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New CVS deal highlights value in AET bonds

| August 14, 2020

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.

CVS tapped the debt market for the second time this year with proceeds, coupled with cash on hand, used to fund a tender offer of some its 2023 and 2025 bonds. The issuance and tender help to smooth out two of its three largest debt maturity years while extending duration. Given the overall rate environment and that spreads are only +20 bp off the tights witnessed in February, CVS was able to price the deal at record low coupons for its capital structure.  CVS priced a new 20-year bond (2.7% 8/21/40) at +135 bp (+157 bp g-spread) and is currently trading right around new issue level. A comparative value are the bonds of CVS’ wholly owned operating subsidiary, AET 6.625% 6/15/36,  which are currently trading at the +163 bp level (+205 bp g-spread). A swap out of the new CVS 20-year bond into the AET 2036 bonds provides for a pickup of +47 bp g-spread while shortening maturity by 4 years.

Exhibit 1: CVS curve 5-year to 30-year

Source: Bloomberg TRACE

AET Outperforms in 2Q

Second quarter results saw a large benefit from the Healthcare Benefits unit which more than offset higher operating costs associated with increased pay wages and cleaning costs at the retail unit. Revenues at the Healthcare Benefits unit were up 6.1% driven by strong membership growth in Medicare and Medicaid products. Government membership was up 22.4% year-over-year to $6.1 million. Adjusted operating income witnessed at strong 141% increase year-over-year to $3.5 billion, primarily driven by unprecedented lower benefit costs due to the deferral of discretionary medical visits as quarantine orders called for a shelter-in-place. As such, the medical benefit ratio (the lower the better for profitability) declined 1370 bp year-over-year to 70.3%. This growth is expected to moderate in 2H20 as shelter in place orders have largely been lifted.

Liquidity Strong and Cash Flow Supports Debt Reduction

CVS ended the quarter with total liquidity of roughly $13 billion as cash and equivalents totaled $7 billion and the company had $6 billion of availability under its credit facilities. During the quarter, CVS generated a very strong $6.7 billion in free cash flow, which was up from $4.8 billion in the year ago period. Management continues to prioritize debt reduction and repaid $2.75 billion of debt that matured in July (subsequent to quarter end). Management also reiterated its commitment to not repurchasing shares until it achieves its leverage target of low 3.0x, which they noted they remain on track to hit in 2022. At quarter end, we estimate that debt/EBITDA was 3.7x, while lease adjusted leverage was a half turn higher at 4.2x. Post the aforementioned debt reduction, leverage has declined another two ticks to 3.5x and 4.0x, respectively. CVS met S&P’s deleveraging expectation in fiscal 2019 and the agency believes that the deleveraging trend will continue given the company’s ample free cash flow generation.

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