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Why CVS Stock Is So Cheap -- Barrons.com

DOW JONES & COMPANY, INC. 7:29 AM ET 1/18/2019

Symbol Last Price Change
CVS 63.37down 0 (0%)
CI 194.5down 0 (0%)
UNH 259.77down 0 (0%)
QUOTES AS OF 04:01:01 PM ET 01/17/2019

Cheetos and liver-function tests could soon be available under the same roof. CVS Health(CVS) , which operates 1,100 walk-in Minute Clinics in its stores, announced this month it will begin testing new store designs with expanded health-care offerings, including in-house blood work.

Details are few, but the opportunity appears vast. Americans spend more than $2 trillion a year on care for chronic diseases, and waste is rife. If CVS can lure patients who can't get quick appointments with their primary-care doctors, or who have been using emergency rooms for routine care, the result could be years of healthy revenue gains. CVS could purge the front of its stores of slow-sellers to make room for lucrative services, and save its recently acquired health-plan operator, Aetna, some of what it now shells out for hospital visits. That's the accounting equivalent of winning both the office weight-loss contest and the Super Bowl pool.

CVS stock, down 20% in the past year, has rarely traded at a humbler valuation. Before the financial crisis, it sometimes topped 20 times forward earnings estimates. Recently, it changed hands below nine times. But like the thought of a hernia check in what used to be aisle four, the stock brings concerns of uncomfortable exposure. That's because of a squeeze caused by slowing drug-price inflation -- and something called PBM rebates.

Read more: Health Care Costs Could Drop

Pharmacy-benefit managers pool the buying power of their customers, like health plans, to secure price concessions, often rebates, from drugmakers. Three of them dominate the U.S. market: the Caremark unit of CVS; Express Scripts, which was bought last month by Cigna(CI) ; and OptumRx, owned by UnitedHealth Group(UNH) .

PBMs rose to prominence over the past two decades, and there has been lively disagreement over their broad effect on drug prices. Contract terms have been murky, but that is starting to change. For example, CVS last month introduced a new plan model that will pass on to customers 100% of rebates from drugmakers. In 2018, the company kept an estimated 2% of rebates, or $300 million.

Rebates get tricky when PBMs guarantee specific dollar amounts to customers. To do that, they must estimate future prices. If they guess too high, and actual rebates are smaller than promised ones, PBMs could be forced to make up the difference out of their pockets. That's a problem now, because the drug industry has hit what, by its standards, counts as a slow patch for price growth.

Drugmakers have long treated themselves to two fat price hikes a year, which has lowered their popularity with consumers to somewhere between that of robo callers and a kick in the shin. That has emboldened politicians. President Donald Trump Twitter-shamed Pfizer (PFE) over price hikes last summer, and Pfizer backed down. Many drug companies raised prices only once last year. The inflation rate for branded drugs has slowed from an estimated 12% in 2016 to half that last year.

PBM contracts typically last three years, so companies must now make good on rebate guarantees that were set back when drug-price inflation was much higher. At the same time, OptumRx has reportedly been bidding aggressively to try to win market share, forcing its rivals to follow. Mizuho Securities analyst Ann Hynes estimates that CVS's negative exposure to rebate guarantees could sap 58 cents per share from its 2019 earnings. It's unclear how much of that headwind the rest of the Street is factoring in. The consensus earnings estimate for 2019 is $7.37 a share. Hynes predicts $7.02.

CVS could shed more light when it reports fourth-quarter earnings in early February. So while the stock offers cheap exposure to the retailization of health care, buyers might want to wait a bit to learn more about the PBM pinch. Shares closed Thursday at $63.37.

Write to Jack Hough at [e-mail]


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