CVS Health Corporation's Biggest Mistake in 2016

Everyone makes mistakes -- even some of the biggest companies in the country. While CVS Health Corporation (CVS 1.15%) did plenty of things right in 2016, the giant pharmacy services company also made a few blunders. Here's CVS Health's biggest mistake of all this year. 

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Out-hustled by a big rival

CVS Health's stock is down nearly 20% in 2016. Most of that drop came in the last four months of the year. It's no coincidence that the company's major rival, Walgreens Boots Alliance (WBA -0.23%), made a couple of significant deals during that period at CVS Health's expense.

First, Walgreens announced in late August that it had formed a strategic alliance with Prime Therapeutics, the fourth-largest pharmacy benefits manager (PBM) in the U.S. Prime is owned by 14 Blue Cross and Blue Shield health plans. Under this agreement, Prime's 22 million members will be steered toward Walgreens' pharmacies.

Next, Tricare announced in September that CVS Health was being booted from its network and being replaced by Walgreens. Tricare serves 9.4 million members of active-duty and retired military personnel and their families.

Another rival to CVS Health was involved in the Tricare loss. Express Scripts (ESRX) operates Tricare's pharmacy network and competes with CVS Health's PBM business segment. Walgreens and Express Scripts had a major dispute several years ago, resulting in Walgreens' departure from the Tricare network.  

I would combine both of these losses into one major mistake for CVS Health: being out-hustled by the competition. Walgreens obviously wanted these contracts more than CVS Health did. The really troubling thing is that CVS Health appeared to be blindsided by both developments. The company lowered its full-year 2016 guidance as well as its 2017 outlook in response to Walgreens' wins.  

Overshadowing good moves in 2015

CVS Health had made a couple of smart decisions in the previous year. The company completed an acquisition of Omnicare in August 2015. This deal gave CVS Health a significant presence in the pharmacy services market for long-term care organizations.

In December 2015, CVS Health finalized its acquisition of Target's pharmacy and clinics business. This transaction provided CVS with the national retailer's 1,672 pharmacies across 47 states plus 79 in-store clinics. 

I expected these two acquisitions would help CVS Health achieve stronger growth. And they have. However, the company's failure to stay ahead of the competition overshadowed the positive results from the Omnicare and Target deals.

It's possible that these major acquisitions simply caused CVS Health to lose focus on the bigger picture. The company worked hard to assimilate the Omnicare and the Target businesses. In fact, CVS Health's management stated that the Target pharmacy integration was one of its "smoothest integrations ever." But while CVS successfully integrated the new business, it was losing existing business to its arch-rival Walgreens. 

Moving on

The best response after making a mistake is to learn from it and move on. That seems to be what CVS Health is doing.

CVS Health's Caremark PBM business ranks second in size only to Express Scripts and continues to show solid growth. David Denton, CVS Health's CFO, said in his third-quarter earnings call comments that the company had a successful selling season for 2017 with a retention rate around 97%. 

The company's retail business is more challenging, however. On top of the losses to Walgreens, CVS Health isn't yet realizing all of the expected benefits from the Omnicare and Target transactions. The retail pharmacy segment also faces significant reimbursement pressure.

Despite these headwinds, CVS Health thinks it can deliver 10% average annual earnings growth with free cash flow between $7 billion and $8 billion on average. Further acquisitions could play a role in helping the company achieve this growth. 

Wall Street seems to think that CVS Health can meet its earnings growth goal. I agree. Combined with the company's continued commitment to paying dividends, the pharmacy services giant should remain a decent pick for long-term investors despite its serious mistake this year.