CVS Caremark: A Prescription for Profits?

After recently closing on the acquisition of Longs Drugstores, CVS is now the largest integrated provider of pharmaceutical services. It fills over one billion prescriptions annually with over 6200 locations in 40 states. Its pharmacy benefits division is a leader in its field, nicely complementing the retail drugstores. 2008 revenues should exceed $86 billion and 2009 sales are projected to be almost $94 billion with the full year’s contribution from the former Longs units.

CVS shares have been knocked down from an all-time high of $44.29 last June to just $26.52 yesterday despite the company’s excellent operating results.

The year wrapping up next week will be the seventh straight year with higher EPS and the fifth consecutive year with an increased dividend.

These are high-quality, low volatility shares (beta =0.80). Value Line assigns CVS Caremark a financial strength rating of ‘A’, with ‘stock price stability’ and ‘earnings predictability’ rankings of 90th and 95th percentile compared with the 1700 stock universe.

When CVS offered to buy Longs, many thought the company was low-balling its bid and that Walgreens (WAG) or someone else might launch a higher tender. Due to the current convoluted credit markets, the deal was able to close without needing to be raised. CVS management has proven adept at integrating acquired chains having assimilated many Eckerd stores in 2004 and the Save-On and OSCO chains in 2006.

Here are the (split adj.) per share numbers for the past six years as reported by Value Line. 2008 figures include estimates for Q4 ending Dec. 31st:

Year …… Sales …… C/F …… EPS …… Div …….. B/V …... Avg. P/E

2002 .….. 30.76 …… 1.29 ……0.88 …… 0.12 …... 6.29 …… 16.8x

2003 …... 33.62 …… 1.49 ……1.03 …… 0.12 …... 7.31 …… 14.1x

2004 …... 38.15 …… 1.75 ……1.10 …… 0.13 …... 8.43 …… 18.4x

2005 …... 45.45 …… 2.15 ……1.38 …… 0.15 …... 9.96 …… 19.6x

2006 ….. 53.06 …… 2.50 ……1.57 …… 0.16 …...11.75 …… 19.3x

2007 ….. 53.14 …… 2.59 ……1.92 …… 0.23 …...21.66 …… 19.1x

2008 ….. 60.50 …… 3.35 ……2.43 …… 0.26 …...24.00 …… 13.6x

With this year’s estimate at $2.43 and next year’s consensus centered on $2.70, CVS has a trailing P/E of just 10.9x and a forward multiple of 9.8x.

Those are the lowest valuations since the company was spun off from Melville in 1995. How cheap are these shares today? The best previous buying opportunity on CVS came in Q1 2003 when the shares hit an absolute price of $10.90 on trailing earnings of $0.88 for a 12.4 P/E. Holders of CVS back then saw their shares surge 189% to $31.60 by mid-year 2005.

Today’s well covered dividend yield of 1.04% may not seem generous, but it is comparable to the 1.1% that buyers at the exact low in 2003 received and higher than at all other times since their 1995 spin-off.

While we may not see future multiples go right back to their historical levels, I think a 14 or 15 multiple should be seen again before the end of 2009. Even 14 times year-ahead expectations of $2.70 would lead me to a 12-month target price of at least $37.80 or + 42.5% above yesterday’s closing quote.

Is that reasonable? CVS shares hit highs of $36.10, $42.60 and $44.30 in 2006 – 2007 and 2008 all when fundamentals were less favorable than they are right now. The dead lows in 2006 and 2007 were $26.10 and $30.50.

If you want a lower risk way to play CVS Caremark and are comfortable with options, here is a combination play that makes sense to me.

…………………………………………….. .Cash Outlay …… Cash Inflow

Buy 1000 CVS @ $26.52 ………………….. $26,520

Sell 10 CVS Jan. 2010 $30 calls @ $3.40 …………………… $3,400

Sell 10 CVS Jan. 2010 $25 puts @ $4.60 ……………………. $4,600

Net Cash Out-of –Pocket …………………… $18,520

If CVS shares are above $30 (+13.2% from our starting price) on expiration date - Jan. 15, 2010:

• Your shares will be called. You will receive $30,000.
• Your $25 puts will expire worthless (a good thing for you as a seller).
• You will have no further option obligations.
• You will hold $30,000 for your original cash outlay of $18,520.

That’s a maximum potential gain of $11,480/$18,520 or + 62%.

If CVS shares are unchanged on expiration date:

• Your $30 calls will expire worthless.
• Your $30 puts will expire worthless.
• You would have no further option obligations.
• You will still own 1000 shares of CVS worth $26,520 for your original outlay of $18,520 for a gain of $8,000 or + 43%.

If CVS shares are below $25 on expiration date:

• Your $30 calls will expire worthless.
• Your $25 puts will be exercised. You would be forced to buy another 1000 shares for an additional $25,000 outlay.
• You would still own the original 1000 shares of CVS.
• You would have no further option obligations.

What is the risk on this trade?

Break-even on the original shares would be the $26.52 purchase price less the $3.40 /share call premium = $23.12 /share.

Break-even on the $25 puts would be the $25 strike price less the $4.60 /share put premium = $20.40 /share.

The break-even on the whole trade is thus $21.76 /share or 17.9% below the starting purchase price of $26.52 /share. That price is lower than the low prices touched at any time since 2004 when full year EPS were $1.10 versus this year’s likely $2.43.

Disclosure: Author is long CVS shares and short CVS options.

Comments

[quick:]

No comment on the sales of prescription drugs or the retail side of the business and how it's been impacted by the economic slow down? Good overview of the stock fundamentals though.

2008 Dec 25 08:57 PM

[Paul Price:]

CVS shares got hit after Walgreens reported lower than expected EPS in their latest quarter.

In my view the industry weakness is the main reason why we can buy CVS so cheaply right now.

If you wait for better news the valuation won't be this low.

2008 Dec 25 09:34 PM

[Ludovici:]

Please forgive an elementary question. In explaining your options strategy, here with CVS as in several of your other posts, you write, "If CVS shares are above $30 (+13.2% from our starting price) on expiration date - Jan. 15, 2010, .... Your $25 puts will expire worthless (a good thing for you as a seller)." But aren't the options exercisable at any time until they expire? So that if the price dips, they could be exercised long before expiration date, right? In the course of a year, the price might well decline and then rise, I would imagine.

2008 Dec 26 09:38 AM

[Paul Price:]

It's true that [American style] options can be exercised at any time up to their expiration date.

They rarely are used early, however, as the owner of the options would be forfeiting all remaining 'time premium'. As long as there is 'time premium' left in an option a holder of that option would make more money by selling the option itself rather than by exercising it.

Early exercises only tend to happen when options become very 'deep in the money' and 'time premium' is virtually non-existent.

2008 Dec 26 10:58 AM