CVS: Walking Away - Amazon Effect Proving Too Great

Introduction

I finally had to throw in the towel on CVS Health Corporation (NYSE:CVS) and walk away from the stock. Since its all-time highs in 2015, several headwinds have negatively impacted its growth, and the changing marketplace conditions have plagued the stock. Exacerbating this downward movement from the factors above, Amazon (AMZN) has entered the fray and has resulted in another leg down for the stock. The latter half of 2015 and throughout 2016 the political backdrop was a major headwind for the entire pharmaceutical supply chain from drug manufacturers to pharmacies/pharmacy benefit managers (i.e., CVS and Walgreens (WBA)) and the drug wholesalers in-between (i.e. McKesson (MCK), Cardinal Health (CAH) and AmerisourceBergen (ABC)). Marketplace trends forced CVS to cut guidance for Q4 2016 and the full-year 2017 numbers. CVS stated that “unexpected marketplace actions that will have a negative impact on our Q4 2016 results and a more meaningful impact on our outlook for 2017”. CVS suffered a self-inflicted wound and lost a contract with the Department of Defense which carries tens of millions of prescriptions on an annual basis. A new restricted network relationship between Prime Therapeutics and Walgreens impacts CVS Pharmacy’s participation in selected fully-insured networks in several key states, and many cases make CVS Pharmacy a non-preferred provider for Medicare Part D as well. These prescriptions tend to be the most profitable prescriptions as well. Lastly, Amazon’s purchase of Whole Foods and behind the scenes moves in the healthcare space has incited rumors that Amazon is looking to gain entry into the pharmacy space via leveraging the Whole Foods physical footprint of storefronts. I’ve written several articles contending that CVS presents a compelling investment opportunity in the ever-expanding healthcare space. My investment thesis was based on an aging population, growth in long-term care facilities and the pharmacy benefit management segment. All of this in a backdrop of CVS being highly acquisitive, continuing to deliver earnings growth, revenue growth, growing dividends and has an aggressive share buyback program in place. The wildcard may be the Amazon threat with its first real pivot after acquiring Whole Foods with subsequent potential in entering the pharmacy space as well.

The Nascent Amazon Threat

The backdrop without the potential Amazon threat was positive in my opinion considering the past acquisitions of Target’s pharmacies and the Omnicare. These proactive measures significantly expanded its presence and ability to dispense prescriptions to the general public and in long-term care facilities. As healthcare costs and prescription drug costs continue to rise and the population continues to age with the elderly comprising a larger segment of the overall population, CVS looked poised to benefit. That was until Amazon decided to entertain the possibility of entering the pharmacy benefits management space. Early reports consisted of rumors and the potential impact of Amazon with its technology and reach disrupting the current marketplace. It has been reported that Amazon is hiring a business lead to figure out how the company can break into the pharmacy market. This new hire was Mark Lyons from Premera Blue Cross to build an internal pharmacy benefits manager for its employees. Furthermore, Amazon has also hired Box’s Missy Krasner, VP and managing director of the healthcare and life sciences group. Whether or not this is directly related to selling prescriptions and the intent thereof is unknown however these moves are potentially invading on CVS’s turf. Amazon has also started selling medical supplies and equipment in the U.S.

The Whole Foods Acquisition Becomes Substantive

With Amazon’s recent $13.7 billion acquisition of Whole Foods, Amazon has officially entered the retail space and has shown further intentions to gain entry in the healthcare space, more specifically the potentially lucrative prescription drug space. There’s a lot of speculation that Amazon will disrupt the entire grocery space as it has successfully done to some retail brick and motor businesses. An extension of that thesis threatens ancillary retail companies such as CVS considering CVS operates storefronts. It has been theorized that Amazon will leverage the Whole Foods storefronts as a means to enter the pharmacy business. Ostensibly, Amazon is inching its way towards the pharmacy space with its first pivot via the Whole Foods acquisition. However, I don’t feel that this space is nearly as easy of a target as its bread and butter consumer goods success.

Amazon’s Inevitable Prescription Drug Market Entry

Amazon is on the brink of deciding whether or not it will be selling drugs online while its push into pharmacy is very much an "if" and not a "when," according to sources. Amazon is in the final stages of ironing out its strategy to get into the multibillion-dollar prescription drug market. Amazon will decide before Thanksgiving whether to move into selling prescription drugs online, according to an email from Amazon and a source familiar with the situation. If it decides to make that move, it will start expanding its senior team with drug supply chain experts. The U.S. prescription drug market is estimated to be a $560 billion per year business, so the opportunity is vast for a potential Amazon entry. Thus far in 2017, Amazon has ramped up its hiring and consulted with dozens of people about a potential move into the pharmacy market. Amazon decided to bring in talent to build an internal pharmacy benefits manager for its employees. This internal effort may serve as a proof-of-concept for the broader drug supply chain effort. Amazon already has a business selling basic medical supplies online (i.e., gauze and thermometers). Amazon has a health team called 1492, which is focused on both hardware and software projects, like developing health applications for the Echo and Dash Wand. Its cloud service, Amazon Web Services, continues to dominate the health, life sciences and technology market.

Express Scripts Heeding The Amazon Threat

Express Scripts has taken notice of Amazon’s intent to enter the prescription drug market and acquired medical-benefits manager EviCore Healthcare for $3.6 billion. The Evicore acquisition should help to stabilize earnings and provide a sense of sustainability of the business due to the sector-wide pricing pressures and government backdrop. This is noteworthy and provides credibility to the Amazon threat considering Express Scripts was downgraded due to "escalating competitive pressures." Express Scripts was recently stung by the loss of its biggest customer Anthem, which represented nearly a third of its 2016 earnings. Which further led me to relinquish my CVS holdings. Considering the contact above lapse by Express Scripts with Anthem, Amazon could step in and grab a significant market share if it were to secure this business. It’s conceivable that CVS could bid for the Anthem contract, but Amazon may be hungry and entering the arena at a convenient time. Winning a contract with Anthem could be the difference on how quickly Amazon becomes relevant as a pharmacy benefit manager player. As Ben Nye states, “It will be tough for Amazon to make inroads immediately, but the biggest catalyst in the near term is the Anthem contract.”

CVS Weathering The Storm

To be fair, CVS Health Corporation (NYSE:CVS) reported robust earnings for Q2 2017, beating on EPS and revenue for the second straight quarter. CVS posted EPS of $1.33 (versus Q1 for $1.17) on $45.69 (versus $44.51 for Q1) billion in revenue, up 4.5% year-over-year (versus +3.0% year-over-year for Q1). The retail side remains weak with another contraction in growth however this aligns with the broader retail landscape. CVS raised the lower end of prior guidance for 2017 EPS from $5.77 to $5.93 to $5.83 to $5.93. Specialty pharmacy remains a bright spot for CVS where growth continues to outpace the market. CVS sees strong growth in the open market while securing significant wins in the standalone specialty market. In Q2, specialty revenues increased 11.5% with PBM revenues of $32.3 billion, up 9.5%. Growth was driven by increased volume in pharmacy network claims (up 9.5%) as well as brand inflation and solid specialty pharmacy growth.

During the FY2016 Q4 call, CVS presented actions on returning to healthy growth. This included partnering more broadly, new PBM products, enterprise streamlining initiatives and returning value to shareholders. Despite the negative narrative surrounding CVS, the company has posted robust earnings for both Q1 and Q2 2017, and we’ll see how these initiatives continue to bear fruit in the ensuing quarters to come to round out FY2017. Thus far, CVS has been able to contend with and evolve to marketplace challenges as seen from the Q1 and Q2 2017 results. CVS stated that they are a very active voice in Washington regarding health care issues. The new FDA has embraced proposals to prioritize the review of generic drug applications, launching a Drug Competition Action Plan. The agency has published a list of more than 260 off-patent branded drugs without approved generics to encourage the development of ANDAs in markets without competition. Also, they now will expedite review of generic drug applications until there are three approved generics for a given drug product. May and June of this year have seen the most generic drug approvals since the FDA began tallying its monthly approvals. Initially, I thought if these initiatives and adoption to marketplace challenges continue then CVS will weather the short-term storm while the long-term thesis remained intact. Unfortunately, now that Amazon is in the fray, I’ve relinquished my position in CVS altogether.

Summary

Amazon has created a confluence of potential market entry events that has led me to relinquish my long-term position in CVS Health Corporation (NYSE:CVS) due to further competitive pressures within the PBM space. Since its all-time highs in 2015, several headwinds have negatively impacted its growth, and the changing marketplace conditions have plagued the stock. Exacerbating this downward movement from the factors above, Amazon has entered the fray and has resulted in another leg down for the stock. With Amazon’s recent $13.7 billion acquisition of Whole Foods, Amazon has officially entered the retail space and has shown further intentions to gain entry in the healthcare space, more specifically the potentially lucrative prescription drug space. Amazon is on the brink of deciding whether or not it will be selling drugs online while its push into pharmacy is very much an "if" and not a "when," according to sources. Amazon decided to bring in talent to build an internal pharmacy benefits manager for its own employees. This internal effort may serve as a proof-of-concept for the broader drug supply chain effort. Amazon already has a business selling basic medical supplies online. Express Scripts has taken notice of Amazon’s intent to enter the prescription drug market and acquired medical-benefits manager EviCore Healthcare. The competitive landscape has become too much of an overhang for me and I’ve since thrown in the towel.

Noah Kiedrowski
INO.com Contributor - Biotech

Disclosure: The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of stockoptionsdad.com a venue created to share investing ideas and strategies with an emphasis on options trading.