Analysis: CVS

Before the bell on Wednesday, CVS Health (CVS) reported a mixed headline result with its fourth quarter earnings. Revenues of $54.4 billion (up 12.5% year over year) slightly missed the consensus of $54.58 billion, however, adjusted earnings per share of $2.14 (up 11.4% year over year) topped the consensus of $2.05.

"With the completion of the Aetna acquisition, we have set the stage for CVS Health to excel in a market that is rapidly transforming," CEO Larry Merlo said in the press release. "We strongly believe in the long-term value that the full breadth of our capabilities can provide. Our unique combination will drive above-market growth going forward across all of the enterprise. Maintaining our focus on community level products and services will drive meaningful value for both consumers and payors, while improving our bottom line and the value we return to shareholders. Ultimately, our open platform model allows us to meet the needs of all payors with newly created products and services. We're more excited than ever about the opportunities that lie ahead."

Before getting into the results, let's talk about 2019 guidance. Heading into today's print, the market certainly was building in optimistic expectations as CVS rallied more than 6% from the date of this Alert (when we outlined Morgan Stanley's guidance scenarios) to yesterday's close. Much to our chagrin, guidance was on the downside as management expects fiscal year 2019 adjusted earnings per share in the range of $6.68 to $6.88, well short of the consensus $7.41. Curiously, given all the headwinds/tailwinds of the 2019 year and general integration uncertainty, we would have expected a wider range in guidance, and this might suggest the downside is now firmly in.

Consolidated Revenue was much more encouraging as management is expecting that to be in the range of $249.86 billion to $254.29 billion, well ahead of the $246.33 billion consensus. But like adjusted earnings per share, adjusted operating income is expected to come in below the consensus of $15.273 billion, as management guided to the range of $14.84 billion to $15.15 billion.

Digging further, some of the factors impacting guidance that management highlighted on the call are, "a declining benefit from new generics, lower brand inflation and ongoing question around rebates" as well as structural and CVS-specific challenges in long-term care. Despite these short-term pressures, management believes it has a plan that should mitigate these impacts and make them only transitory. In Retail, management believes its product and service initiatives will accelerate top line revenue and profitability, and its new retail contracting strategy better aligns reimbursements to its service. In PBM, the new contracting model CVS has created is expected to add transparency and simplicity for the client. Third, management has a four-point plan to get long-term care back on track, and work is being made to accelerate this plan. Next, cost reduction efforts are being made company wide, and management noted they are on track to exceed their near-term synergy target of $750 million. And finally, management is in constant evaluation of its assets and roles they enable. Merlo views 2019 as a "bride to the future," and he expects the company's businesses "to strengthen meaningfully from the integration of CVS and Aetna's core capabilities." Guidance was a hit, but there are reasons to be optimistic in the company's longer-term future.

One last note on full year guidance, even though earnings are expected to be weaker than expected, projected cash flow from operations is still robust at between $9.8 billion and $10.3 billion. This figure is slightly below the $10.778 billion consensus, but it still should provide management with the cash needed to pay down its debt.

For the first quarter of 2019, management is expecting consolidated revenue in the range of $59.61 billion to $60.53 billion (consensus $59.54 billion), adjusted operating income in the range of $3.39 billion to $3.345 billion (consensus $3.496 billion) and adjusted earnings per share in the range of $1.49 to $1.53 (well short of the $1.65 consensus). Within Retail/LTC and PBM, management expects its "greatest level of year-over-year deterioration in Q1," with improvements in adjusted operating income growth in those segments through the course of the year. In HCB, the cadence is very different as adjusted operating income is expected to be its greatest in the first quarter and lowest in the fourth.

This guidance is a tough pill to swallow, but it looks like a reset for the future. "2019 will be a year of transition as we integrate Aetna and focus on key pillars of our growth strategy," Merlo added in the release. "We are fully aware of the need to address the impact of certain headwinds that are having a disproportionate impact in 2019 compared to prior years, and importantly, we are taking comprehensive actions to move past them. We understand acutely the importance of balancing near-term execution with longer-term vision, and we are confident that our actions will position us well in 2020 and beyond."

Pharmacy Services Segment

In the Pharmacy Service segment, revenues of $34.89 billion (up 2.2% year over year) was slightly below expectations of $35 billion. Management highlighted how growth was driven by increase in pharmacy network and specialty volume, brand inflation, and increase in Medicare Part D revenues; partially offset by continued price compression.

For full year 2019, management expects adjusted revenue in the range of $136.49 billion to $138.95 billion with total adjusted claims in the range of $1.94 billion to $1.97 billion, and adjusted operating income in the range of $4.83 billion to $4.92 billion (down low single digits %). Some factors influencing this outlook are pricing compression, exacerbated by cumulative effect on rebate guarantees from lower brand inflation; net benefits of selling season expected to be modest; and PSS will benefit from the shift of Aetna Mail Order and Specialty operations.

Retail/LTC Segment

At Retail Pharmacy/LTC, revenues of $22.0 billion (up 5.04% year over year) was slightly above the expectations of $21.7 billion. Management cited how growth was driven by increased prescription volume and branded drug price inflation, partially offset by continued reimbursement pressure. The same-store-sales statistics were generally positive, as total store sales increased 5.7%, Pharmacy sales increased 7.4%, and pharmacy prescription volumes increased 9.1%, which was at the high end of guidance. Even the front store delivered a positive comp of 0.5%. At Minute Clinic, full year revenue increased 9.8% year over year, and there are now 1,104 clinics spread across 33 states and Washington, D.C. This is all key as management turns its brick and mortal locations into its new "HealthHUB". In other positive news, CVS' market-leading script growth increased its pharmacy market share to 26% in December.

This all said, the big headline in the quarter was the adjusted operating income deterioration. Adjusted operating income came in at $2.0 billion, a decline of about 7.6% year over year. Additionally, adjusted operating margin of 9.1% compressed by about 130 basis points year over year. The culprits here were management decisions to invest a portion of the tax reform benefits into wages and benefits, as well as continued underperformance in long-term care. In fact, management incurred a $2.2 billion goodwill impairment charge related to continued industry-wide and operational challenges with the long-term care business. Stripping out these two items, stand-alone Retail Pharmacy adjusted operating income would have growth by about 5% year over year, but unfortunately, LTC is still part of the business and this was the main driver behind the light full year guide.

For full year 2019, management expects adjusted revenue in the range of $85.25 billion to $86.79 billion with adjusted prescriptions in the range of 1.4 billion to 1.43 billion, and adjusted operating income in the range of $6.59 billion to $6.71 billion (down ~10 %).

Health Care Benefits Segment

This segment was established as a result of the Aetna acquisition and is equivalent to the former Aetna Health Care segment. Revenues in the fourth quarter were $5.549 billion with adjusted operating income of $276 million. Total membership as of December 31, 2018 was about 22.1 million, and government programs were about half of the business's insured member base as of year-end.

For full year 2019, management expects adjusted revenue in the range of $67.68 billion to $68.71 billion with adjusted operating income in the range of $5.10 billion to $5.19 billion, core commercial medical cost trend at 6.0% (plus or minus 50 bps), YE Medical Membership in the range of 22.7 to 23.0, and Medical Benefits Ratio of 84% (plus or minus 50 basis points).

Overall, the fourth quarter results were fine sans the long-term care impairment, however it's the weak guidance that will get the most attention. And it is rightfully so, as guidance was well short of what the market anticipated. We expected some form of a guide down, but not of this magnitude as the long-term care issue took many by surprise as it was not telegraphed at all this quarter. How come? The company already incurred a $3.9 billion noncash pre-tax and after-tax good will impairment charge to its Omnicare business on the second quarter 2018 print. It was reasonable to think that one impairment would be it for the year. However, the company is still running into issues related to "lower occupancy rates in skilled nursing facilities, significant deterioration in the financial health of numerous skilled nursing facility customers, which resulted in a number of customer bankruptcies in 2018, and continued facility reimbursement pressures. In total, the $2.2 billion impairment this quarter puts the full year 2018 impairment charge at $6.1 billion. Still, LTC is a business the company believes can stabilize through their plan and this second round of impairments limits the remaining exposure. Again, when you back out LTC and some of the company's investments in wages and benefits, adjusted operating income would have grown about 5% year over year.

Shares are trading sharply lower on Wednesday, and we are keeping our ONE rating on the stock because there is still value here and we will continue to battle as long as there is value. We anticipate better than feared results during this "bridge to the future year", however, we recommend club members wait for the selling pressure to abate as the downgrades come in (already one this morning) before buying. Our requirements to add to our position are a price that meaningfully helps our average cost basis and offers a good yield. We are looking at $62 as our next price to buy. 

It is also worth noting how this stock has one of the lowest multiples in pharmacy and the now ~3.15% dividend yield offers more than sufficient compensation for the integration patience. But we will be lowering our price target to $84, which reflects a roughly 12x multiple on a now $7 adjusted earnings per share target. Indeed, this figure is above management's guidance range, but we are optimistic in that this was just a reset of the earnings base, leading to better than feared results as we move through 2019 and into 2020, when all this year's investments/initiatives really pay off.