The Business Of

Healthcare | CVS Health | What Do They Do With Their Profits?

Morning All!

Yesterday we put together CVS Health’s costs with their revenues. And we’ve covered a fair amount this week. So, let’s have a quick recap…

• Bigger Than Tech - with its pharmacy, PBM and insurance segments, CVS Health makes more revenue than Microsoft and Facebook… combined!

• Spread Pricing Ban - one main way the PBM business makes its profits is through spread pricing. But US politicians are looking to ban this practice!

• Supermarket Margins - we’ve seen the similarities between Tesco and CVS Health’s supply chains. And we’re about to see the similarities in their margins...

… because that’s right! It’s a Thursday morning. Which means it’s time to take a look at our famous TBO EBIT Margin ranking! Below, we can see our ranking updated to include CVS Health. And would you believe it - we have a new lowest margin!

And this incredibly low margin really comes through in CVS Health’s valuation. Because although CVS Health make ~50% more revenue ($311bn) than Microsoft ($208bn). Microsoft’s company value of $2.54 trillion is 28 TIMES BIGGER than CVS Health’s ($89bn)!

Now, on the face of it - this probably doesn’t make too much sense! Because how can a company have 50% more revenue than another. But be valued 28x smaller?! Well, tomorrow we’re going to do a valuations special. And really explore the relationship between revenues, margins and market value and get to the bottom of it! But for now, let’s crack on. And figure out what CVS Health does with all their profits/cash!

Acquisitions Big Again!

Okay, so last week, we saw that AbbVie spent a lot of their cash from operations (CFO) on acquisitions (~44%). And guess what - CVS Health are the same! And in fact, the waterfall chart below shows us that CVS Health are even bigger spenders than AbbVie! With just over half of CVS Health’s CFO ($145bn) spent on acquisitions ($73bn)!

So, let’s focus on acquisitions today. And first question - what are CVS Health actually acquiring with all these billions? Well, the acquisition story for the company really has 2 parts. One is their pharmacy acquisitions. And the other is their wider acquisitions. Let’s start with the pharmacy part!

Supermarkets Need Scale… So Do Pharmacies!

Okay, so back in 2002, CVS Health had ~4,000 pharmacies. And by 2022, this figure had grown to ~9,900. So, a growth of almost 6,000 pharmacies! Now, some of these extra pharmacies will have come through CVS building their own stores.

But as we can see in the chart below, the majority of these additional 6,000 came from acquisitions! With the 1,670 pharmacy stores bought from Target in 2015, their largest acquisition of drug stores since 2002.

But why are CVS doing this? Why weren’t they just content with the 4,000 they had back in 2002? Well, obviously the company wants to grow profits and adding additional stores will help that. But it’s actually a bit more than that. Pharmacy stores are a low margin business. We saw this yesterday with CVS’s pharmacy business having a gross margin of 25% and an EBIT margin of only 4%!

And one way pharmacies can improve that margin is through economies of scale! Now, what do I mean? Well, remember yesterday we saw that the largest cost for CVS pharmacies is their ‘cost of products sold’. Which is the price they pay wholesalers like McKesson for the drugs (products) they need in their stores. Well, the bigger CVS are - the more stores they have - the more bargaining power they’ll have to negotiate with McKesson. And get lower prices for those drugs!

And guess which other business is like this…? Tesco! In the supermarket industry, scale is so important! Because again, if you have the most stores, and hence most market share - you can get more favourable terms from suppliers. And this is what we see in the charts below! (You might need to zoom in, sorry!)

Tesco has nearly 2x as many stores as any competitor. And because of that, they can go to Coca-Cola or PepsiCo and say ‘Hey, we’re your biggest customer in the UK. And because of that, we’d really love to get the best price for these drinks’. And the evidence of this is seen in the second chart above. Tesco’s ability to get lower prices from suppliers has meant their margin is consistently the best vs peers!

This scale and margin dynamic will be the same for CVS and pharmacies in the US. Who are McKesson going to give the best price to? CVS with nearly 10,000 pharmacies? Or a local pharmacy chain with 10 pharmacies? CVS! And that’s why the company have been acquiring lots of pharmacies. Alrighty, let’s move on!

Let’s Be More Than Just A Pharmacy Chain!

Okay, so that’s how CVS have acquired in the pharmacy space. But the company’s also made several moves outside the pharmacy segment. And these acquisitions have been made to make the company more vertically integrated.

To understand this, let’s first look at what CVS’s position in the healthcare value chain looked like when they were just a pharmacy chain.

Okay, as we know, CVS Pharmacy would pay wholesalers for their drugs. Insured individuals would get their prescriptions from the pharmacy stores. And CVS Pharmacy would get paid by the PBM. However, back in 2009, CVS did something interesting. They said ‘okay, we’re doing well with all our pharmacies. But why don’t we capture more of the value chain - why don’t we do PBM as well?!’

And that’s what the company did! In 2009, CVS bought a PBM company called Caremark for $24bn and rebranded the company, CVS Caremark! And as we’ve seen this week, that acquisition has been a roaring success. With the PBM business now the biggest revenue stream for CVS Health!

And as the graphic above shows, the Caremark acquisition not only gave CVS more revenues. But it gave CVS more control of the healthcare value chain. From being just a pharmacy chain. CVS became a company that interacted with every player in the drugs value chain! And that control ramped up even more with the next acquisition…

Too Much Control… Not Enough Controls?

… because then, in 2017 - not content with pharmacy and PBM - CVS Health made one of the boldest acquisitions in US healthcare history. And bought one of the largest health insurance companies in the US - a company called Aetna - for $69bn!

Now again - why did CVS do this? Well, this link here gives you a great, in-depth view on the reasons. But one of the main reasons was that the acquisition again helped CVS Health capture more of the value chain! Look at the graphic below after the Aetna acquisition. CVS Health now make revenues and profits from (i) the pharmacy segment, (ii) the PBM segment and (iii) the health insurance segment!

But whilst this all sounds great for CVS shareholders. Many experts were surprised the regulator actually allowed this acquisition to happen. Because CVS’s different segments could potentially help each other out in ‘unfair ways’! For instance, Aetna could ask its insured members to get their prescriptions from only CVS stores. Which would grow CVS Pharmacy revenues, but hurt competition. Or CVS Caremark could pass on more of its discounts from drug manufacturers to Aetna than it would to other insurers. Again, something that would be deemed ‘anti-competitive’.

And it’s not just other companies who who are worried. How beneficial will vertically integrated healthcare giants be for individuals?! If a company has so much control, they could easily keep drug prices high and increase their profits couldn’t they? Well, that’s something we’ll cover in more detail next week! But this article here gives a fairly simple overview of the dangers of CVS becoming so big!

6th Jul 2023

Nigel Jacob CFA