The Business Of
Healthcare | CVS Health | What Are Their Margins?
Morning All!
So, yesterday we dug into how CVS Health makes money. And we saw that CVS Pharmacy is the biggest pharmacy chain in the US, with ~9,500 locations. We saw that the company’s biggest segment is its pharmacy benefit management (PBM) segment, making up ~46% of revenues. And we saw that the company has been able to grow revenues at ~14% CAGR over the last 2 decades… which is mighty impressive!
But that’s enough with revenues for now. Today, let’s turn our attention to costs and margins. And look at what’s really necessary to operate a business model like CVS Health’s! Let’s start with a split of the company’s cost structure…
We can see that ‘cost of products sold’ (across both PBM and Pharmacy) make up the majority of the costs (~70%). So, without further ado, let’s dive into what these costs really are!
The Tesco Of Drugs!
Okay, so to understand what CVS Pharmacy’s costs of products are, let’s remind ourselves of another business we’ve covered on TBO… Tesco! And the graphic below reminds us how the value chain works for the UK supermarket firm.
Let’s use the example of a £1 can of Pepsi - which is the product. An individual shopper will go into Tesco and pay £1 for the can. And this would be Tesco’s revenue. But their ‘cost of product’ here is the 80p they’ve paid Britvic - the wholesaler we mentioned 2 weeks ago - to get the Pepsi in their store.
In our example, Tesco will keep 20p as gross profit. But, you may be wondering - why am I talking about supermarkets when I’m meant to be talking about pharmacies?!
Well, because the cost profile for pharmacies and supermarkets is very, very similar! Pharmacies are basically supermarkets for drugs after all! And the graphic below illustrates this for us. Like how individuals go to Tesco for Pepsi cans, individuals go to pharmacies needing prescription drugs. And like how Tesco paid Britvic (the wholesaler), here we see CVS pharmacies pay wholesalers (like McKesson) to get those drugs into their stores!
The only difference really is on the revenue side. Because unlike in the Tesco example, where the supermarket gets its revenue from the individual. Here, the pharmacy gets its revenue from the PBM. However, cost-wise it’s basically the same! And in our example above, we see that CVS pharmacy’s revenue is $100. And their ‘cost of product’ is $80.
And what’s important to note is what margin pharmacies get on these products. If - as in my hypothetical example - CVS Pharmacy are buying Pfizer’s drugs from the wholesaler at $80, and selling them at $100. It means a gross profit of $20, and a gross margin of 20%. And the chart below shows us that my hypothetical example wasn’t far off. Because CVS Pharmacy’s gross margin in 2022 was actually ~25%!
Now, I want to come back to something we touched on yesterday. Because we saw that a much higher % of the drugs being sold at CVS pharmacies were generic drugs. And the reason the company were doing this was because generic drugs had higher margins. However, what we see in the chart above is that margins haven’t been going up - they’ve been gradually declining for the last decade!
So, what’s going on here? Well, we don’t have time to really get stuck into it. So I’ll keep it short - it’s PBMs! Remember, PBMs are the ones who decide how much to pay pharmacies for drugs. And they’ve just been paying pharmacies a little less every year! That’s pretty much it - let’s move on!
TSMC’s EBIT Margin is 10x Higher Than CVS Caremark’s Gross Margin!
Okay, so we know that ‘cost of products’ for the Pharmacy division is the cost CVS’s pharmacies pay wholesalers for the drugs they’re selling. Now, let’s move onto the PBM side of things. And ask ourselves - what are the ‘cost of products sold’ for CVS’s PBM segment - CVS Caremark?
Okay, so to be honest, we covered most of it yesterday when we explained how CVS Caremark made money! But let’s look at the graphic below again - where we assume the list price for the Pfizer drug in our example is $100. The green line going from Pfizer to CVS Caremark indicates the $30 (30%) rebate CVS Caremark negotiate with the drug manufacturer. This is CVS Caremark’s revenue! And the cost here is the $25 CVS Caremark pass on to the health insurers. The $5 that the company keeps is their gross profit. *Yesterday I mistakenly said that the $5 CVS Caremark keeps is their revenue… my bad!
But there’s a second ‘cost of product’ for CVS Caremark. And that’s the cost of paying for the insured person’s prescription drug. And here, it makes more sense to start with the cost-side. When an insured person goes into Walgreens and gets their $100 prescription drug. Walgreens will contact the PBM saying they’ve just sold that drug. And the $100 CVS Caremark then sends to Walgreens is CVS’s ‘cost of product’. The PBM will then charge the health insurer a higher amount ($105) as we saw yesterday - which is the PBM’s revenue! Again the PBM gets $5 gross profit!
Okay, so hopefully that’s all clear! If not, this short, simple video can help fill in any of the foggy parts! Now, let’s turn to what gross margins for PBMs like CVS Caremark actually look like. And the chart below gives us the answer… gross margins are incredibly low!
I thought CVS Pharmacy’s 25% gross margin was fairly low. But 5% is absolutely razor thin! But this does leave one important question. If gross margins are so low - how low will EBIT margins be?! Because we still haven’t even looked at operating expenses! So let’s turn our attention to that now…
Lots of Employees, Lots of Admin!
Okay, so there’s not too much to say on this cost line. Because as we saw in the first chart today, ~70% of CVS Health’s costs are the ‘cost of products’. Which we’ve just covered. But what are some of the operating costs involved for CVS?
Well, first thing’s first - drugs in pharmacies don’t fly off the shelves into customers’ hands! These pharmacies need people - pharmacists - to serve people. In fact, CVS Health has ~300,000 employees - which is pretty huge! To put that into context, the biggest private employer in the UK is Tesco and they have ~300k employees!
In addition, the PBM segment actually needs quite a lot of IT systems and administrative people to manage the pharmacy network. We know CVS Caremark pays pharmacies for the prescription drugs insured individuals get. But guess how many pharmacies CVS Caremark actually serve in their pharmacy network - 66,000! Including their own 9,500 pharmacies.
And processing the right prescription drug requests to the right pharmacy out of the 66k in the network isn’t that straightforward! But as I said, let’s not dwell too long here. Let’s move on to the good stuff. And see what EBIT margins look like for CVS Health!
Reminder: AbbVie’s EBIT Margin Was 32%…
Okay, so let’s wrap up. We’ve seen what gross margins look like for the Pharmacy (~25%) and PBM (~5%) divisions. Now, let’s look at what overall margins are like for this US healthcare giant.
And the chart below paints a pretty bleak picture doesn’t it? Group gross margins are tiny at 14%. And EBIT margin in 2022 was a scarcely believable 2%! Yes, 2%!
Just a reminder that last week, we saw AbbVie had a EBIT margin of 32%! And it really begs the question - why are margins so high for AbbVie? But so low for CVS Health? I mean, they operate in the same industry! Well, this is a cracking question. And it’s what we’ll be chatting about in some depth on Friday. When we’ll be exploring the relationship between margin and value-add!
5th Jul 2023
And that’s a wrap for today! I hope you enjoyed diving into AbbVie’s cost structure. Tomorrow we’ll look at how the US drug giant actually spends all its profits, and we’re in for a few surprises!
Have a fabulous day!
The Business Of Team