Investment thesis: CVS Caremark (NYSE:CVS) is the largest integrated provider of prescriptions and health-related services in the United States, with 2012 sales of $123 billion. It operates the country's largest chain of retail pharmacies, all under the CVS name. Caremark, its pharmacy benefits manager (PBM), is the second largest in the United States.
Its consistent double digit growth rate, free cash flow (FCF) yield around 8%, and varied growth possibilities suggest that the stock may be undervalued, and that it may be significantly undervalued when taking account of its relatively low-risk nature (it falls within Value Line's least risky 6% of all 1700 stocks it follows).
History: CVS Caremark (called CVS herein) has a multi-decade history of sustained growth, primarily via numerous acquisitions. The company provides this history in summary form on its website.
CVS may be the largest roll-up (industry consolidator) in the United States. Sales were $123 billion in 2012.
CVS began as Consumer Value Stores in 1963. It was acquired by Melville, a retail conglomerate, in 1969.
Throughout its history, CVS ha been an active acquirer of other retail pharmacy chains, and has thereby grown rapidly.
In 1996, Melville restructured and changed its name to CVS. The many non-pharmacy divisions were divested. Its other retail pharmacy chains that Melville owned were folded into CVS. Anyone looking at a long-term stock chart of CVS should start with 1996; prior data are irrelevant.
In 2005, CVS became the largest pharmacy retailer in America. It currently operates about 7454 stores.
2007 saw a transformative merger with (acquisition of) Caremark Rx, now simply called Caremark. PBMs provide are mail order drugs and other services. PBMs operate in an extremely competitive, low-margined business segment. CVS' competitor Walgreen's acquired a PBM but could not make it work, and sold it. Merck acquired an industry pioneer, Medco, but also divested it. Thus it speaks well for the management skills of CVS as well as those of Caremark that this merger appears to be working as planned.
All CEOs who came after the co-founder/CEO were promoted to that position after many years with the company. This continuity engenders confidence that CVS will not diversify into unrelated fields.
CVS obtains nearly 80% of its retail store revenues from pharmaceutical sales plus health and beauty items. This is a notably larger percentage than Walgreen's (WAG); CVS is not competing with Wal-Mart (WMT) and its ilk as much as is Walgreen's. CVS is therefore more a pure play in healthcare than its main pharmacy chain competitors (including Wal-Mart itself as well as Walgreen's and Rite Aid (RAD)), which may provide a greater degree of recession-resistance.
Growth opportunities: The company recently acquired a 44-store drug store chain in Sao Paulo, Brazil. This is its first foray outside of the U.S. Now that its stores blanket America, it is probably going to obtain much of its future growth from foreign countries. My view is that management has proven such a skilled acquirer that the challenges of operating in other countries will be overcome. CVS could experience rapid international growth for years to come.
The company is guiding to low single-digit expansion of domestic retail selling space, though faster growth via acquisition would not be surprising. It is successfully implementing a variety of measures that are increasing customer retention as well as improving sales per customer. For example, the company is putting a good deal of effort into individualizing its e-mail and other outreach, and may be the industry leader in this effort.
CVS has been rapidly expanding its MinuteClinic division, which provides in-store medical care for a variety of medical needs, under the supervision of a nurse practitioner or physician's assistant.
It also is increasing its profit margins by gradually expanding its private label general merchandise and health and beauty sales.
The latest Seeking Alpha conference call transcript provides more information about the above initiatives.
Financial analysis: Because CVS has grown primarily via acquisition, it has large non-cash charges to earnings from writedowns of intangibles and good-will. Both the company and the analytic community therefore focus not on GAAP EPS, but on free cash flow . The company calls this measure "adjusted EPS". Dilution from stock options is insignificant.
Adjusted EPS grew from $2.44 per share in 2008 (the first full year after Caremark merger to $3.44 last year, with consensus around $4.00 for 2013. (Last year's results exclude a one-time loss of $0.17 for early repayment of debt.) Using $4.00 for 2013, the 5-year compounded growth rate would be 10.4%. (Thus, 2013 is expected to show about 16% profit growth over 2012.)
The above growth rate is impressive, considering that the Great Recession and its aftermath have made double-digit revenue and profit growth difficult for many companies.
Analysts are expecting low-double digit growth in EPS and other relevant metrics for the coming 5 years.
Per Value Line, the 10-year growth rate in adjusted EPS has been 12.5%, slightly faster than the growth of sales (11%). Dividends have grown 13% per year over the past decade, but dividend growth has accelerated to 21.5% per year for the past 5 years.
CVS has been retiring 4% or more of its existing share base annually for several years while simultaneously accelerating dividend growth. These are shareholder-friendly activities.
The company is rated in the high BBB credit range by Moody's and S&P. Value Line gives CVS an A+ rating for financial strength and high ratings both for earnings predictability and for consistency of the stock's outperformance pattern versus that of the market at a whole.
The Federal government projects that healthcare spending in the United States is expected to grow at a 7.4% rate in 2014 compared to this year. The "Obamacare" legislation takes full effect next year. The following shows how well positioned CVS is for this change, and for the growing senior population. From the government:
...these expansions are expected to increase the number of people with health insurance and the demand for healthcare (particularly prescription drugs and physician care).
The wind appears to be at CVS' back.
Based on forward 2013 adjusted earnings of $4.00 and a stock price of $51.17, the FCF yield is nearly 8%. If the company grows FCF below historical trend at 7% per share per year for the next 10 years, the implied FCF yield per share would be 15-16% a decade from now.
Thus, compared to today's very low long-term bond yields, if CVS executes well, shareholders may reasonably expect a growing stream of dividends and a rising share price.
Yet Mr. Market knows this. It is a good idea to try to come up with an explanation of why a well-known company would be undervalued. I can come up with at least two reasons. One is that large-cap quality growth-and-income stocks may be undervalued. Per Vanguard data, the Russell 2000 (R2K) trades around 25X earnings but only shows a 5-year compounded growth rate of 5%. CVS, IBM and many other "Steady Eddie" companies have lower P/E's, greater financial strength and higher dividend yields than the average R2K company, but trade at much lower valuations. Perhaps as was the case in 1999 and 2000, the market has gotten relative stock prices wrong.
Another reason may perhaps be that the Street is worried about the combination of margin pressures on Caremark as well as uncertainty about the pace and success of international expansion. These are indeed reasonable concerns. I trust management to navigate the omnipresent challenges as well as it has done over its 50 years of non-stop growth. Not everyone agrees with that viewpoint.
Further evidence of possible undervaluation comes from the following considerations:
Value Line data shows that CVS' average P/E for 2005 was 19.6, at a time when earnings were rising rapidly. Even at that high P/E, investors have been well-rewarded. The stock has doubled since 2005 (using the midpoint of its 2005 trading range), thus CVS stock has far outperformed the market from then to now, providing about a 10% total annual return until now.
CVS began trading around $8 in 1996 as the successor company to the restructured Melville. Since then, the compound annual growth rate of the stock price has been about 11.5%. Adding dividends lets one estimate a 12% annual total return since then. This return exceeds that of the S%P 500, which has risen from 678 in mid-1996 to 1519 at yesterday's close. This has been a growth rate of about 4.9%. Add dividends and the total S&P return has been somewhat less than 7% annually. Thus CVS appears to be have beaten the S&P 500 by about 500 basis points annually for nearly 17 years Further, it has beaten it steadily: Value Line rates CVS' price growth persistence at 85.
Risks: All the many business risks of investing in a healthcare company exist. These include adverse economic conditions, regulatory changes, the rapidly-changing health insurance field, scandal, a failed or inappropriate merger or acquisition, and of course competition.
CVS operates in a highly competitive industry where net margins are low and where deflationary price pressures exist.
However, over a time period appropriate for patient investors, vital industries such as healthcare and pharmaceuticals should, in my view, allow cyclical profit fluctuations to even out. Often, the best operators in a field outlast the competition during a period of diminished profit margins and then end up with a greater market share than before when the cycle turns.
Summary: CVS Caremark has a 50-year record of growth, beginning with one store and rising toward "category-killer" status. Its strong, experienced management team appears to have the skills to continue growing the company's profits, providing investors with reasonable hope for double-digit annual returns for some years to come.