On Wednesday, CVS Health Corp. (CVS, Financial) announced a deal that has been a long time in the making. As the next step in its growth plan, the retail pharmacy giant has agreed to acquire primary care provider network Oak Street Health Inc. (OSH, Financial) in a deal valued at $10.6 billion, consisting of $9.5 billion in cash and the rest in debt assumption.
That works out to $39 per share, which is 73% above where the stock traded when rumors of the deal first surfaced in January. Shares of both stocks climbed about 5% on Wednesday, showing the market’s positive sentiment on the deal.
Some investors are skeptical about how successful CVS will be in its health care service ambitions due to the potential for conflicts of interest with its insurance business. However, if CVS can take control of primary care assets, it should be able to coordinate special compensation, referral privileges and medical record surveillance while offering lower prices than independent health care businesses, thus making its stock look undervalued compared to its growth potential.
The question for investors is, will customers really flock to this model? There are some glaring problems with it regarding the potential for conflicts of interest and lower quality care, but the U.S. health care system is notoriously expensive and inefficient, and CVS claims it can help overcome these issues to make health care more affordable. Then there are also potential antitrust issues to consider. Is CVS truly as undervalued as it seems at first glance, or is this deal a ticking time bomb?
The Oak Street deal
Oak Street owns more than 160 primary care centers, mostly serving older adults on Medicare. CVS said it plans to leverage business synergies to double Oak Street’s clinic count to more than 300 by 2026.
This deal follows hot on the heels of another that CVS announced in September 2022, in which the company agreed to buy home health care services company Signify Health Inc. (SGFY, Financial) in an $8 billion deal. Signify conducts home assessments, mostly for patients enrolled in Medicare.
In fact, some of Oak Street’s patients already have Medicare Advantage plans with CVS’s insurance arm, Aetna. CEO Karen Lynch said that following the acquisition, the company will be able to refer customers it reaches in Signify home health assessments to Oak Street for primary care and then refer them to fill their prescriptions from CVS pharmacies.
For now, it seems like CVS is primarily focusing on elderly people on Medicare for its primary care foray, perhaps because it will be easier to build a synergistic network.
The case for CVS
In addition to the synergies with CVS’s pharmacy and insurance businesses, an expansion into primary care offers an opportunity to help fix persistent cost-related issues in the U.S. health care system.
Despite spending more on health care than any other high-income nation, the U.S. scores worse than other high-income nations on several key health measures, including life expectancy, preventable hospital admissions and maternal mortality, according to data collected by Harvard Medical School. According to the Consumer Financial Protection Bureau, 58.5% of bankruptcies filed between 2013 and 2016 were due to being unable to pay sky-high medical bills.
By cutting some extra steps from the health care value chain, CVS has an opportunity to offer lower prices than individual practices, which have to contend with a more complex system. This could help attract new customers, who then might be incentivized to get their insurance and prescriptions through CVS as well. It could even drive more foot traffic to its retail stores.
According to Fierce Healthcare, the primary care market in the U.S. is estimated to be worth around $260 billion. A report from Bain and Company predicts that retailers, startups and other non-traditional health care companies could grab as much as 30% of the market by 2030.
The competition
CVS is not the only non-traditional company trying to make it big in “Big Medicine.” Its main retail pharmacy competitor, Walgreens Boots Alliance Inc. (WBA, Financial), has established a partnership with VillageMD to offer Village Medical at Walgreens clinics.
Then there is e-commerce and cloud data giant Amazon.com Inc. (AMZN, Financial) which is also trying to get a slice of the primary care pie. In July 2022, Amazon announced its plans to acquire primary care provider One Medical for $3.9 billion. Amazon has also launched a telehealth service and an online pharmacy.
Discount big-box retailer Walmart Inc. (WMT, Financial) expanded into primary care and other health services in 2014, building off of its existing pharmacy and optical services. Target Corp. (TGT, Financial) followed right behind, though unlike Walmart, Target offers its primary care services under a different label, Included Health.
The bear story
In counterpoint to the advantages and potential synergies of these health care mega-mergers, there are a few downsides that stand out, most notably the potential for conflicts of interest and lower quality care (these two kind of go hand in hand).
Both of these issues are already present in combining primary care under the same umbrella as pharmacy operations, as the leadership of such companies has a strong incentive to instruct health care providers to prescribe more medications. The U.S. already has a problem with overprescribing drugs, which is driven by the typically small amount of time patients get to spend with their health care providers as well as the cultural approach to health care of “treatment rather than prevention.”
Add in Aetna, the health insurance business that is under the CVS umbrella, and we get even more conflicts of interest. The insurance business would benefit from the primary care providers making fewer hospital referrals. According to an investigation conducted by Capitol Forum in November 2022, more than 20% of Oak Street Health clinics list no doctor on staff, which poses a risk to patient safety and tracks with CVS’s recent trend of cutting back on its pharmacy hours.
If customers note a drop in quality of care due to said conflicts of interest, many of them may opt to avoid primary care clinics run by CVS, even if other options are more expensive.
Valuation and risk assessment
There are both pros and cons to CVS expanding into primary care. Another factor to consider is that the deal is not guaranteed to get past regulators. The Signify Health acquisition has faced significant antitrust pushback, and the Oak Street acquisition looks slated to receive similar treatment. Other non-traditional health care disruptors like Walmart and Walgreens have received less pushback because they do not own health insurance companies outright.
If the deal does go through, CVS will have a chance to grab a slice of a market that could be worth $78 billion (as per the estimates from Fierce Healthcare and Bain and Company referenced previously). This has the potential to bring back CVS’s growth prospects in light of analysts projecting stagnation recently as brick-and-mortar retailers are expected to continue losing to e-commerce.
According to the GuruFocus free cash flow-based discounted cash flow calculator, even if CVS were to see its free cash flow per share decline by 6.46% per year for the next decade, it would still be fairly valued at current levels. The GF Value chart rates the stock as fairly valued.
While I can certainly understand the market’s optimism on the CVS acquisition of Oak Street, I personally think there are too many risk factors that, when combined, may outweigh the valuation and growth outlook.
