What's the Right Prescription for This Ailing Drug Store?

By Matthew Cochrane Markets Fool.com

Image source: CVS Health.

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Investors in CVS Health Corp (NYSE: CVS) have had a rough year. Since late summer, shares of the drug store and pharmacy benefit manager (PBM) have plunged from the high-$90s to where they stand today, a roughly 18% drop, while most of the rest of the stock market has soared.

It's not that CVS has reported poor quarterly results in the interim. To the contrary, net revenues increased to $46 billion in the fourth quarter of 2016, a robust 11.7% increase, and adjusted EPS was $1.71, an equally solid 11.8% increase. Rather, it has been the guidance for 2017, fueled by two huge losses to arch-rival Walgreens Boot Alliance Inc , that has dismayed investors. CVS management is guiding for adjusted EPS of between $5.77 and $5.93 for the upcoming year, which is essentially flat year over year.

For a company that routinely executes double-digit revenue and EPS growth, this guidance has naturally led to a contraction in its valuation. Coupled with the increasing attention paid to the role pharmacy benefit managers have in rising drug costs, it is no wonder that CVS' stock price has faced an increasing amount of downward pressure the past six months.

CVS' plan to right the ship

In the company's 2016 fourth quarter earnings release, CEO Larry Merlo tried to put a positive spin on the numbers by expressing confidence in the company's plan to return to future growth. He stated:

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As we outlined late last year, we have a four-point plan in place to return to more robust levels of growth in the years ahead. We remain confident in our model and our position in the evolving healthcare landscape. We can bring value to all healthcare stakeholders, helping them achieve their goals of making care more affordable, accessible, and effective.

The four-point plan Merlo referred to was unveiled in the prior quarter's conference call. Besides some usual corporate boilerplate about implementing cost saving initiatives and returning capital to shareholders (none of which is necessarily bad, mind you), the plan called for offering better value to other PBMs and health insurance plans by bundling exclusive services "such as MinuteClinic services, infusion, and long-term care capabilities".

What might such a step look like? Investors saw a great example of this when CVS announced a new partnership with UnitedHealth Group Inc's PBM, OptumRx, near the end of 2016. Under the agreement, the two pharmacy platforms will be able to offer employers more benefits for the plans they provide their employees. For instance, eligible OptumRx members will be able to fill their 90-day prescriptions at the same cost at CVS pharmacy locations. While it is unknown how many OptumRx members will ultimately take advantage of a perk like this, it should be noted that OptumRx manages and fills more than one billion prescriptions annually. That's a lot! This kind of arrangement will drive more traffic to CVS and lead to higher front store sales too.

CVS is moving forward in other ways as well. New capabilities on its CVS Pay app allows customers to fill a prescription, pay for retail items, and even use ExtraCare with one scan of the app. CVS Curbside, a new service that allows customers to order and pay for items on their mobile devices and pick them up at a participating store without getting out of their car, is now live at more than 4,000 locations.

Light at the end of the tunnel?

So is the worst over for CVS investors? It is impossible to tell. The company still faces headwinds making up for the deals lost to Walgreens. In addition, political pressure on drug prices can seemingly rise up at any time, and it's tough to predict how these could impact CVS' business.

Yet despite the political headwinds the company's PBM business faces, the segment still sports a 97% customer retention rate. Not too shabby! And what politicians take away, they can also give. There are few companies that would stand to benefit more from corporate tax reform than CVS. Its effective tax rate last quarter was 38.5%. That rate could be significantly reduced if tax reform legislation passes later this year. Any money saved would most likely be passed on directly to shareholders in the forms of dividends or share repurchases. This would not be out of character for a company that, in 2016, returned $6.3 billion to its investors via these two methods.

CVS currently trades at an adjusted P/E ratio of about 13.9.Some investors might think this is high, given management's guidance for flat EPS growth in 2017. Yet after these tough comparable quarters pass, management expects to return to "healthy" levels of growth following this year. In previous conference calls, management has guided for long-term adjusted EPS annual growth of 10%. This guidance makes CVS's valuation look a lot more attractive. So, while the road ahead may be bumpy over the next year, investors who take a long-term view stand a good chance of being rewarded for their patience.

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Matthew Cochrane owns shares of CVS Health. The Motley Fool recommends CVS Health and UnitedHealth Group. The Motley Fool has a disclosure policy.