For CVS Health Corporation (NYSE: CVS), there was one good thing about 2017: It wasn’t as bad as the previous year. But that’s faint praise at best. In 2016, the pharmacy giant reeled from two contract wins by rival Walgreens Boots Alliance (NASDAQ: WBA), causing CVS stock to drop 19%. After the dismal performance, CVS Health CEO Larry Merlo called 2017 “a rebuilding year.”
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But investors didn’t see any rebuilding of the stock’s value. CVS Health’s valuation is down more than 10% so far this year. Why was 2017 such a year to forget for CVS Health?
Delayed pain
To understand one key reason behind CVS Health’s dismal performance in 2017, we have to look back to last year. In August 2016, Walgreens announced a strategic alliance with Prime Therapeutics. Fourteen Blue Cross and Blue Shield plans own Prime, which ranks as the fourth-largest pharmacy benefits manager (PBM) in the U.S. The next month, Walgreens landed a contract with Tricare, the healthcare program for the U.S. military.
While those deals were made in 2016, CVS Health didn’t fully experience the pain from the losses until this year. Tricare began steering its 9.4 million members away from CVS Health and to Walgreens on Dec. 1, 2016. CVS dropped out of the network for Prime Therapeutics’ 22 million members on Jan. 1, 2017.
Just as expected, CVS Health’s bottom line took a big hit when the company announced its first-quarter results in May. Net income fell nearly 17% year over year, with CVS Health attributing the decline largely to lower volume stemming from the losses to Walgreens.
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Major headwinds
But the departures of Prime Therapeutics and Tricare weren’t the only problems for CVS Health in 2017. The company faced several headwinds. While its PBM business remained strong, CVS Health’s retail/long-term care (LTC) segment didn’t fare so well.
The introduction of new generic drugs stood out as one significant issue weighing on retail pharmacy sales. These drugs are less expensive than brand drugs, and therefore cause sales to be lower. At the same time, CVS Health reported higher generic dispensing rates, which increased the impact of the issue. The flip side of the coin, though, is that generic drugs can actually be more profitable for pharmacies than brand drugs.
One challenge that CVS Health went up against that doesn’t have a silver lining, however, is continued reimbursement pressure. The company cited this pressure as an issue in all three of its quarterly updates so far in 2017.
Another headwind for the company’s retail business this year was wind — literally. In the third quarter, CVS Health’s financial results were negatively impacted by three major hurricanes that hit the southern U.S. and Puerto Rico.
A looming threat
As if all that weren’t enough, investors were also rattled by the potential entrance of a formidable new rival in the retail pharmacy industry. In May, reports began to surface that Amazon.com (NASDAQ: AMZN) was evaluating the possibility of selling prescription drugs online. The news caused the stock prices of the big pharmacy chains to drop almost immediately.
Could Amazon take a significant chunk of market share away from CVS Health? Some might scoff at the idea, but I wouldn’t be surprised if the internet retailer was successful if it decides to jump into the pharmacy world. In my view, dismissing the potential threat from Amazon would be a huge mistake.
Apparently, CVS Health’s executives agree at least to some extent that Amazon is a threat. CVS revealed a new home-delivery program in early November that analysts quickly began referring to as the company’s “Amazon strategy.” The company will offer next-day delivery from all of its stores starting in 2018. CVS Health will also provide free same-day delivery for prescription drugs and some front-store products in certain markets.
Looking ahead
Will 2018 be a better year than 2017 for CVS Health? Possibly. The company had a strong PBM selling season for 2018. Personalization and promotional strategies have improved front-store profitability. CVS is enjoying solid growth from its store brands. The possibility of corporate tax reform in the U.S. could also be a big deal for the company, with its high effective tax rate.
Then there’s the matter of a potential acquisition of Aetna (NYSE: AET). The Wall Street Journal reported in October that CVS Health had made a $66 billion bid for Aetna, the third-largest health insurer in the U.S. CVS Health’s executives didn’t say anything about this possible deal in the third-quarter conference call. However, the company’s CFO, David Denton, stated that “M&A [mergers and acquisitions] has always been at the core of our business, and we will continue to do that as we think — as we look forward.”
If an Aetna deal does happen, 2018 won’t be a year to forget for CVS Health. Instead, it will be a memorable year that radically transforms the company over the long run.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Keith Speights has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.
