The Long and Short

CVS ratings hold despite slated acquisitions

Meredith Contente | February 10, 2023

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 recently announced a definitive agreement to acquire Oak Street Health (OSH) for $10.6 billion including net debt. OHS provides primary care for Medicare patients through a network of clinics that coordinate services and specialized care when needed. The announcement comes on the heels of CVS’ acquisition of Signify Health, expected to close in the first half of this year. The two acquisitions increase CVS’ primary care reach, as Signify is a provider of in-home primary care services through a network of over 10,000 clinicians. Coupled with CVS’ existing retail health, pharmacy and virtual care, the deal should accelerate the company’s long-term growth rate.

The deals should not affect the company’s ratings as CVS’ leverage will remain within the accepted range for the company’s current mid-BBB ratings. Armed with over $5 billion of cash on hand at the parent, CVS looks likely to finance the acquisitions with some cash and new debt. As with previous purchases, management seems likely to look to delever to bring leverage closer to the low 3.0x area. CVS spreads widened slightly on the deal announcement, which looks like a better buying opportunity, particularly in the long end of the curve.

Exhibit 1. CVS Curve vs. US Healthcare BBB Curve

Source: Bloomberg Trace; SanCap

Acquisitions to drive growth and unlock synergies

The acquisitions of both OHS and Signify will not only help CVS create a leading Medicare value-based care platform, but management sees the combination of both assets with CVS’ existing portfolio as an opportunity to unlock synergies and drive adjusted EBITDA growth. When evaluating OHS’ portfolio of 169 clinics across 21 states, management noted that the level of both patient engagement and positive patient experiences helped to achieve profitability within the first three years of opening. Once profitable, each clinic has the ability to generate $7 million in annual adjusted EBITDA, proving for embedded adjusted EBITDA of over $1 billion in the existing network. Furthermore, CVS believes the opportunity exists to scale OHS clinics across the nation, with a goal of over 300 clinics by 2026. At that scale rate, CVS projects just over $2 billion of embedded adjusted EBITDA within the network.

On the synergy side, CVS sees five main opportunities to unlock over $500 million of value. Management sees the ability to accelerate OHS patient growth through existing CVS Health channels, while also improving Aetna Medicare retention rates utilizing OHS clinics. Additionally, CVS sees greater utilization of both its pharmacy and Caremark services though the clinics. Lastly, OHS operating economics will benefit from CVS’ existing scale and the integration of complementary assets and improved lease costs.

Leverage to remain within range for current ratings

CVS ended fiscal 2022 with adjusted net leverage of 2.9x and gross leverage of 3.1x. Management projects that leverage will increase to the mid-3.0x area after the close of both transactions, which is within the range acceptable for the company’s mid-BBB ratings. A ratings trigger would occur if CVS were to sustain leverage above the 4.0x threshold.

CVS has a long history of delevering post acquisitions, as evidenced by the repayment of approximately $25 billion of net long-term debt since the close of the Aetna (AET) acquisition. However, CVS’ transition away from a traditional brick-and-mortar retail pharmacy to an integrated healthcare company has seen an increase in capital spending and acquisitions. As such, management is no longer targeting leverage below 3.0x. That said, CVS still seems likely to delever post acquisitions, while balancing shareholder rewards and funding its opioid settlement (around $5 billion over 10 years). Management has noted that it remains committed to its mid-BBB ratings, which means leverage will likely remain below the 4.0x threshold. The mid-BBB ratings ensures P2/A2 commercial paper (CP) ratings, providing for a lower cost of CP funding. Should CVS look to participate in any further acquisitions that could push leverage over the 4.0x area, management will likely look to dial back share repurchases in order to bring leverage below that threshold, similar to its strategy post the AET acquisition.

Strong cash flows support capital allocation plans

For fiscal 2022, CVS generated $13.5 billion of free cash flow, which more than covered debt reduction of $4.2 billion and $6.4 billion in shareholder remuneration. For fiscal 2023, CVS is guiding to cash flow from operations in the $12.5 billion to $13.5 billion range and capital expenditures to be roughly $3 billion, translating to free cash flow in the $9.5 billion to $10.5 billion range. Free cash flow estimates are enough to cover the annual dividend of around $3 billion, a $2 billion accelerated share repurchase program and further debt reduction. CVS has approximately $1.7 billion of debt maturing in 2023. While that debt could be refinanced, as CVS seems likely to tap the primary market to help fund the pending acquisitions, management will likely employ a balanced capital allocation approach, with some free cash flow to be earmarked for debt reduction.

Meredith Contente
meredith.contente@santander.us
1 (646) 776-7753

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