CVS is under pressure and is considering a break up. Here's why that can be risky

It's time to do a wellness check CVS Health.

The company's shares have fallen more than 20% this year as it grapples with higher-than-expected medical expenses under pressure from its insurance unit and pharmacy reimbursements, among other issues.

As it seeks to regain trust with Wall Street, the company is considering breaking itself up

CVS has engaged advisers in a strategic review of its business, CNBC reported Monday. One option being weighed is splitting its retail pharmacy and insurance units. It would be a stunning turnaround for the company, which has spent billions of dollars on acquisitions over the past two decades to become a one-stop health destination for patients.

Some analysts claim that a breakup of CVS will be challenging and unlikely.

CVS risks losing customers and revenue if it splits its vertically integrated business segments, which include health insurer Aetna and major pharmacy benefits manager Caremark. That could translate into more lost profits for a healthcare giant that has cut its full-year 2024 earnings guidance for three quarters in a row.

“There's really no perfect option for a breakup,” said Rajeev Leventhal, senior analyst at E-Marketer, who believes a breakup is still a possibility. “If that happens, one side of the divide becomes really successful and prosperous and the other will struggle significantly.”

Notably, CVS executives met Monday with major shareholder Glenview Capital to discuss how to fix the flailing business and restore its stock, CNBC previously reported. But Glenview on Tuesday denied rumors that it was pushing to break up the company.

If CVS remains intact, CEO Karen Lynch and the rest of the management team will have to implement major changes to address what industry experts say is disrupting its bottom line and stock price.

The company has already undertaken a $2 billion cost-cutting plan CVS announced in August to help boost profits. CVS said Monday that the plan involves laying off about 3,000 workers.

Some analysts say the healthcare giant must prioritize margin recovery in its insurance business, which they believe is the main issue weighing on its stock price and financial guidance for the year. That pressure led to a leadership change earlier this year, with Lynch taking direct oversight of the company's insurance unit in August, displacing then-president Brian Kane.

CVS' management team and board of directors “continue to explore ways to create shareholder value,” a company spokesperson told CNBC, declining to comment on breakup rumors.

“We are focused on driving performance to deliver high-quality healthcare products and services enabled by our unmatched scale and integrated model,” the spokesperson said in a statement.

Investors may get more clarity on the way forward for the company during its upcoming earnings call in November.

Some analysts say CVS is unlikely to separate its retail pharmacy and insurance divisions because of synergies between the three combined businesses. Separating them could bring risks, they added.

“The strategy itself is still vertical integration,” Jefferies analyst Brian Tanquilut told CNBC. “The execution may not have been the biggest, but I think it's a broken strategy that's really a little early to draw conclusions.”

Many of CVS's clients contract with the company across its three business units, according to Evercore ISI analyst Elizabeth Anderson. Anderson said that “carving out a whole deal and setting it apart” in the event of a breakup could be “operationally quite difficult” and could result in lost customers and revenue.

Pharmacy benefit managers such as CVS' Caremark sit at the center of the drug supply chain in the US, negotiating drug discounts with manufacturers on behalf of insurers, creating lists of preferred drugs covered by health plans and reimbursing pharmacies for prescriptions.

That means Caremark sits at the intersection of CVS's retail pharmacy operations and its Aetna insurer, increasing the competitive advantage of both businesses. In the case of a breakup, it is not clear where Caremark would fall.

Separating Caremark from Aetna would put the insurance business at a competitive disadvantage as all of its major rivals, including United Health Group, Cigna And HumanaThey have their own PBMs, says eMarketer's Leventhal.

But Caremark, in some cases, also funnels drug prescriptions to CVS retail pharmacies, he said. This has helped the company's drugstores gain meaningful prescription market share over its main rivals, walgreens, which is struggling to function as a largely standalone pharmacy business.

CVS is the top U.S. pharmacy by prescription drug revenue, holding more than 25% of the market share in 2023, according to Statista data released in March. Walgreens lagged with about 15% of that share last year.

Now, CVS drugstores must maintain an edge over competitors at a time when the broader retail pharmacy industry faces profitability problems, largely due to declining reimbursement rates for prescription drugs. Competition has increased since the amazon And for other retailers, inflation and softer consumer spending are making it more difficult to turn a profit on store fronts. Meanwhile, burnout among pharmacy workers is also putting pressure on the industry.

Operating margin for CVS's pharmacy and consumer wellness businesses was 4.6% last year, down from 3.3% in 2022, 8.5% in 2019 and 9.9% in 2015.

CVS and Walgreens have both moved from relentless retail drug store expansions over the years to closing hundreds of locations across the U.S. CVS wrapped up a three-year plan to close 900 of its stores, including 851 as of August.

The rocky outlook for retail pharmacy could make it difficult for CVS to find a buyer for drugstores in the event of a split, according to Tanquilut. He said a spinoff of CVS's retail pharmacies would be more likely.

“There's a reason they're cutting stores. Why would it break up if the relationship between Caremark and CVS Retailer is what makes it outperform the rest of the pharmacy peer group?” Tankilut Dr.

CVS has other assets that would need to be distributed in the event of a breakup.

That includes two recent acquisitions: fast-growing primary care clinic operator Oak Street Health, which the company acquired last year for $10.6 billion, and Signify Health, an in-house healthcare company that CVS bought in 2022 for about $8 billion. The deals were aimed at building on CVS's major push into health care — a strategy that Walgreens and other retailers have also pursued over the past few years.

Mizuho managing director Ann Hynes wrote in a research note Tuesday that Oak Street Health could theoretically exit with Aetna in the event of a split.

The primary care clinic operator complements Aetna's Medicare business because it cares for older adults, offering routine health exams and diagnoses, among other services. CVS also sells Aetna health plans that offer discounts when patients use the company's medical providers.

But CVS has begun integrating Oak Street Health with its retail pharmacies. The company has opened these primary care clinics, along with some drugstores in Texas and Illinois, with plans to open two dozen more in the US by the end of the year.

Several companies, including Amazon, WalmartCVS and Walgreens are feeling the pain from bets on primary care. That's because building clinics requires a lot of capital, and locations typically lose money for several years before becoming profitable, according to Tankiloot.

Walgreens could potentially exit that market entirely. The company said in a securities filing in August that it was considering selling its primary care provider, VillageMD.

But Tanquilut said it doesn't make sense for CVS to sell Oak Street Health or Signify Health because “they're actually hitting their numbers.”

Signify saw a 27% year-over-year revenue increase in the second quarter, while Oak Street sales rose nearly 32% from the same period last year, reflecting strong patient subscriptions, CVS executives said on an earnings call in August.

Oak Street ended the quarter with 207 centers, up 30 centers from last year, executives added.

“Why get rid of them when they are still strategic in nature?” Tanquilut told CNBC it will be difficult to find a buyer for Oak Street because of the tough market for primary care centers.

If CVS doesn't go through a breakup, the “single best value-creation opportunity” for the company is solving ongoing problems on the insurance side of the business, according to Leerink Partners analyst Michael Cherney.

The segment's performance this year fell short of expectations due to higher expected medical costs — the biggest hit to the company's fiscal 2024 guidance and stock performance, he said. Cherney said he is confident the problem is “fixable” but that it will depend on whether CVS can execute the steps it has already indicated to improve margins in its insurance unit next year.

Aetna covers the Affordable Care Act, Medicare Advantage and Medicaid, as well as dental and vision plans. Medical costs for Medicare Advantage patients have jumped compared to last year for insurers as more veterans return to hospitals during the pandemic to have procedures they delayed, such as hip and joint replacements.

Medicare Advantage, a privately run health insurance plan contracted by Medicare, is a key source of growth and profit for the larger insurance industry. More than half of Medicare beneficiaries are enrolled in those plans as of 2024, with lower monthly premiums and additional benefits not covered by traditional Medicare, according to health policy research firm KFF.

But investors are now worried about the skyrocketing costs of Medicare Advantage plans, which insurers warn may not come anytime soon.

Cherney said CVS has faced a “double whammy” on Medicare Advantage this year, grappling with additional membership growth at a time when many seniors are using more benefits.

In August, CVS also said its full-year outlook reflected a decline in the company's Medicare Advantage star rating for the 2024 payment year.

These important ratings help patients compare the quality of Medicare health and drug plans and determine how much bonus payments an insurer receives from the Centers for Medicare and Medicaid Services. Plans that receive four stars or higher receive a 5% bonus for the following year and increase their benchmark, giving them a competitive advantage in the market.

Last year, CVS estimated that it would lose up to $1 billion in 2024 due to a lower star rating, the company disclosed in a securities filing.

But things could start looking up in 2025.

One of the company's large Medicare Advantage contracts has regained its four-star rating, which will “create a cumulative tailwind” in 2025, CVS executives said in August.

“We're giving them the benefit of the doubt because we know that star rating bonus payments will return in 2025,” Tanquilut said.

During a conference in May, CVS said it would pursue a “margin over membership” strategy: CVS CFO Tom Cowhey said the company is poised to lose 10% of its existing Medicare members next year in an effort to regain its margins. on track.”

The company will make significant changes to its Medicare Advantage plans by 2025, such as raising copays and premiums and cutting some health benefits. This would eliminate the costs associated with those facilities and drive away patients who need or want to use them.

The actions will help the company achieve its goal of a 100- to 200-basis-point margin improvement in its Medicare Advantage business, CVS executives said in August.