CVS: A Bet On Continued Multi-Payer Healthcare – CVS Health Corporation (NYSE:CVS)

CVS Health Corp. (CVS) wants to become the future face of healthcare in America. Despite the sluggish pace of progress in the health/medical space, the company is rapidly evolving into a comprehensive “health care destination” that may reshape the way Americans pay for and receive care.

Management has a grip on most of the risks it faces as this newfound conglomerate (and other writers on Seeking Alpha have done a good job of explaining them), but there remains one big risk that is difficult to quantify: the looming threat of healthcare reform that would usher in a single-payer system.

CVS’s planned evolution promises to provide consumers a convenient and affordable alternative for healthcare financing and provision, but only if true single-payer does not come about. How big of a threat to CVS is single-payer?

Source: CNN

The Company

CVS is steadily progressing on the path to becoming a holistic one-stop-shop for healthcare needs, including provision (HealthHUB & MinuteClinics), pharmacy services / prescription drugs (CVS, Omnicare), pharmacy benefits management (CVS Caremark, Omnicare), insurance (Aetna), and to a lesser extent, over-the-counter retail health products.

Drawing in customers with each segment should increase revenue in the others. More traffic in stores due to MinuteClinics should increase retail and pharmacy sales. Taking on the ~39 million Aetna benefit clients should draw more traffic to CVS pharmacies. And so on.

The company’s goal is to create “a consumer-centric technology infrastructure. Its HealthHUBs, including minute clinics, will expand to four markets by year-end and will expand to 1,500 retail (pharmacy) locations by the end of 2021.” (See their investor day presentation.)

In two and a half years, then, CVS plans to have HealthHUBs in stores (including some Target stores) all across the country. These locations will have on-site nurse practitioners, physician assistants, dietitians, lab services, and medical supplies. Nutrition and exercise classes may also be offered, and some stores may even offer basic dental services. The company hopes to become the go-to spot for primary care and ongoing health monitoring for chronic conditions such as high blood pressure or diabetes. Just five conditions — heart disease, diabetes, high blood pressure, asthma, and mental health — account for roughly 85% of private healthcare spending in the US, and CVS stands to gain some of that market share.

If even a fraction of patients with a chronic condition go to a MinuteClinic for minor issues rather than waiting until they become a major issue that warrants a trip to the emergency room, money will be saved and the medical system as a whole will be more efficient. Now that CVS owns Aetna, the company is incentivized to encourage benefit clients to seek out the lower-cost preventive care option rather than the much higher cost emergency procedures that come from neglecting health issues.

An electronic records system will ensure that patients can visit any MinuteClinic in the nation and not have to undergo identical rounds of paperwork, questioning, or tests. These records may contain not just basic health information but also progress on nutritional and weight goals in order to provide a more holistic approach to care. Now, perhaps this will not work out to be quite as transformational as I am making it sound, but any step toward holistic, preventive health care is an improvement upon a system mainly focused on sick care.

What’s more, CVS aims to provide a high degree of price transparency for their MinuteClinics, which is refreshing in a time when most healthcare service prices are concealed from patients. The company website already offers a lengthy price list for various services, treatments, and tests.

How will CVS locations be modified to create space for these MinuteClinics? By reducing floor space used for poorer performing (lower profit margin) items such as greeting cards or snacks.

Yes, it is true that CVS has a history of overpaying for acquisitions. For instance, a few quarters ago, it had to write off $2.2 billion as a goodwill impairment due to the underperformance of its Omnicare pharmacy business. It may end up having to accept a write-off for the Aetna acquisition as well. But without overpaying for these quality assets, CVS likely never would have obtained them and become the one-stop-shop health destination that it envisions.

First Quarter Results

After a tough quarter in Q4 2018, CVS enjoyed 35% YoY sales growth and 43% net income growth in Q1 2019. But EPS was up only 9.5% YoY due to higher income taxes and interest expenses. Most but not all of the growth is due to Aetna, as same-store sales rose 3.8%.

As of Q1, CVS’s insurance segment represents 29% of total revenue, while its bread and butter segment, pharmacy services, represents 54.5% of revenue.

As of yet, it is still too difficult to tell whether there will be significant synergies (management estimates $750 million) and additional revenues gained from the $69 billion acquisition of Aetna. It may take years to know just how much CVS overpaid for the nation’s fifth largest health insurer (and it’s almost certain that they did overpay for it).

The Risks

Pharmacies are struggling against the headwinds of increased generic drug usage, lower reimbursement from the various private and public payers, and a bi-partisan political drive to cap prescription drug prices. This is partially what drove the decision to acquire Aetna in the first place.

While there’s little to be done about generic drugs or reimbursement rates, the threat of new legislation enacting prescription drug reform is overblown, in my judgement. For two reasons: First, there has been a bi-partisan attraction to drug reform for a long time and yet nothing major ends up getting done because the two political parties can’t agree on what to do. And second, the pharmaceutical sector and healthcare industry more broadly are some of the biggest spenders on lobbying and have exercised their purchased power multiple times in the past to ensure a favorable political outcome.

Of course, some legislation may come, whether at the state or federal level, but it’s not likely to be devastating for PBMs (pharmacy benefit managers) like CVS Caremark. Proposed laws are just “nibbling at the edges” rather than imposing full price transparency and competition, says Linda Cahn of Pharmacy Benefit Consultants.

What’s more, merging insurance with the PBM is expected to create cost efficiencies that should translate into savings for the consumer.

The Threat of Single-Payer

What about the elephant in the room? How big of a threat is the “Medicare-for-All” proposal currently being pushed by several Democratic presidential candidates and numerous members of Congress?

It is important to acknowledge that while “Medicare-for-All” is a very popular rallying cry for Democrats right now (just as “repeal and replace” was for Republicans in and before 2016), there is not widespread agreement among the party about its exact meaning. In fact, there are at least three major categories of what could be meant by “Medicare for All”:

  1. Canadian-style single-payer healthcare.
  2. Universal health insurance in which Obamacare exchanges and Medicaid are rolled into an expanded version of Medicare, but employer-sponsored plans remain (e.g. “Medicare for America”).
  3. A Medicare opt-in program in which a subsidized Medicare-type plan is offered to everyone on the Obamacare exchanges, and employers can choose to use Medicare rather than a private insurer for employee coverage (e.g. “Choose Medicare”).

The good news for CVS is that Aetna has completely pulled out of all Obamacare exchanges nationwide as of last year, so the second and third options would likely have little effect as far as the exchanges go. On the other hand, at least some versions of the “Medicare for America” plan involve giving employees the option to apply their employer’s contribution to health insurance toward a Medicare plan. That may cause a decline in Aetna’s total number of insured. The third option may erode Aetna’s client base in a similar way but is unlikely to significantly diminish it.

The worst case scenario for CVS would be the first option: true, Canadian-style single-payer. That would leave Aetna able to play only a very minor role, if any, in insuring wealthy clients who wish to obtain additional coverage on top of what the government would provide.

Private employers and households currently pay for about half of all healthcare spending, the other half coming from government programs. That means that $3.5 trillion of American healthcare is paid for privately each year. For all of that to be taken on and paid for by a single-payer system, assuming no change in costs or expenses, would require roughly $10,700 of new taxes to be raised per person per year. Another estimate puts the cost of a single-payer system at $3.2 trillion per year, assuming administrative costs are halved and other expenses are cut down. This would require a mere additional $9,775 per year in tax revenue.

Raising that amount of taxes would be difficult. First, it’s difficult to raise taxes on moneyed groups because they have the wherewithal to lobby against it and pay professionals to help them avoid it if their lobbying efforts fail. And second, it’s difficult to raise taxes on the middle class because that is more politically unpopular.

Some polls have shown that support for Medicare for All drops significantly when people find out the amount by which taxes would need to be raised or that one would not be able to keep one’s employer-based insurance in a single-payer system. Evidently, there is still widespread confusion among the American population about what “Medicare for All” or even a single-payer system more specifically entails.

For these reasons and more, I find it unlikely that a Canadian-style single-payer system is likely to pass. As explained by the Harvard Political Review, the United States has experienced 45 years of failed attempts at healthcare reform. Senator Ted Kennedy tried to pass an essentially single-payer system in the 1970s and failed. In 1993, President Clinton proposed a universal healthcare system, but with a divided Democratic Party, it went nowhere. And, of course, while the Affordable Care Act (“Obamacare”) was significant reform, it was basically incrementalist in nature and was not even truly universal.

Serious proposals for single-payer systems have been entertained in California, Vermont, and New York, and in each case, Democrats had complete control of the state government. In each case, however, Democrats could not come to an agreement on policy details and the proposals ultimately failed. Plus, policymakers had trouble selling the tax hikes that would go along with such programs — an 11.5% payroll tax on businesses plus a state income tax of up to 9.5% in Vermont’s case.

How much more difficult would it be on the national level? “I could see a light form of the public option coming about,” says Obamacare architect Jonathan Gruber, but he says true single-payer is much less likely. “There’s 800 billion reasons why the insurance industry would spend money attacking it.” (The private health insurance industry is roughly $800 billion in size.)

And even if single-payer passed both houses of Congress and gained the president’s approval, it would surely be challenged in court. Though John Roberts ultimately voted to preserve Obamacare, it’s difficult to see a John Roberts-led, conservative-leaning Supreme Court affirming the Constitutionality of a Canadian-style single-payer healthcare system.

Perfect: The Enemy of the Good

There’s an old saying attributed to Voltaire that goes, “Don’t let the perfect be the enemy of the good.”

It is not my opinion that the current healthcare system we have is ideal. There are numerous problems with a primarily third-party payer system. Attempting to apply an insurance model, meant to handle catastrophic and accidental events, to nearly all spending on a basic necessity like healthcare transforms it into a complicated, expensive payment plan-type system. Add in subsidies, various state and federal programs, and loads of regulations (many of which are favorable to the biggest corporate players in the space), and you wind up with the Byzantine, overpriced, opaque medical financing structure that we seem to be stuck with in America.

A single-payer system would, in my personal opinion, further the trend away from competition in the healthcare space, and the price controls that typically go along with single-payer would diminish the incentive for private players to invest and innovate. The cost of Lasik eye surgery, which is outside the third-party payer system completely, has fallen precipitously even as quality has drastically improved due to competition and the incentive to innovate. Of course, not all healthcare can be like Lasik eye surgery, but overall, costs could be much lower, quality higher, and transparency greater if more of the healthcare industry operated along those lines.

What’s more, there are, admittedly, potential problems with PBMs taking more control over the dispensing of drugs at the expense of physicians and independent pharmacies. Control of over 85% of claims volume for 95% of Americans belonging in the hands of just three companies smacks of oligopoly. Such a situation gives the major PBMs the power to pressure manufacturers and attain special — often secretive — deals and kickbacks. It has also historically resulted in higher out-of-pocket costs for consumers, and billions of dollars of rebates have been pocketed by the major PBMs rather than returned to consumers.

However, as of December, after having some unwanted light shed on PBM practices, CVS committed to returning 100% of rebates to their clients, which should end up back in the pockets of consumers. Caremark’s new Guaranteed Net Cost model promises to provide simplicity and predictability to insurance plan sponsors.

One can hold a view of the ideal healthcare financing system that differs from the status quo (as I do) while acknowledging that CVS is not responsible for the macro issues with our system and does not make it worse than it otherwise would be. In fact, there’s good reason to believe that CVS’s vertical integration of various segments of the healthcare space will lower costs while lifting quality and convenience. And despite the consolidation, there’s nothing stopping other market players like Walmart or Amazon from entering the space to compete with CVS if their plan turns out to be less consumer-friendly than they advertise.

The point is that concerns with how the healthcare system as a whole operates should not necessarily dissuade one from investing in individual players within that space, especially when those players have plans in place to improve the system. CVS, for one, has a plan to create cost efficiencies, and at least some of the savings are expected to be passed on to consumers. That is a step in the right direction.

(Alright, I’m off my soapbox now. Feel free to disagree with some or all of the above.)

Looking Forward

Analysts estimate 7.2% compound annual earnings growth over the next five years. Add the 3.6% dividend yield plus around 12% annual gain from a reversion to a 12x P/E multiple, and we arrive at a five-year projected annual return of 22.8%.

For conservative dividend investors such as myself, let’s posit dividend growth over the next few years of zero (management has wisely chosen to freeze the dividend for two years), followed by 5% the next three years after that, followed by 10% the next five years (the previous ten year CAGR was 22.73%). This gives us average annual dividend growth of 6.5% over the next ten years. That would deliver a 6.45% yield on cost at the end of the ten years, as well as a 22.1% estimated annual return.

Given CVS’s low payout ratio of 29% based on 2019 earnings, I think the above projection is reasonable. Even if earnings don’t grow as fast as they are projected to, management will have room to expand the payout ratio, especially after debt levels, merger costs, and store transformation expenditures are reduced in the next few years.

As long as a Canadian-style single-payer system is not forthcoming in America’s near future, CVS is positioned for stellar, market-beating returns in the years ahead. It promises to improve the medical care experience for millions of Americans while containing costs and enhancing health outcomes. If all goes more or less according to their plan, CVS will benefit patients and investors alike in the decades to come.

But shareholders certainly have several issues to monitor in these next few critical years — both within the company and in the political realm.

Disclosure: I am/we are long CVS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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