CVS Health (CVS) is one of America’s most dominant healthcare players. The company operates the nation’s second largest pharmacy chain with over 9,800 retail locations. CVS is also one of the nation’s largest pharmacy benefits managers (PBMs), with over 94 million plan members who used CVS to file 1.3 billion medical care claims in 2017. CVS acquired Caremark RX for $21 billion in 2006 to become the second biggest PBM.
The pharmacy benefits business provides vital services to employers and insurance companies by determining which drugs are covered for patients and negotiating price discounts with drugmakers.
In 2017, the majority of CVS’s sales came from its PBM segment, which, thanks to a faster growth rate than its retail pharmacy business, is likely to only become more important over time.
However, because of the much smaller operating margins in its PBM segment, CVS still generates the majority of its operating income and free cash flow from its retail business.
Business Analysis
CVS’s legacy retail pharmacy business has historically grown though industry consolidation, allowing it to create a massive nationwide store network on par with Walgreens Boots Alliance (WBA). Offering customers convenience and leveraging its scale to keep prices affordable proved to be an effective strategy.
However, CVS management recognized years ago that rising healthcare costs would increasingly put pressure on every aspect of the medical sector to cut costs, which is why it bought Caremark RX for $21 billion in 2006.
This acquisition made CVS the second largest PBM in America. By becoming more vertically integrated and achieving economies of scale, CVS was able to generate very impressive earnings, cash flow, and dividend growth over the past decade.
Why was the PBM segment such a boon to CVS? Mainly because, as rising costs and increased regulatory complexities under the Affordable Care Act (i.e. ObamaCare) set in, many organizations, including health insurance companies such as Aetna (AET), are willing to outsource the nitty gritty logistical details of managing various health programs to PBMs such as CVS.
This is because PBM’s are responsible for saving their clients as much money as possible, through things like negotiating price breaks with pharmaceutical companies and medical component makers.
And better yet they are willing to sign long-term contracts, like the 12-year deal that Aetna inked with CVS back in 2010, which gives management a lot of future cash flow predictability with which to plan its further growth efforts.
In other words, CVS has evolved beyond just a chain of pharmacies and stores, turning into one of the most important names in U.S. health insurance. Thanks to the continued expansion of its PBM business, CVS is able to generate large economies of scale, which means some of the lowest per claim costs in the industry. That helps CVS maintain market share which only further grows its moat and helps maintain high retention rates with PBM customers.
Even as the medical sector as a whole consolidated, driven by a growing desire to achieve greater scale and the leverage over suppliers and customers that comes with it, CVS has managed to continue growing.
In 2015, the company acquired 1,667 of Target’s (TGT) in-store pharmacies and 79 clinics for $1.9 billion. That year CVS also made its $12.7 billion purchase of PBM Omnicare, adding to that aspect of its empire as well.
However, all that growth and vertical integration hasn’t spared CVS from hitting some bumps in the road more recently. Specifically, while its PBM business continues to grow at a high-single digit clip, the pharmacy business and retail stores saw same-store sales contract by 2% to 3%.
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