If you follow social media, you’ll see a ton of people calling CVS Health (NYSE:CVS) a compelling bargain right now. The stock sells for just over book value, 7.6x forward earnings, and offers a more than 3.5% dividend yield. For investors in the Peter Lynch “buy what you know” school of investing, CVS stock seems appealing. A respected company with omnipresent stores across the country selling at a deeply discounted valuation. So what’s not to like?
Source: Mike Mozart via Flickr
There are a few reasons for caution on CVS stock, despite the apparent positives. For one, the company has become far more than a pharmacy chain. And in its numerous acquisitions, it has loaded the company up with debt and risk.
For another, the company’s profit margins are under fire on many sides. The stock market isn’t being unreasonable in pricing CVS stock for a series of difficult years ahead.
I was never a fan of CVS’ move into the pharmacy benefit manager (PBM) space. It may feel quite closely related to the main business; a PBM manages prescription benefits for self-insured companies, government organizations and other such entities that don’t use a major health insurance operator. CVS could certainly achieve cost savings by fusing these two operations together, right?
In practice, though, they are quite separate businesses. Dealing with private companies and Medicare is much different than running its pharmacies and walk-in clinics. As it would so happen, both retail pharmacy and PBMs have been struggling over the past few years, so CVS’ diversification did little to alter its trajectory as compared with Walgreens Boots Alliance (NYSE:WBA).
That said, CVS recently went all-in on becoming a one-stop health care destination. It made a gigantic $68 billion deal for health insurer Aetna. This was reportedly a defensive move, as Aetna itself was a major client of CVS’ PBM. Buying them kept that business in-house rather than risking defection; it also took one major M&A target off the market. This was viewed as an important move to try to keep Amazon (NASDAQ:AMZN) from potentially entering the industry.
Now, with the Aetna deal closed, CVS controls a significant chunk of the whole health care supply chain, from a walk-in flu shot on up through drug dispensing, Medicare management, and private health insurance.
Deals Don’t Inspire Confidence
Unfortunately, this health care colossus faces a number of challenges. For one, management is showing questionable judgment. Its $12.7 billion acquisition of Omnicare in 2015 has already led to more than $6 billion in write-offs. CVS both misread that market in long-term care and also overestimated how many synergies there would be in the deal.
This is problematic, since a large number of analysts believe CVS overpaid for Aetna. They offered a sizable premium to a stock that was already trading at all-time highs and was up exponentially heading into the deal. Aetna stock traded in the $20s a decade ago; CVS paid more than $200 per share.
Interestingly, between 1977 and 2000, Aetna stock created only modest value for its shareholders. In a normal health care market, a health insurance firm should not spike in value nearly 10-fold inside of a decade. If you want to see why health care costs are soaring, the PBMs and the health insurers are a great place to look.
Political Risk Looms
Recently, we’ve see a huge blame the other person game going on with health care costs. The drug companies say prescription pills are expensive because the PBMs and health insurers are overcharging everyone, taking way too much of a cut as middlemen. The health insurers are blaming the PBMs for overcharging them. The PBMs, in turn, have been blaming the pharmacies.
This has been a profitable game for the past decade, everyone inflating costs while blaming someone else, but it won’t and can’t go on much longer. The health care system is simply too expensive for this sort of activity to drag on indefinitely.
CVS is again promising huge synergies with the Aetna deal, but they won’t get them. CVS is essentially competing against itself here in a way, as you have the entities that were all sticking each other with excessive costs now under one roof. With only CVS standing between the pharmaceutical company and the end patient, it will be far harder for CVS to wring so-called excessive profits out of this system.
You see analysts expecting profit margins (which are already trending well downward) to continue dropping for both retail pharmacy and PBMs. Perhaps CVS felt compelled to buy Aetna as the health insurers are still doing better for the time being. These sorts of gains can’t keep up if Medicare is going to remain solvent. Unfortunately for CVS, they top-ticked the market buying Aetna for an absurd price.
This fall has coincided with the rise of anti-private health insurance candidates such as Bernie Sanders for the 2020 presidential election. Health insurance costs will be a major campaign issue, and CVS has launched itself into the crossfire by paying up for Aetna.
CVS Stock Verdict
As I mentioned, it’s easy to make a case that CVS stock is cheap on valuation. However, there are several things to take into account before hitting the buy button. For one, CVS has a huge debt load post-Aetna, with its $70 billion debt just about equal to the company’s market cap. The company’s earnings will need to be channeled in large part to managing its debt rather than dividend hikes or share buybacks for the time being.
Additionally, nearly all segments of the business are struggling. Retail pharmacy has issues, as results from Walgreens and Rite Aid (NYSE:RAD) have confirmed. PBMs have been weak in recent years, and now Aetna is at risk as the politicians threaten to regulate profits from that sector sharply lower or outlaw big chunks of the business entirely.
Finally, CVS’ management has not shown good discipline in dealmaking, first with the disastrous Omnicare deal and now this most questionable Aetna one. With the health care industry passing through such trying times, CVS stock is an easy avoid for the time being.
At the time of this writing, Ian Bezek owned WBA stock. You can reach him on Twitter at @irbezek.
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