Image Source: Mike Mozart
We are putting the fair value estimate of CVS Health under review while we re-evaluate the competitive environment and reassess the company’s appetite for leverage, which could impact dividend health.
Brian Nelson, CFA
Boy has CVS Health (CVS) been hit by a storm of negativity in recent months.
After we added it to the newsletter portfolios, the company has gotten caught up in a whirlwind of investor concern regarding Amazon’s (AMZN) probable entrance in the pharmacy market. We noted as much in our September 30 note, “Amazon Casts a Large Shadow Over the Pharmacy Market,” and we said that even we were “growing more and more cautious on shares,” as we pointed to Amazon’s potential acquisition of Rite Aid’s (RAD) PBM business that could accelerate its entrance into the pharmacy business:
An opportunity for Amazon to purchase an existing PBM may become available once the long-running acquisition of a portion of Rite Aid’s existing store base is completed. Rite Aid will offload a tad less than half of its 4,741 store network to Walgreens to raise cash to help mitigate some of the debt burden that continues to plague the company. The 2,186 stores combined with three distribution centers will help shrink Rite Aid’s overall store footprint as the company will exit some key markets in its entirety, thus ending the company’s aspiration to build out a credible national competitor to Walgreens and CVS Health.
Curiously, Rite Aid owns a growing PBM business that it acquired in 2015 called Envision RX Options that is not included in the deal with Walgreens. We find it interesting that Walgreens continues to focus on building out its network, while purposely shying away from the lower-margin PBM business as opposed to the hybrid model employed by CVS Health. Walgreens’ pure-play model allows for maximum optionality that can be operated through numerous partnerships, including a theoretical tie-up with Amazon should it choose to move forth with a foray into the pharmacy business. An acquisition of an existing PBM will accelerate the learning curve Amazon faces with entry into the field, though an outright purchase of an existing player may not be completely necessary for scale (it would make it easier though).
Frankly, we underestimated the ease of the path by which Amazon could enter the pharmacy space, especially as the online giant scoops up wholesale pharmacy licenses, and from a competitive standpoint, it’s hard to argue that Amazon’s robust free-cash-flow generation emanating from its AWS operations won’t be used to fuel a more-directed attempt to tackle the pharmacy market, squeezing existing players. Certainly, the prospects of the changing structural dynamics of the PBM market have us concerned, but that is not all.
We probably were least-of-all pleased with having learned about the acquisitive nature of CVS Health in its bid for Aetna (AET) for no small sum, reportedly over $200 per share ($66 billion). Having also talked to Anthem (ANTM) and United Health (UNH), CVS Health is clearly on the defensive following Amazon’s foray into the pharmacy space. However, launching a huge acquisition such as one with Aetna, one that might bury the company in debt while its operations could be squeezed on the margin, makes for a rather ominous scenario, at the very least with respect to the long-term health of the dividend.
We’re taking a close look at our valuation model of CVS Health, and we expect to continue to update readers on our thoughts as we wait for more details about the reported CVS-Aetna tie-up, of which we are not fans.
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