Analysis: WBA CVS AMZN

In the wake of Tuesday's disastrous earnings release from Walgreen's Boots Alliance (WBA) , we have been fielding several questions about our view on CVS Health (CVS) .

These two companies are both known from their massive retail pharmacy footprint, but we see plenty of differences in their respective investment cases when we look more under the hood. Below we call out these key differences.


Let's start with corporate strategy. Walgreen's has opted to take a horizontal path in terms of integration, spending billions of dollars to expand its retail pharmacy footprint through the acquisition of Alliance Boots and most recently, Rite-Aid stores. Essentially, they have doubled down on a challenged industry and missed out on encompassing the full healthcare spectrum.

Meanwhile, CVS Health's approach to mergers and acquisitions has been drastically different as they have taken the vertical route. For example, in 2007, CVS completed its merger with Caremark RX, a pharmacy benefits management company. Although the PBM (pharmacy-benefit managers) industry has been challenged of late, it does serve an important role for CVS Health's overall business. As the Wall Street Journal pointed out on Tuesday, "Walgreens and CVS are getting squeezed as they negotiate with pharmacy-benefit managers. PBMs, as they are known, serve insurers and other clients by choosing which medicines to cover and wresting lower prices from both makers and sellers of drugs. Although CVS owns one of the country's biggest PBMs, Walgreens doesn't, leaving it more exposed to pricing demands."

Then in late 2018, CVS Health completed its massive acquisition of Aetna, a managed health care company with a solid long-term growth outlook and expected to represent approximately one-third of enterprise's operating income in 2019. This deal was the perfect way for CVS Health to differentiate itself in the healthcare marketplace and diversify its business operations away from what is challenged. Larger questions still remain regarding management's ability to successfully integrate Aetna with a retail strategy; however, we remain confident that CEO Larry Merlo can pull it off.

How about tobacco? In 2014, CVS Health made the commitment to stop selling tobacco products in all its stores because it conflicted with its core message of improving public health. Becoming the first national retail pharmacy to make this change was quite the radical decision at the time, and indeed, this change hurt front-end sales after it was first implemented. Still, it was a commendable action and important step that helped improve the company's health brand.

Meanwhile, Walgreen's has been far slower ridding tobacco products from its stores, and they haven't completely shaken the negative stigma attached. In early March, the company drew the ire of the FDA and was accused of selling tobacco products to minors. To its credit, Walgreens is currently de-emphasizing the product, but this change is negatively impacting comparable retail sales to the tune of 125 basis points last quarter. This is a headwind that is completely removed from CVS, and it shows up in front-store expectations. Current FactSet consensus expect CVS front-end stores to deliver +0.5% front-end comps in calendar year 2019, while WBA's are expected to have comps of -1.1% in the same period. Uninspiring numbers here, but at least CVS is in positive territory.

One thing both names have in common is that Amazon (AMZN) represents a material threat to the front of the store on the retail side and the back of the store on the pharmacy side as it looks to build out its healthcare-related offerings, including prescription fulfillment via Pillpack, the online pharmacy Amazon recent acquired for nearly $1 billion. However, while both CVS Health and Walgreens Boots Alliance face the same issue, the way they have chosen to handle it is what we believe provides CVS with a bright future, while the outlook for Walgreens remains less certain.

Whereas Walgreens is seeking to improve performance via cost cutting, including targeting a $500 million to $600 million reduction in IT spend in 2019 (and reduce expenditures but at least $1 billion within three years), despite a push to digitize, CVS Health is looking to improve by investments (with capex expected to increase from $2.0 billion 2018 to $2.3 - $2.6 billion in 2019), building a better business that can compete online against the likes of Amazon (or online pharmacy delivery platform Capsule) and differentiate itself with the acquisition of Aetna, which allows the company to provide a more holistic approach to healthcare.

Walgreens appears ready and willing to continue down the pharmacy-only path, despite Amazon eating away at its bricks-and-mortar retail business, and reduce IT expenditures despite the obvious need to invest in an omnichannel initiative and build out the ability to compete online. Yet CVS Health is investing heavily to become much more than a pharmacy with the acquisition of Aetna, new initiatives in-store such as the health-hub and increased investments online to better compete in a digital world where more prescriptions are being fulfilled online.

Furthermore, what these two companies must do to lure consumers into their stores is play a little offense and get creative with their concepts. Walgreen's track record in this area is spotty. In 2013, Walgreen's teamed up with the now-defunct Theranos and offered in-store blood tests. If you are familiar with the history and failures of Theranos, this decision looks pretty sub-optimal in hindsight.

Meanwhile, CVS has begun testing its brand new HealthHub Store format in select locations. This concept is expected to be personalized and experiential, with focus on customer engagement and education through a new concierge service. Furthermore, the HealthHubs will include community spaces, digital offerings, and feature Wellness Rooms available for services such as group events, health classes, nutritional seminars, and more. These stores have the potential to change the way consumers approach health, facilitating the company's push to unlock better health for its consumers and communities. More on the HealthHub concept can be found at the site here.

Geographic Exposure

It's also worth noting that CVS Health and Walgreen have vastly different geographic exposures. Roughly one-quarter of Walgreen Boots Alliance's revenue comes from outside the United States, with the majority of that figure from countries within the European Union including the United Kingdom. Although Brexit will most likely have little impact on the pharmacy industry, its legislation carries risk and creates a much more uncertain economic environment. Meanwhile, CVS Health derives 100% of its revenue inside the United States. This company's pure domestic exposure was one reason why we invested in the company back in November 2018.

Earnings Outlooks

How about their respective earnings outlooks? Yesterday, Walgreens followed up an $0.08 earnings per share miss with a meaningful cut to its full-year EPS guidance. Management now expects EPS to be roughly flat on a constant currency basis from the 7% - 12% growth they previously expected. Walgreen's discussed several headwinds related to increased reimbursement pressure, decreased generic deflation and branded inflation, as well as weak market conditions in the U.K.

The huge double-digit drop in WBA rippled through the industry, causing CVS to fall nearly 4% on the day. While it makes sense that stocks in similar industries move together, we believe a very strong argument can be made that this information was already priced in to CVS. These headwinds, save for the U.K. market but add in Long-Term Care Challenges, were addressed when management initiated its 2019 adjusted earnings per share outlook of $6.68 to $6.88, which is down from $7.08 in 2018.

Look, we are not saying CVS Health is perfect. The company is facing real challenges of its own, like in Long-Term Care which has battled through two impairment charges in the past 12 months, and also a leveraged balance sheet. Regarding the issue of the former, we did feel more confident that this business is under control after hearing from Merlo not too long ago in Jim's "Mad Money" interview that we wrote about here. Then of course, we obviously dug into this position far too early and we did not appropriately factor in the risks of 2019 being an investment year.


Having said that, we believe these several divergences in strategy bring us back to the conclusion that CVS is still undervalued at 7.5x forward earnings versus WBA at 9x. This holds especially true as CVS Health aims to transform and disrupt the healthcare industry, whereas we believe Walgreen's has some shortcomings with their vision. Furthermore, CVS's multiple lags despite it having the fast-growing Aetna business, which we remind members should be more profitable than previously thought thanks to the U.S. government increasing its final Medicare Advantage (MA) Rate for 2020, coming in at 2.53%, up from the 1.59% rate initially proposed.

Putting it all together, we believe the more likely outcome is that CVS closes this gap in the price-to-earnings multiple through expansion, rather than continued compression on WBA's end.