Weak CVS Outlook Disappoints, but Valuation Compelling

Narrow-moat CVS Health CVS reported fiscal 2018 results that largely met our expectations for the legacy business, but the addition of Aetna created some volatility in the reported numbers. However, the highlight was 2019 guidance that fell short of our profit expectations across the board while missing prevailing consensus estimates by an even wider margin. As we adjust our model, we may tweak our $96 per share fair value estimate, but we continue to view the firm as deeply undervalued despite the weaker outlook. While 2019 appears to be a more onerous transition year than originally anticipated, shares represent compelling value at current market prices that imply less than 10 times adjusted earnings.

A good portion of the shortfall in 2019 stems from ongoing weakness in the firm's long-term-care business that's led to depressed profitability in the retail segment. Management took two separate goodwill write-downs over the course of 2018 as a result of end-market disruption affecting its skilled nursing customers, totaling nearly half the amount spent to acquire Omnicare in 2015. While that was a disappointing outcome for shareholders, we plan on leaving our Standard stewardship rating in place for now. Moreover, persistent prescription reimbursement pressure at the pharmacy combined with a lack of generic launches and weaker branded drug inflation expected in 2019 culminated in overall segment operating profits set to fall at a high-single-digit rate over the coming year.

On the pharmacy benefit management side of the business, performance should be more closely aligned with our model that already calls for structural margin pressure in the coming years. That said, 2019 and 2020 will be further affected by incremental costs needed to coordinate the firm's new partnership with Anthem. That said, Centene's decision to bring in-house its PBM operations over the next few years should partially offset the long-term benefits from adding Anthem's claim volume.

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