverage is an increasingly concerning 4.1.
The 1Q24 report and downwards revised FY24 outlook caused three analyst firms (Leerink, HSBC and UBS) to jump ship and downgrade the stock to a Hold. The overall analyst firm community is roughly split between maintaining Buy or Hold ratings on the stock. On average, they expect CVS to earn $7.03 a share (non-GAAP) on revenue of $368.8 billion in FY24, followed by $7.85 a share (non-GAAP) on revenue of $387 billion in FY25. These bottom-line estimates are significantly lower than the $9.00 and $10.00 per share (non-GAAP) in the spring of 2023.
Verdict:
Even though it is challenging to predict Medicare Advantage utilization trends, the credibility of management’s forecasts has to take a hit with the rather drastic revisions to its FY24 outlook after only one quarter in the books. That said, if Street analysts – who have also been wrong – are to be believed, shares of CVS trade at an 8.6 P/E ratio on FY24E EPS and roughly seven times management’s minimum FY24E operating cash flow projection.
Factor in a safe 4.4% yield with the dour FY24 outlook factored into its price, look for CVS Health Corporation stock to become range bound between roughly $55 and $65 per share. This makes the stock a solid covered call candidate, but not much else other than a somewhat tepid dividend holding.
Note: CVS was recommended exclusively to our Investing Group members as a covered call trade one month ago when the stock traded just above $55 a share (roughly the bottom of what, we believe, will be the stock's new range over the medium term)
Author's note: I present an update my best small and mid-cap stock ideas that insiders are buying only to subscribers of my exclusive marketplace, The Insiders Forum. Our model portfolio has more than doubled the performance of the Russell 2000 since its launch. Membership also includes our lucrative'option play of the week' feature. Join our community today by clicking on our logo below!
