Written by Sam Kovacs.
Introduction
For those of you who've been with us for a while, you know that June is "cull season." It's the time of year, when we review our holdings, our coverage, and ask the tough question: when were we wrong?
In the game of investing, you're never going to get a perfect scorecard. Every investor gets some things right, and gets some things wrong. Every single one. I can think of 10 instances in the last few years when Warren Buffett turned out to be wrong.
There's a certain breed of analysts on Wall Street that seem to always be right. They say "buy" at $20, then again at $10, then again at $5. They are never wrong, the market is. They're also 75% out of pocket, but that's another problem.
Sometimes the market is wrong. Most of the time, we are.
With CVS Health Corporation (NYSE:CVS) I believe I was wrong, and this stock will kick off the cull list.
Management is inconsistent.
We got into CVS last year based on giving management's integration plan more weight than it deserved. Based on this idea of integration, we believed the firm could consolidate an interesting moat in its industry.
From $73 in April 2023 when we initiated coverage, CVS has declined to $61, declining 17%.
Management recently took part in Bernstein's annual strategic decisions conference, where management of various companies are interviewed on the strategic outlook of their firm.
Rather than giving me more confidence, this conference shattered it.
Management was cagey, showing signs of oversight, missing the ball and not having a great way to overcome it.
Here are a few snippets of particular value:
On Medicare Advantage pricing issues (emphasis added):
Obviously, in the quarter, we had a tough quarter in Medicare Advantage, which was disappointing to us, as I said earlier...
One of the things we did was we missed trend and we had a super elevated trend and then a flat stable trend. That's not what we saw in the market. Obviously, we continue to see elevated trends.
On potential membership losses:
But could you lose 5% of membership in that case? Sure. Could you lose up to 10%? It's very possible. But that's okay because we're making rational decisions about the progress that we want to make on margin in 2025.
On utilization rates:
As you think about that level of trend relative to the rate that we have for '25, the first order of business, just to stay at par, is you've got to go through and pull all of the levers that you can to try to cover that gap.
CVS Health Corp. is facing mounting challenges across its business segments, threatening its competitive edge.
The company's ambitious integration model, recent performance issues, mismanagement, and increased competition underscore the pressures on its operations.
Additionally, government scrutiny of the Pharmacy Benefit Management industry adds another layer of complexity to CVS’s situation.
Health Care Benefits: Medicare Advantage Struggles
The Health Care Benefits segment, bolstered by CVS's acquisition of Aetna, was expected to drive growth. However, the Medicare Advantage (MA) business is encountering significant problems.
CVS reported adjusted EPS of $1.31 for Q1 2024, below expectations, and subsequently lowered its full-year EPS guidance to at least $7.
The company cited higher than expected utilization rates in outpatient services, supplemental benefits, inpatient admissions, and pharmacy expenses as key drivers of this underperformance.
Regulatory pressures from the final 2025 rate notice and the Inflation Reduction Act are also expected to disrupt benefit levels and reduce margins.
CVS’s ability to adjust benefits, exit unprofitable counties, and enhance medical management will be crucial, but the outlook remains challenging. I don't see a clear case of improvement here.
Retail: Adapting to Changing Consumer Behaviors and Amazon’s Growing Influence
The retail segment, encompassing CVS's brick-and-mortar pharmacies and long-term care services, is under significant strain.
The shift towards online shopping, accelerated by the pandemic, continues to impact foot traffic in physical stores. CVS has been closing underperforming stores to maintain profitability, but this indicates underlying struggles in the retail space. They closed about 600 stores since 2022, and they're going to close 300 more in 2024.
Amazon Pharmacy's entry into the market poses a considerable threat to CVS's retail operations. Offering competitive pricing, online ordering, and fast delivery services, Amazon Pharmacy targets the same customer base that traditionally visits CVS pharmacies. This new competition exacerbates existing pressures from other retailers like Walgreens and Walmart.
Amazon's RxPass offers unlimited drug deliveries for $5 a month and just expanded to everyone on Medicare. They're increasing their healthcare presence and creating an increasingly uncomfortable situation in terms of the balance of power within the industry.
Health Services: Government Scrutiny and Competitive Pressures
The company’s pharmacy benefit management arm, is facing increased government scrutiny. Legislators have raised concerns about the transparency and practices of PBMs, with several bills introduced in Congress aimed at increasing oversight and regulation.
This scrutiny could lead to more stringent regulations and reduced profit margins for PBMs, further complicating CVS’s future.
Nothing has come out of this yet, and PBM profits are quite obscure due to the rebates, which are classified as "confidential information."
PBM regulation would cause further profit risk here, when the firm really can't afford more trouble.
Conclusion
I misread CVS' competitive advantages. A closer look tells me I was wrong in dismissing the past quarter in my earnings review, and with the awful momentum, the stock has here, the stock could go a lot lower.
Sure, it's still earning enough to pay the dividend, that isn't at risk, but growth rates might be as they focus on deleveraging and are counting on a recovery of margins in the MA business to delever. This isn't as certain as management would want us to believe, as they have proven that there are many things in this complex industry which are maybe not in their control.
Sorry for the mistake. I'm removing CVS from coverage and from our portfolios in the next month.
I think CVS Health Corporation shares should be avoided, despite its semblance of undervaluation. Sell.
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