CVS Faces Steepening Challenges in Its Pharmacy Benefit Management Business

Senior Equity Analyst

Julie Utterback

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CVS aims to be the most customer-centric health company in the United States and has spent over a decade positioning itself as a managed care leader, with the acquisitions of pharmacy benefit manager Caremark (2007), insurance provider Aetna (2018), and healthcare service provider Oak Street (2023) defining its strategic direction. CVS' top-tier retail pharmacy, health insurer, and PBM franchises create the potential to improve health outcomes and even bend the healthcare cost curve for its clients, especially if it can align incentives by owning healthcare service providers, as well.

CVS appears uniquely positioned to improve health outcomes, and we appreciate management's focus on better leveraging its assets through digital and other means to bring a more consumer-centric approach to healthcare, which could provide many benefits. For example, management recently highlighted an observational study that showed when members use both CVS medical and pharmacy benefits, their medical costs decline 3%-6% over a three-year period through factors like fewer hospitalizations and emergency room visits. Driving savings like that would be attractive to many potential clients, like self-funded employers, and CVS' own at-risk operations, like its Medicare Advantage plans, by reducing medical costs. Also, CVS continues to dive further into healthcare services through its HealthHub strategy and recent acquisitions of primary-care assets. We think the relatively high-margin healthcare services business could eventually accelerate CVS' profit growth directly or by reducing long-term costs in its medical and pharmacy benefit businesses. 

With its integrated strategy, management aims to accelerate bottom-line growth to the low double digits on a maintainable basis in the long run, but management has pushed the target date for that back multiple times. Now, we only think that growth rate is possible with significant share repurchases toward the end middle of our explicit 10-year forecast period on mid-single-digit operating profit growth in the long run.

Business Strategy & Outlook

CVS Health earns a narrow economic moat rating from us. As a top-tier medical insurer, pharmacy benefit manager, and pharmacy retailer, we believe CVS possesses enough scale-related cost advantages to generate economic profits for the long run. Even after the late 2018 Aetna merger, which cut into returns on invested capital including goodwill, and its recent healthcare services acquisitions, we estimate that CVS' ROICs should remain above its capital costs throughout our explicit 10-year forecast period. CVS generates profits almost equally among its three major segments, and we see the medical insurance and PBM assets as generally stronger than the retail store chain. 

In medical insurance, we see two moat sources—cost advantage and network effects. An insurer’s cost advantages relate primarily to scale, both broadly and locally. The legacy Aetna operations represent the third-largest insurer that we cover, with about 26 million members, albeit a distant third in our coverage universe behind Elevance and UnitedHealth. With such significant scale in the fragmented health insurance market, we believe CVS benefits from local scale advantages in specific metropolitan markets. Local scale advantages allow for greater negotiating leverage versus service providers than smaller insurers in each community, which contributes to cost advantages in each specific location. Also, when local scale advantages are significant enough, we think CVS’ insurance operations benefit from a network effect. According to the American Medical Association, the share of local insurance markets in the U.S. that were highly concentrated grew to 75% in 2021 from 71% in 2014, with the leaders likely taking share in those markets due to local market dynamics. For example, in communities where CVS already has substantial market share, it can offer lower costs or more benefits per member to existing and potential clients than its peers. If that offering is compelling enough, more employers will be attracted to CVS’ insurance plans in those communities, and local service providers, such as hospitals and physician groups, will have more incentive to join and offer lower prices to CVS’ insurance networks to gain access to its large, growing membership rolls. As CVS’ local market share rises, its negotiating leverage with providers also rises, which can create a virtuous cycle (a network effect) where CVS attracts even more clients and more providers to its insurance network in that area. Overall, these dynamics create barriers to entry for would-be competitors, as compiling an attractively priced provider network in a new geography would be difficult without an established membership pool.

CVS’ Caremark segment provides PBM services and appears competitively advantaged in its own right with a combination of moat sources. The PBM industry has consolidated into three top players—CVS, UnitedHealth, and Cigna—controlling nearly 80% of U.S. prescription volumes on an adjusted basis, and we believe those players built their leadership on previous cost advantages. However, with limited cost advantages over each other, we see evidence of some switching costs (through contracts) and network effects now, although CVS' recent contract losses create some new uncertainty around these moat sources, in our opinion. We believe CVS’ leadership position in its PBM operations should help it generate excess returns over time. We continue to view the fixed-cost leverage associated with processing about 2 billion of the nearly 7 billion adjusted prescriptions filled annually. This consolidation of purchasing power helps CVS extract discounts from drug manufacturers on one end of the transaction and pharmacies on the other end of the transaction, which helps create value for its clients, such as insurance plans and employers, on their pharmacy cost trends. We see some switching costs in this business with contract lengths typically around three years and annual retention rates in the high 90s for all three of the top-tier PBM players. Switching the administrative activities, partner relationships, and pharmacy benefit plan specifications to a new PBM vendor can be time-consuming and onerous, which creates inertia for clients with limited realistic alternatives, in our opinion. However, switching is possible, and the loss of specific clients could constrain the firm's growth eventually, especially as new insurance competitors like Elevance, Amazon, and the Mark Cuban Cost Plus Drug Company taking aim at this market. 

CVS possesses a top-tier position in retail pharmacy stores that appears to have some positive qualities, if not a strong moat. CVS drives significant volumes through over 9,000 pharmacy locations. This large store network is attractive for pharmacy benefit managers when assembling plans to obtain volume-based discounts from pharmaceutical manufacturers, and also assembling convenient retail store locations that would be attractive to an insurance plan members. And while it trails Walgreens’ average revenue per store, CVS’ average store revenue remains significantly higher than most other U.S. pharmacies. Scale allows CVS to leverage fixed costs (such as pharmacist salaries and rent) more effectively than subscale peers, and both CVS and Walgreens continue to steal share from smaller independent pharmacies. CVS, Walgreens, and Walmart also have advantageous relationships with the top U.S. drug distributors, which may give them a mild leg up over other retail pharmacies on generic drug pricing. Beyond that, these retail store locations give CVS a unique asset that it may be able to leverage into destinations for higher-margin healthcare services, like primary care, eventually.

In terms of environmental, social, and governance issues, our narrow-moat view of CVS is informed by an analysis of potential changes to the U.S. healthcare system. The key long-term ESG risk that CVS faces, in our opinion, is how U.S. strives to reach universal, affordable coverage. While some strategies considered in recent years to reach universal coverage included eliminating the private insurance industry, those plans have largely been rejected for more moderate proposals that build on the existing healthcare system and include private insurers even in government-sponsored programs like Medicare and Medicaid. During the next 10 years, we view scenarios where CVS provides medical and pharmaceutical benefits through employers and government-sponsored programs (like Medicare Advantage and Medicaid MCOs) as much more likely than not. And overall, since the 2020 election, the impact of potential policy changes has been limited, and we suspect considered changes in the near term (such as increased regulations on the PBM) will be manageable for CVS.

Narrow

Economic Moat

CVS Health

Aetna is an American managed health care company, which sells traditional and consumer directed health care insurance plans and related services, such as medical, pharmaceutical, dental, behavioral health, long-term care, and disability plans. Aetna is a member of the Fortune 500.

Aetna

CVS Pharmacy is a subsidiary of the American retail and health care company CVS Health, headquartered in Woonsocket, Rhode Island. It was also known as, and originally named the Consumer Value Store and was founded in Lowell, Massachusetts, in 1963. The chain was owned by its original holding company Melville Corporation since its inception until its current parent company CVS Health was spun off into its own company in 1996. CVS Pharmacy is currently the largest pharmacy chain in the United States by number of locations (over 9,600 as of 2016) and total prescription revenue. As the retail pharmacy division of CVS Health, it ranks as the 7th largest U.S. corporation according to Fortune 500 in 2016. CVS Pharmacy's leading competitor Walgreens Boots Alliance ranked 37th.

CVS Pharmacy

CVS Health Corp. is a health solutions company, which engages in the provision of healthcare services. It operates through the following segments: Pharmacy Services, Retail or Long-Term Care, Health Care Benefits, and Corporate and Other. The Pharmacy Services segment focuses on the pharmacy benefit management solutions. The Retail or Long-Term Care segment includes the sale of prescription drugs and an assortment of health and wellness products, and general merchandise. The Health Care Benefits segment offers traditional, voluntary, and consumer-directed health insurance products and related services, including medical, pharmacy, dental and behavioral health plans, medical management capabilities, Medicare Advantage and Medicare Supplement plans, Medicare Part D prescription drug plan, Medicaid health care management services, and health information technology products and services. The Corporate and Other segment is involved in providing management and administrative services. The company was founded by Stanley P. Goldstein and Ralph Hoagland in 1963 and is headquartered in Woonsocket, RI.

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