Our Reflections on CVS / Oak Street
TL;DR: A lot has already been said the last few days about the CVS and Oak Street merger. Rather than rehashing that coverage of the deal here, we’re going to focus on a handful of important strategic questions the deal presents for the combined entity in order to help think about whether or not the deal will be successful moving forward. Obviously CVS paid a hefty premium for Oak Street, and you’ll see our skepticism emerge. It’s certainly understandable why CVS felt the need to acquire the premier value-based care asset on the market, and Oak Street deserves a lot of credit for building a business as consistently as it has. But buying an asset that is going to be dilutive to EPS for at least four years in the midst of a potential massive landscape shift in Medicare Advantage seems like it could go sideways very quickly for CVS if the market turns.
Table of Contents
Here's how the rest of the article breaks down from here if you want to skip ahead to various sections:
The 30,000 Foot View
- Perspective For the Deal
- Perspective Against the Deal
- An Overview of Our Strategic Questions
- Summary Articles
Key Strategic Questions
- What if the Golden Age of MA profitability is coming to an end?
- Why did Humana reverse course in the MA primary care market?
- How confident should we be in Oak Street’s J-Curve?
- What becomes of Oak Street inside of CVS?
The 30,000 Foot View
At the highest level, this is a pretty straightforward deal with two pretty clear opinions on it:
For the deal
In one camp, you have folks who think this is a necessary bet for CVS to take as it cements its status as a healthcare business versus a retailer. CVS had fallen behind other vertical consolidators in the race to become the leading “payvidor”, and the One Medical miss left a gaping hole in their product offering as an insurer. Bringing Oak Street in house both shores up the existing Medicare Advantage business for CVS, simultaneously helping manage the STARs problem that has cropped up as well as member retention issues in the business. CVS also should be able to drive more members into Oak Street clinics, helping improve the profitability for these clinics. The high level strategy here is really straightforward when you look at CVS compared to its competitive set. You can almost hear the sense of relief in the first analyst question in the earnings call Q&A: “I know every quarter I’ve asked about this strategy around value-based care and what you’re going to do in this area. So I’m happy that you finally have done this.” In this camp, it’s a no-brainer to acquire the blue chip value-based care asset and bring it in house. The only question is why CVS didn’t get this done sooner. It allows CVS to further tap into the Medicare Advantage profit pool as a core business driver moving forward.
Against the deal
In the other camp, you look at the valuation here and it’s a real head scratcher. CVS is paying almost $60 million for Oak Street’s 169 primary care clinics! Meanwhile, Oak Street has effectively conjured up a new financial metric they call Embedded EBITDA to demonstrate how the model can theoretically get to profitability in the future while it loses hundreds of millions of dollars a year. Yes, Oak Street has executed incredibly well on its Medicare Advantage VBC model. Nobody can argue that. The way they have executed on their story despite a highly tumultuous period on the public markets has been impressive. Their historical data on cohort performance and how they move clinics along the profitability J-curve is impressive in its consistency. But as everyone knows in healthcare, it is really hard to scale consistently given all of the dynamics at play. The likelihood that Oak Street is able to get 300 clinics to $7 million of EBITDA consistently is extrapolated off a pretty small dataset, and it is bound to get screwed up along the way. Not to mention, you have the broader headwinds the MA space is potentially facing as CMS appears to be wisening up to the profitability of these models and potentially cracking down. Meanwhile, CVS is going to need to spend the next four years investing in this asset before this deal even gets to EPS breakeven for them, and that’s in the best case scenario.
Our Strategic Questions
As we look at it, the majority of what is written in both of those paragraphs appears to be true to us, which in many ways highlights the complexity of this deal. CVS is acquiring a foundational care delivery asset it can build around. It’s also an asset that it probably overpaid for as the Medicare Advantage market faces some headwinds. At the same time, CVS as an insurer needed that asset in order to keep up with its competition. And not to mention that Oak Street likely recognized it would benefit from an insurance partner as the MA market potentially enters some leaner years and we reach the limits of what primary care models can achieve.
As you’ll see in the coming sections, we have a number of strategic questions about the rationale for the deal and whether Oak Street’s success to date as a standalone business will be replicated inside of CVS. We’ll come back to our perspective on the transaction at the end of this article, after addressing a number of key strategic questions we think are worth examining:
- What if the Golden Age of MA profitability is coming to an end?
- Why did Humana reverse course in the MA primary care market?
- How confident should we be in Oak Street’s J-Curve?
- What becomes of Oak Street inside of CVS?
Before diving in, we should note that this article assumes the reader has a general understanding of the deal and Oak Street’s model. If you want to get up to speed on the transaction before coming back here, here are some other articles we’d recommend checking out.
Here are some of the most helpful materials to get up to speed on the basics of the deal and rationale for the transaction:
- Blake Madden’s Deal Review in Hospitalogy. This article does a really nice job outlining Oak Street’s model and the rationale for the transaction.
- Home Health Care News. This article hones in on the interplay between Oak Street and Signify in terms of integrating primary care clinics with home health.
- CVS Q4 2022 Earnings Call Transcript. Oak Street’s CEO Mike Pykosz joins CVS’s earnings call to discuss the transaction.
- CVS / Oak Street Merger Presentation. The SEC filing with the slides from the merger presentation.
- Oak Street 2022 Analyst Day Review. Our review of Oak Street’s Analyst Day in March 2022, which provides a good summary of the model.
Ok, with that out of the way, let’s proceed to some of the big strategic questions we’re asking ourselves related to this deal.
What if the Golden Age of MA profitability is coming to an end?
We think that in many ways, the biggest question related to this deal rides on the success of the broader MA market over the coming decade. If profits for the industry continue to grow unabated, CVS is probably going to come out looking wise. But if the tide shifts and the market gets tougher, this deal could quickly turn into an albatross.
Like most public companies, CVS is an organization heavily focused on meeting quarter-to-quarter EPS numbers. Yet CVS leadership acknowledged that this deal will be dilutive for the next several years. On the earnings call they mentioned it would be EPS neutral in four years, and that will certainly be a challenge for CVS leadership to manage through here. If CVS’s overall business is growing and this is just a minor drag on that growth, that seems manageable. But if the market turns and CVS runs into financial obstacles, this could become an issue quickly.
What could cause the market to turn on CVS so quickly when Medicare Advantage has been such a profitable environment for so long now? Well, CMS could change the rules of the game.
CMS Changing the Rules
We think the biggest existential threat to the model here comes out of D.C. While CVS’s CEO noted on the earnings call they were pleased to hear bipartisan support for Medicare in the State of the Union this week, there has been a growing critique of the potential for excess profits in the Medicare Advantage model, with risk adjustment at the center of that.
The questions about the profitability of these models aren’t exactly new. Back in 2020, this excellent Health Affairs article explored in detail the economics of advanced primary care models, based on Blue Cross Blue Shield of North Carolina’s experience. It highlights how incredibly profitable MA primary care can be for the VBC primary care provider. If you are at all interested in the economics of VBC in Medicare Advantage, that article is a must read.
The article included this chart below, illustrating how the profitability for an individual MA member changes over time with an advanced primary care model. It shows plainly how the payor, the provider, and the patient all benefit, ultimately at the expense of the federal government.
And this, in many ways, is the existential threat for Oak. Oak appears to have grown on the back of what seems to be a very generous MA payment model. What happens if CMS decides to stop playing this game?
The CMS Hypothetical
Here’s a hypothetical to see how this might play out over the next few years. Let’s say you run CMS. You believe the quality data that shows that Medicare Advantage - and in particular the advanced primary care models that have taken off within MA - are a good thing in terms of improving the quality of care for seniors in this country. CMS’ push to expand this approach into Medicare FFS via Direct Contracting / ACO REACH provides pretty good evidence you think this is the case and this is an aim of yours.
But at the same time, you’ve seen data like the above chart and heard the growing critique of for-profit models in the space. You’ve concluded that this is indeed the dynamic that is playing out in the Medicare Advantage market. The health plan, the consumer, and the provider are all doing significantly better at the moment, but you’re left holding the bag as CMS. You’re starting to feel significant political pressure given the state of the Medicare Trust Fund and the amount of profits Medicare Advantage seems to be generating for the industry.
So you have a tricky task - you want to start taking steps to curtail spending and manage your budget wisely, but you also want payors and providers to continue offering these models to patients. So if you’re CMS, maybe you start suggesting changes like revising risk adjustment, which just so happens to be what just occurred in the 2024 Advance Notice last week.
You’re quite certain that the industry will push back hard on this move, so you need to make these changes deliberately, as you also need the industry to continue supporting this program. But over time, this is just your first step towards more meaningful systematic changes where CMS says to the industry: “Hey, we generally like this model, but we don't want to be left holding the bag like we clearly are at the moment. So instead, we’re going to pay you less to do the same thing!”
Who knows what CMS is actually up to and whether that is actually happening. What we do know is that the first two steps of that appear to be unfolding as we speak: 1) CMS is attempting to start to squeeze the profitability of the model, and 2) the industry is (not surprisingly) pushing back. America’s Physician Groups released a statement this week essentially arguing CMS’s advance notice for 2024 is starting this exact process by making changes to the risk adjustment model:
As a result of these risk-adjustment changes, some of our physician group members have concluded that they will face revenue cuts ranging from more than 10 percent to as much as 20 percent in caring for their Medicare patients enrolled in MA. Multiple consequences could ensue, including inevitable decisions by some of our members to close inner-city and rural clinics, many of them barely financially viable already, that cater to older adults – many of whom have the conditions described above.
It’s worth noting that if APG is suggesting that physician groups will lose 10% - 20% of revenue if this change happens, that Oak Street is probably at the very top end of this range given the sophistication of its model. Why do we think they’re likely at the top end of the range? Because everything that Oak Street talks about how good it is in terms of performance - i.e. how the model helps identify and close gaps in care - also means that they are likely very efficient at capturing risk scores compared to other providers. So if CMS takes that away, it’ll likely impact Oak Street’s revenue the most. You can also see the argument APG is preparing against this change - that pulling the plug on risk adjustment will negatively impact inner-city and rural clinics that are barely financially viable.
The big question in this hypothetical is whether CMS can actually successfully navigate this given the pushback from industry, which seems like it is just beginning. In the earnings call discussing the deal, CVS mentioned that it discussed the Advance Notice changes with Oak Street, but didn’t seem too worried about it, noting that a lot of questions still need to be answered. So it’s not like these two parties were unaware of the changes, and you have to imagine Oak Street leadership in particular understands the impact of this change better than anyone in the industry. Reading between the lines, it’s not hard to envision a scenario where CVS / Oak Street believe the industry will successfully push back. CVS’s positive comments about the bi-partisan support for funding Medicare during the State of the Union certainly indicates as much.
This is setting up to be a massive battle over the coming months specific to 2024 Advance Notice, and we’d imagine longer. We wouldn’t be surprised if we’re looking back in ten years at this deal as an “RIP Good Times” moment in the Medicare Advantage market, and this deal increasingly looks like an albatross where CVS paid high just as the market turned. Of course, all of that is actually reliant on CMS reining in the industry, which will be no easy task.
Why did Humana reverse course in the MA primary care market?
One of the most interesting parts of the evolution of the Medicare Advantage primary care market over the last decade is how Humana essentially went from being the payor that kickstarted all of the startup activity in the space to deciding to build it on their own.
Humana’s Long History with MA Primary Care Startups
Humana essentially seeded the MA primary care market, and has always been a key revenue driver for MA primary care startups including Oak Street. To this day, Humana is still by far Oak Street’s largest customer, after it was Oak Street’s first value-based relationship back in 2015 in Chicago. Over the past three years, Oak Street has made a significant effort to diversify away from Humana as its key revenue driver, which you can see in the table below.
As of Q3 2022, Humana still represents 31% of Oak Street's revenue, and the combo of Humana, Wellcare, and UHC represent 57% of Oak Street’s revenue. As the space becomes more competitive and MA insurers partner up with their various care delivery entities, it’s not hard to imagine this dynamic getting significantly more competitive. Humana has recently made it a point of emphasis to get involved with brokers at the point of enrollment - noting in its Q4 earnings call last week that 60% of new members had a visit scheduled by December 31st. It doesn’t seem like a huge jump to suggest that, where available, Humana is strongly encouraging their members to visit CenterWell clinics. It seems unlikely that this has a major short term impact on Oak Street given the symbiotic relationship between payors and providers in MA, even if these deals are moving towards more “frenemy” status. Humana hinted at the competitive back and forth here by announcing a five year deal with ChenMed on the same day as the CVS / Oak Street announcement.
It’s also worth keeping in mind that Humana was not only a customer of the MA primary care clinics like Oak Street, but it also funded the growth of these companies. Humana invested $50 million in Oak Street back in 2018 and had a representative on Oak Street’s Board from 2019 - 2021. When Oak Street went public back in 2020, Humana was the third largest shareholder in Oak Street with a 5.9% stake in the company. Heck, even in the CVS / Oak Street merger deck, there’s a footnote on Slide 6 noting that 57% of Oak Street’s clinics are leased from Humana. Humana’s fingerprints are all over this business, as they are of many MA startups.
Humana & Welsh Carson
Given that close relationship, it seems notable that in the past few years Humana has decided to invest in building out its own primary care footprint rather than acquiring Oak Street or any other MA primary care startup. Humana has instead created two Joint Ventures with private equity firm Welsh Carson to invest in building out 167 primary care clinics. Humana and Welsh Carson appear to have struck quite the “win-win” deal between themselves, where Welsh Carson finances the upfront losses of the clinics while Humana reaps the long term benefits of the clinics (and Welsh Carson presumably does quite nicely on the deal as well for a relatively risk free investment). In the second JV, Humana and Welsh Carson are deploying $1.2 billion to stand up 100 primary care clinics, which equates to roughly $12 million per primary care clinic that will be stood up. It’s worth comparing that number to the number that CVS is paying here - $9.5 billion for Oak Street’s 169 clinics equates to approximately $60 million per clinic.
So it seems notable that Humana essentially purchased a front row ticket to observe every MA startups’ growth over the past several years, but ultimately appears to have decided to recreate this business instead of acquiring them. While we don’t fully know what Humana learned, it’s not hard to imagine that there were at least two key learnings from their work with startups early in the space:
- Operating an MA primary care model isn’t rocket science. There is limited “IP” here, beyond the know-how that comes with hiring good people and leveraging the payment model to enable those people to spend more time taking care of fewer patients.
- Patient acquisition is the crux of getting a clinic to profitability, and if a primary care clinic model is growing just by a payor throwing its membership to the primary care clinic, that payor is the one actually doing the heavy lift driving members to clinics.
(An aside - Oak Street appears to have invested in this patient acquisition capability heavily over the past few years and now seems to have best-in-class capabilities here, along with a partnership like AARP)
One of the things that Humana appears to have learned from its work with companies like Oak Street over time is the importance of the J-Curve in evaluating the financial success of these primary care clinics. Humana shared this J-curve slide in their 2022 Investor Day, showing how its centers grow to profitability over time.
As we’ll dive into more in the next section, this J-curve chart from Humana’s 2022 Investor Day looks quite similar to Oak Street’s J-curve (which you can view below), with two notable exceptions. First, Humana’s clinic contribution margin only gets to $3 million in 6-7 years, versus Oak Street’s of $7 million in 6 years. Second, the upfront losses in building out each center are bigger, with $2 - $3 million of CapEx and $4 - $6 million of center losses before reaching breakeven in year 3, versus only ~2.5 million of center losses for Oak Street. If you’re looking at those numbers and scratching your head wondering how Oak Street is operating a similar style model in a significantly more profitable way than Humana / Welsh Carson can, we’re right there with you.
Given all of the above, it is not particularly hard to imagine that Humana looked under the hood at these models and decided it could rebuild them for significantly cheaper. Instead of purchasing Oak Street for $60 million a clinic, it found a financial partner that has both minimized Humana’s dilution from the clinic build-out, and also puts the cost at roughly $12 million a clinic. With that lens, it becomes pretty clear CVS overpaid for the asset here.
But the question to ask within that is whether CVS had any other choice at this point in time. It also seems pretty clear from the above that CVS was years behind Humana in its advanced primary care strategy. Given the pressure that CVS leadership was under to make a move, it doesn’t appear that it had the luxury of time to build this model internally. So instead, CVS paid a premium to acquire the clinics and talent and speed up the timeline. It’s an expensive way of entering the market, but it certainly speeds up the market entry.
How confident should we be in Oak Street’s J-Curve?
Oak Street’s financial success ultimately can be observed pretty easily via its J-curve. For folks who are like “what the heck is a J-curve”, here’s a quick explanation. When you open an MA primary care clinic, you lose money for a period of time. This is because you have to build the clinic, and then also have to hire staff. Those staff need to build up their patient panels. So for the first few years of operating a clinic, it loses money while keeping the lights on, employing staff, and growing the patient panel. As the clinic grows patient volume, that fixed cost is spread out over more revenue, and the model gets increasingly profitable. If you map out the profitability of a clinic over time, it should form the shape of a “J”. So the name “J-curve” represents the shape of the profit margin curve described above over the six years a VBC primary care clinic is built.
Oak Street’s Consistent J-Curve
This J-Curve is really the crux of the MA primary care financial model. If you can finance the losses and move the clinics to profitability consistently, you have a really nice business. And what Oak Street has done beautifully over the last several years is paint a picture of how it maniacally executes on its J-curve. You can see Oak’s J-curve in the upper right of this slide from their 2023 JPMorgan presentation.
The entire financial proposition for Oak Street relies on them consistently getting clinics to the top of the J-curve, meaning that clinics are generating $7 million in contribution margin in year six. Oak Street has shown historically that it has been able to move clinics along this curve really consistently. What Oak Street has done as well as anyone is demonstrate consistent improvement over time toward that $7 million target. As you can see in the bullet points of the slide above, Oak Street generated $8.5 million in the 15 most scaled centers, while the 24 oldest centers expect $6.7 million. As a public company, Oak has reported on and achieved these numbers with impressive consistency.
But at the same time, many clinics are still early in the process, which causes Oak Street to burn cash - as we mentioned above, in the first nine months of 2022 they lost ~$184 million in Adjusted EBITDA. So the entire story of Oak Street’s profitability relies on the assumption that the early profitability it has seen in some of its centers will be applicable to all of its centers, and eventually it will turn a cash flow on the business.
Oak Street and CVS both like to highlight the financial opportunity here by talking about a metric called Embedded EBITDA. It’s highlighted here on slide 8 of the merger slides as Oak Street cites the $2 billion opportunity that Oak Street presents in 2026:
It’s worth pausing on that number for a second as it involves a rather large assumption: that all 300 clinics continue progressing along the J-Curve exactly as discussed above. The $2 billion in 2026 Embedded EBITDA cited above is a straightforward calculation:
300 (projected number of OSH clinics in 2026) x $7.0 million (profitability for a mature clinic) = $2.1 billion Embedded Adjusted EBITDA
Seems like a nice tidy calculation right? There’s just (at least) one problem with it, which is that so long as Oak Street is growing the number of clinics, it’s never actually going to hit that number. And so long as it is growing at a reasonable rate, it is never even going to approach it. How do we know that? Well, it’s math based on Oak Street’s J-Curve. You can see it laid out below - based on Oak Street’s numbers, they’re projecting a 2026 Platform Contribution of $738 million - $836 million.
This highlights the challenge that Oak Street has in its model - that it takes a tremendous amount of capital to finance the early years of these clinics, which create a huge drag on the overall profitability of the business so long as it is growing. Keep in mind that in 2021, Oak Street’s Platform Contribution was $31.5 million, while its Net Loss was $414.6 million and its Adjusted EBITDA loss was $228.9 million.
This dynamic is why Oak Street had to slow its anticipated growth significantly in early 2022 as the market turned. In its 2022 JPMorgan presentation, Oak Street was projecting to grow by 70 clinics in 2022, but by its earnings call in March 2022 it had dialed that number back to projecting 40 clinics a year between 2022 - 2025. Turns out that was a wise decision - Oak Street would have been very challenged from a profitability standpoint at the moment had it not done so.
What Breaks the J-Curve?
We touched earlier on what we’ll call the existential risk to the J-Curve - CMS changing the nature of the MA landscape. But even if that existential risk to the model doesn’t materialize, there are a few other tangible risks to Oak Street achieving the same results at a larger scale. The most notable of these is that the Medicare Advantage market is very different today than it was when Oak Street was getting started building the clinics it is now using as examples of success. This is a relatively straightforward challenge as it’s the same thing that always happens when a new market becomes saturated - competitive markets squeeze profits. When Oak Street launched, the idea of a VBC Medicare Advantage primary care clinic was a relatively foreign concept to many around the country outside of some pockets in California and Florida. As Oak Street, Iora, and others started showing signs of early success in scaling this model, we’ve seen more and more entities building VBC MA primary care clinics.
Fast forward to today, and we’ve seen multiple standalone public companies operating in this space, in addition to all the efforts of the vertical consolidators. The market is more crowded today, and Oak Street’s historical data seems less relevant for its performance in this new context. The operational reverberations of a more crowded market are complex - from where you place centers, to your marketing approach for patients, to competing for clinical talent in a market. It isn’t too hard to imagine how that competition might dilute Oak Street’s results over time here.
We’re pretty skeptical that Oak Street will be able to replicate the J-Curve over time. The Embedded EBITDA metric was a brilliant ploy by Oak Street to highlight the upside opportunity it has to Wall Street, but it misconstrues the profitability of the model both today and for the foreseeable future. Achieving this number is reliant on believing that Oak Street’s early results will be consistently repeatable as the model scales, the market becomes significantly more crowded, and CMS potentially changes the rules of the game. That doesn’t even get into questions of why Oak Street’s per clinic numbers look so different from Humana’s. We think it’s a safe bet that Oak Street will struggle to replicate the same success inside of CVS over time.
What becomes of Oak Street inside of CVS?
Between the Oak Street and Signify acquisitions over the last six months, CVS appears to now have the two centerpieces to its care delivery strategy. As we’ve highlighted above, for Oak Street in particular, a lot of the value rests on the idea that it can continue to replicate early success with its J-Curve as it scales. So it’s worth asking the question whether it can continue to demonstrate the level of operational excellence that it has inside of CVS.
CVS Health’s Care Delivery Strategy
As we think about CVS Health’s overall strategy in the care delivery space, it’s worth revisiting what it may have learned from its HealthHUB roll out over the last several years. We started hearing about this strategy in 2019, when CVS anticipated it would open 1,500 HealthHUBs by the end of 2021. HealthHUBs were conceived of as an expanded MinuteClinic, with CVS reporting positive early results from the rollout at the time:
CVS has seen increased traffic and higher margins in its HealthHUB locations across its MinuteClinic, pharmacy and main retail store, a spokesperson told Healthcare Dive — doubly promising as HealthHUBs’ offerings run at higher price points and higher margins compared to regular CVS locations.
As recently as October 2021 - only a year and a half ago - CVS Health’s CEO Karen Lynch shared much more about CVS Health’s care delivery strategy. This article reported that “CVS Health has already remodeled roughly 1,000 of its 9,600 stores into “HealthHUBs”—creating the nation’s biggest network of urgent care outlets.” This number is curiously close to the number of MinuteClinic’s CVS has had, about ~1,100. It’s not hard to imagine CVS decided to stop short of the 1,500 HealthHUB number and instead focus on “upgrading” MinuteClinics.
Additionally, Karen Lynch shared the idea of CVS Health “super-clinics” in this interview:
“Think of our footprint as a series of concentric circles,” Lynch says on our call. The “inner circle,” she explains, will be what we’ll call the super-clinics: They’ll offer “all the things HealthHUBs do now on a bigger scale, plus lots of new services such as mental health counseling.”
And not only that but she actually kinda set the stage for an acquisition like this perfectly:
The super-clinics’ biggest focus will be seniors—especially Medicare Advantage (MA) members, the fastest-growing group in patient services and one of the most lucrative. Lynch grew CVS Health’s MA business exponentially during her seven years at Aetna. Today, Aetna covers 2.9 million MA members, 11% of the total. Lynch sees the first-circle clinics as a way to boost MA enrollment, and she says their eventual locations are “really going to be based on demographics,” pinpointing areas with a high mix of seniors in general—implying a strong tilt toward Sunbelt states.
In many ways, if you look at the structure for what Lynch laid out, it is very clear exactly where Oak Street now fits in that picture and what it has replaced. The strategy that they are following today has a lot of similarities with the vision articulated back in 2021, with one notable exception - the “build” versus “buy” decision:
Back in the 2021 interview, Lynch articulated that CVS wanted to launch “several hundred” clinics focused on serving seniors and boosting Medicare Advantage enrollment for the organization. This essentially was the exact thesis for the Oak Street acquisition, which CVS is planning to grow to three hundred clinics by 2026. So in that regard, Oak Street represents a remarkably good fit for CVS.
Notably missing from the 2021 interview and graphic above is Signify Health. Signify’s home health model theoretically fits nicely with Oak Street, but didn’t appear to be a central part of the care delivery thesis back in 2021.
HealthHUBs: Where art thou?
You’ll notice on the chart above that we’ve replaced the HealthHUB logo with that of MinuteClinic and Carbon Health. What’s happening there?
CVS leadership appears to have entirely scrubbed HealthHUBs from their vernacular, having moved on from the idea of a HealthHUB. Check out CVS repeatedly referred to what appears to be HealthHUB locations as MinuteClinics during the earnings call announcing the Oak Street deal:
These Medicare-focused assets complement our established care delivery assets, including our over 1,100 retail health MinuteClinics in a number of ways
Compare this to 2020, when HealthHUBs were featured prominently during earnings discussions with Wall Street (see for instance CVS’s Q2 2020 earnings call). It seems like CVS has essentially let the concept of HealthHUBs go quietly into the night, instead just referring to those sites as MinuteClinics. It’s not hard to imagine that CVS has struggled mightily in the operational rollout of HealthHUBs. And certainly, HealthHUBs were dealt a difficult hand in trying to prove the value of an in-person model that was launching 1,500 clinics in the middle of the COVID-19 pandemic.
CVS Health’s recent $100 million investment in Carbon Health also seems to indicate the issues it may have been having rolling out the HealthHUB model, as the investment includes CVS piloting Carbon Health’s technology platform to “advance the retail health experience”. It’s not hard to imagine that if said pilot goes well, we could see Carbon Health becoming the future of HealthHUBs, aka CVS MinuteClinics. Turns out, perhaps CVS has realized that taking a “build” strategy can be quite challenging to roll out at scale, and instead has turned to a “buy” strategy in order to string together best in class assets.
The Cultural Question
On the whole, it seems that CVS does not have grand plans to integrate Oak Street at the moment, instead choosing to leave Oak Street as essentially a standalone entity. Evidence of this appears in the discussion of synergies on the earnings call, where CVS notes that the vast majority of potential synergies in this deal simply come from: 1. Accelerated growth for Oak Street (i.e. moving more clinics up the J-curve faster) and 2. Better retention for Aetna MA members.
Both are very straightforward synergy generators in this deal, and won’t require much integration to succeed, which in many ways is the beauty of the deal for both parties. But even so, these are two very different organizations with very different cultures. In Oak Street’s communication to its employed providers (which it filed with the SEC), some of Oak Street’s prepared remarks hint at some of the cultural challenges that might emerge between the two organizations:
It’s not hard to read that list of questions and imagine that Oak Street leadership predicted that its providers will have a lot of concerns moving forward about whether they work for CVS or Oak Street. In particular, question three seems like it is going to be very tricky for CVS’s Health Delivery division to navigate. Oak Street’s model essentially uses an NP interchangeably with an MD, as depicted in this section of Oak Street’s S-1 below:
If you have Nurse Practitioners and Advanced Practice Providers who work for Oak Street and NP/APPs who work for CVS MinuteClinics, it seems like you have some problems if Oak Street NP/APPs are allowed to practice at “top of license” (i.e. managing patient panels), while NP/APPs working at MinuteClinics don’t have that freedom. If you’re an NP/APP applying to work for CVS Health Delivery, why would you want to go work in a MinuteClinic given that? This is just one example of the issue that these two organizations will have in integrating models.
Who is Calling the Shots at CVS Health Care?
One of the interesting questions within that cultural issue is who ultimately will be responsible for making these decisions about Oak Street’s model. As mentioned above, Oak Street was steadfast in its communication to employees that there’d be very little change as part of this transaction.
Yet, it was also curious to see that only a handful of months ago, CVS hired Amar Desai to lead the Care Delivery division for CVS. Mike Pykosz, Oak Street’s CEO, will be reporting to Desai. This is particularly notable given Desai’s background - previously as the CEO of Optum Pacific West, and prior to that, President of Healthcare Partners. Optum acquired Healthcare Partners from DaVita, and as Desai’s profile notes it was a value-based medical group serving over 700,000 members. So basically, Pykosz’s new boss has run this business before and presumably has his own perspective on how to operate this model. It’s also worth keeping in mind Pykosz has likely made enough never to work again - Crain’s Chicago reports his payout will be $321 million in cash, which is a topic that probably deserves its own separate article). While he likely needs to stay on here for a period of time contractually, it’s not hard to imagine that both Desai and Pykosz are going to want to dictate the growth trajectory of this business from here.
Pykosz deserves a lot of credit as the rare leader who has proven capable of managing Oak Street incredibly well through the 0 - 1 phase, the private company growth phase, and then as a public company. This leadership challenge presents another broader cultural risk to Oak Street as the two organizations merge.
Oak Street’s Growth and CVS’s Dilution Issue
The leadership challenge will be particularly interesting to watch because of one delicate issue in particular: the cost of growing Oak Street. It is interesting that during the earnings call, CVS already highlighted its keen awareness of Oak Street’s achilles heel - the amount of upfront capital required to open new clinics. CVS’ CFO highlighted this during the earnings call when talking about how CVS might manage additional clinic growth beyond the 35 - 40 currently projected clinics:
One of the things that we will be doing over the coming months is exploring alternative avenues of accelerating synergy realization but potentially looking at the growth aspect of that, and in particular, avenues that would help us manage greater clinic growth but also manage [that] inside the dilution framework that we’ve talked about within this transaction
CVS recognizes that it wants to grow this model faster, but can’t just fund that growth itself because it would increase the losses generated by Oak Street - as demonstrated in the section above - and as a result, it would increase the dilution to CVS’ EPS. This is also exactly why we’ve seen Humana construct JVs with Welsh Carson to fund the development of Medicare Advantage primary care clinics for Humana, allowing Humana to avoid the upfront dilution while still reaping the long term benefits of such a deal. It wouldn’t be surprising to see CVS consider a similar type of relationship moving forward.
While the strategic rationale for bringing Oak Street into CVS makes sense given what CVS has laid out, the cultural integration seems like it might present a challenge here for both organizations. Clearly it seems the plan for now is to leave Oak Street as a standalone entity, but at some point they will need to tackle rather complex problems like the role of NPs across Oak Street and MinuteClinics. In a model like Oak Street’s where the people play a huge component in the overall success of the approach, we think this presents another large risk that will likely dilute some of the early effectiveness of Oak’s approach.
Wrapping Things Up
As is probably clear by now, we think there are a lot of ways in which this deal could go sideways for CVS. It appears to us that CVS has probably had some really difficult strategic conversations internally about the rollout of its care delivery strategy and what it could accomplish on its own.
The original build strategy centered around HealthHUBs and Super-Clinics seems to have tanked as neither of those concepts appear to exist anymore, underscoring the challenges of the “build” strategy as a large incumbent organization. This failure necessitated a “buy” strategy, as CVS leadership shared with Wall Street last summer that it’d be making a big primary care acquisition in 2022, only to let Amazon out-maneuver it to acquire One Medical. You can imagine CVS leadership feeling significant pressure to move quickly here and play catch-up in building a care delivery asset that competes with the moves UHC and Walgreens, among others, have been making in the market.
There are a lot of questions to be asked about the price CVS is paying here, and in a perfect world CVS could have taken a different, less dilutive approach to building out this capability. But at the end of the day CVS’s insurance arm needed a VBC asset, and it appears CVS leadership was facing too much pressure from the public markets to stand pat here and play a long game building centers. So, while it was an overpay, the deal makes sense in that regard.
If the CMS-driven headwinds for the Medicare Advantage space as a whole don’t become too pronounced, we imagine that CVS will ultimately net out well in this deal, even if it struggles to replicate Oak Street’s early J-Curve success. The benefits of having a MA primary care model inside a payor are that substantial. That said, we’re highly skeptical the MA profit bonanza lasts forever, and think that this deal will ultimately create a lot of headaches for CVS in the coming years as it now has to manage the dilution of building out these clinics. Keep in mind, the deal only becomes EPS accretive in year 5, even assuming Oak Street’s consistent J-Curve growth and $500 million in synergies across the two businesses. This deal makes a lot of sense in “good” times, but the rubber will really meet the road in tougher financial times, which seem to be coming in the not-too-distant future, if they’re not already here.
It will be hard to tell from the outside if and when this change happens, given that we’ll now have a lot less transparency into Oak Street’s model every quarter moving forward. We’ll be keeping an eye on the following three things as a proxy for how well this deal is going:
- New clinic expansion: Will we see CVS continue Oak Street’s trajectory of opening 35 - 40 new clinics a year that remain independent? As we mentioned above, Oak Street has already had to titrate down growth from projecting 70 new clinics a year at JPMorgan in 2022 to this revised growth rate
- Public reporting of J-curve progress: Will we see CVS continue to report consistently on Oak Street’s J-curve progress over time? See the HealthHUB example for how CVS wouldn’t formally provide updates and allowed it to drift off quietly into the night
- Leadership dynamics: How long Mike Pykosz stays at the helm of Oak Street inside of CVS, and what does Oak Street talent attrition look like?
One thing is for certain, this space is evolving quickly, and we imagine it will continue to do so over the next 18 - 24 months. As we wrap this article, we think it is worth coming back to the crux of these MA models - that they ultimately provide better care to patients. Oak Street has done a really remarkable job on executing exactly that to date, and it seems like a win for us all if CVS can usher in a next wave of growth for Oak Street while providing better care for seniors across the country. We hope to see them get there, and hope this article helps equip folks who have made it this far with some questions to think about when evaluating their progress in doing so.