CVS Health: Show-Me Story Is Dead For The Near Term (NYSE:CVS) (2024)

Yesterday, May 1st CVS Health (NYSE:CVS) reported its earnings for Q1 of 2024, largely meeting revenue estimates but significantly missing (~22%) on EPS due to severe profitability challenges in its insurance division amid a further growing Medical Loss Ratio ("MLR"). Since my first note on the company, I regarded CVS a "show-me" story with significant execution risk but a favorable risk/reward based on the potential I saw in management's vision.

Following the abysmal Q1 earnings and guidance cuts of 20% on full year EPS and 13% on EBIT, I now see execution risk prevailing with MLR having surged a further 190bps QoQ (580bps YoY) while key peers reported QoQ declines and communicated a more positive FY outlook. With the "show-me" story dead for at least the near term, I cut my price target by 29% to $65/sh and downgrade shares to Underweight. I do note that the assigning of Seeking Alpha's "Sell" rating does not equate my recommendation to sell the stock but an underweight relative to the sector as I see CVS underperforming vs peers in the near to midterm.

[Note: Peers refer to UnitedHealth (UNH), Elevance Health (ELV) and Cigna (CI). All company projections from the Q1 earnings release and presentation.]

Earnings Snapshot

For the period ended March 31, CVS recorded $88.4B in revenue, up ~4% YoY vs consensus estimates of $87.6B (~1% miss). While top line came in relatively in-line with consensus, the company reported a significant miss on the bottom line, with EPS of $1.31 being down ~40% YoY and a hefty 22% below the $1.70 estimated by analysts. Operating margins fell 180bps vs Q1 23 and 120bps vs Q4 23 as insurance profitability fell sharply amid a surging MLR. I also note that this has been the first miss on EPS in years, in my view, raising significant doubts about the extent of management's communication to capital markets and investors, especially given a miss of this scale.

Balance Sheet - Net debt increased by $1.3B during the quarter to end the period at $83.1B, the majority driven by ~$2.5B in additional debt. With LMT EBITDA falling from $22.1B to $20.8B this led to an increase in net leverage by 0.3x to now stand at 4.0x, the highest value since Q3 21. While not being an immediate problem, I believe CVS can easily withstand short periods of highly elevated leverage, this raises further doubt on management as it has been official communication for a while now to focus on reducing debt levels after the 2023 acquisition spree.

Health Care Benefits - For Q1, the segment reported a strong top line with sales growing almost 25% to $32.2B vs $25.9B for Q1 23, which was driven by both an increase in members and stronger pricing. Total membership figures increased by 1.3MM YoY (~5%) to currently 26.8MM, mainly through increases in Medicare and Commercial including a significant ~500k customer win, while Medicaid fell slightly. Pricing also continued to be strong and even exceed prior Qs with average premia/member up ~19% YoY to $114 for total premia revenue of $30.4B (+25% YoY) of which $21.7B from commercial customers (+24%) and $8.7B from government customers (+27%).

While top line development continued to be excellent with revenue growth almost double that of recent quarters, profitability took a heavy hit with operating margins 470bps lower YoY and 300bps below FY23 respectively. Operating income for the segment stood at $0.73B, down ~60% YoY vs prior year's figure of $1.82B. The key reason for this sharp drop in profitability was the significant surge in medical costs for treatment of insurance members, as measured by the MLR (MLR=Premia collected/medical costs).

Q1 MLR came in at 90.4%, representing a surge of almost 600bps vs Q1 23 and a 190bps expansion vs the prior quarter at 88.5%. As key reasons for this highly unfavorable (and unexpected) development, management noted a combination of increased Medicare utilization and impacts from CVS' 2024 Medicare Advantage star ratings as well as tough YoY comps with Q1 23 MLR ~150bps below both adjacent quarters. On a 4Q-rolling average, CVS's MLR currently hovers at 87.7%, more than 400bps above its Q4 22 low point and surging past ELV during the quarter.

At 580bps YoY change, this represents the fourth quarter in a row with YoY MLR growth above 200bps and the fifth quarter of overall QoQ growth. While this has been an industry-wide development fueled by a catchup in medical treatments post Covid and inflationary pressures, I note that the scope of expansion for CVS's MLR is significantly above peers, with UNH having recorded a maximum YoY growth of 220bps in Q4 23.

I also note that while increasing MLRs have been an industry-wide phenomenon for recent quarters, peers UNH, CI and ELV actually recorded a decrease in MLR from Q4 23 with UNH MLR improving 70bps, ELV MLR more than 350bps lower and CI MLR down 230bps. With peers guiding for Q1 as an inflection point in rising medical costs and issuing a more positive full-year outlook, uncontrollable medical cost inflation seems to become a more and more company-specific problem for CVS.

Health Services - At $40.3B in Q1, segment revenues decreased by ~10% YoY from previously $44.6B, despite management having spent ~$20B during FY23 to acquire primary care players Oak Street and Signify Health. Management attributes the decline primarily to a previously announced loss of a large client during the quarter and continued pharmacy price improvements which were only partly offset by a favorable pharmacy drug mix and the two aforementioned acquisitions. Operating margins decreased 40bps YoY to 3.4% with operating income down ~19% to $1.36B, primarily reflecting continued pharmacy price improvements and the client loss. Management further notes that while Signify's contributions were positive to operating income, Oak Street's recognition generated a net negative impact.

Pharmacy & Consumer Wellness - The segment generated $28.7B in revenues for Q1, an increase of ~3% YoY driven by increased prescription and vaccinations volume and a more favorable drug mix. Positive top line impacts were partially offset by recent introduction of further generics, continued reimbursem*nt pressure and a lower store count. Contrary to the other segments, operating income actually increased YoY to $1.18B (~4%) at a margin of 4.1% (stable vs Q1 23). The increase in profitability is primarily attributed to higher prescriptions volume, improved purchasing and lower opex resulting from store closures.

FY24 Guidance - As part of the call, management also slashed its FY24 EPS guidance to >$5.64 from previously expected "at least $7.06", representing a ~20% downward revision. Adj. EPS guidance was also cut to >$7.00 from >$8.30 for a respective ~16% drop. Annual operating income was further revised downwards from previously >$16.9B to >$14.75B (-13%). Key reason behind the significant downgrade was management's updated forecast now seeing MLR pressures continue through the year, noting that the "majority of utilization pressure observed [...] during the first quarter will persist". As a result, management upped its expected full year MLR by more than 200bps to 89.8% from previously 87.7%, bringing expected insurance segment income down ~33% from previously >$5.4B to now >$3.6B. Guidances for top line development and other segments remained reasonably stable with the most significant cut in Health Services projected operating income down 5%.

As mentioned earlier, this represents a significant downward shift from management's previous assumption of H1 pressure easing into a stronger H2. More importantly, I believe, this also significantly deviates from peers' Q1 results and forward communication with both CI and ELV beating estimates and upgrading their full-year guidance. UNH also beat estimates but refrained from upping their FY guidance, which will also include the specific impact from the cyberattack.

Despite shares being down ~17% on the news, with EPS guidance cut by ~20%, I see potential for further downside in the near term. I estimate this to be a function of 1) downward rerating of multiples from previous levels to account for significantly greater than expected MLR pressures vs peers and 2) further analyst downgrades with Leerink as the first firm to do so. Despite multiples already well below peers, I view both of these factors as putting more pressure on the stock in the near term and advise caution.

Valuation Update

I downgrade my forecasts across the income statement, now expecting a significantly lower full-year profitability in the insurance segment just slightly above the lower end of guidance at $3.7B and a margin of ~2.8%, driven by a slight improvement through the year to 3.5% in Q4. I also adjust my estimates for Health Services both on top and bottom line to ~$171B in revenue (-9% YoY) and $7.03B in operating income for a 4.1% margin as I expect profitability to gain vs Q1 due to improvements at Oak Street. With Pharmacy remaining largely stable, I now expect 24E operating income of ~$15.1B, slightly above the $14.75B lower end of guidance and at a margin of 4.1%, down ~80bps vs FY23 mainly on the back of lower profitability in insurance.

I continue to value CVS through a Sum-of-the-Parts ("SOTP") model with separate valuations for its Insurance & PBM (encompasses Health Care Benefits and Health Services) and Pharmacy Retail business. Considering the Q1 miss and slashed guidance's diversion vs peers, I downwards adjust my target multiple for the Insurance & PBM business from previously 12x forward EBIT to 11x for a segment EV of $118B. At 11x the unit is now valued at a similar multiple to the pharmacy retail business for which I see a total value of $65B.

Continuing to apply a 10% conglomerate discount and adjusting for net debt and minority interests I calculate a total equity value for CVS of $82B, implying a price target of $65/sh, representing a 29% cut vs my previous target of $91 and 15% above current levels.

White Star Research