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A promising transition at CVS
admin | July 12, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
CVS Health Corp (CVS – Baa2 (n)/BBB) spreads should benefit from management’s capital allocation policy which is focused on debt reduction since the close of the AET acquisition. The acquisition of AET also transitions CVS further away from traditional retail pharmacy and into an integrated healthcare company, providing some insulation from competitive threats in the retail pharmacy space. WBA (Baa2/BBB/BBB (n)) is currently sticking with a retail only approach which could prove to be negative over the longer term, particularly as Amazon looks to enter the space. Investors should swap out of WBA 3.8% 11/18/24 and into CVS 4.1% 3/25/25 for a yield pick of 9 bp, 7 bp on a g-spread basis. In 5yr CDS, CVS has rallied from the wides in March and now trades on top of WBA.
Exhibit 1: 5-year CDS of CVS and WBA
Source: Bloomberg
Committed to debt reduction
CVS management remains committed to debt reduction and has been actively paying down debt since the close of the AET acquisition on 11/29/18. At the time of the close, adjusted leverage was 4.7x and management is targeting mid-3.0x leverage by 2021 and low-3.0x by 2022. For 2019, CVS is forecasting to repay about $7.5 billion of debt, of which $5.1 billion has been repaid year to date. Management suspended share repurchases prior to the close of the acquisition to help build cash on the balance sheet and does not plan to return to share buybacks until it reaches its low-3.0x leverage target. Strong free cash flow generation of $6.2 billion (on a last twelve months basis ended 3/31/19) has aided the company’s debt reduction efforts so far this year. While street forecasts are estimating free cash flow generation of $8.3 billion, management has noted additional cash could be free up through further working capital opportunities as well as store rationalization. For comparison purposes, WBA’s adjusted leverage is roughly 4.0x and has increased due to EBITDA deterioration.
A win for the PBM business
CVS got a much needed win this week as it relates to its PBM business as the Trump Administration withdrew its proposal to eliminate the safe harbor for rebates from government (Part D) drug plans. While CVS offers multiple pricing model options for their PBM clients, the elimination of the rebates would have been a short term hit to the margin. Despite the withdrawal, PBMs should look to provide more transparency with respect to pricing and come up with more solutions for clients to better manage costs. CVS is currently offering real time prescription benefit information to members at all touch points, including doctor’s offices and pharmacies to help members and providers achieve lower out-of-pocket costs.
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