Background: Beginning life as Consumer Value Stores in Lowell, Massachusetts, CVS grew rapidly with the aid of a number of mergers and acquisitions centered not around its original focus of discount health and beauty items but around pharmaceutical dispensing. It became CVS Caremark (NYSE:CVS) through a merger in 2007, creating what the company calls "the nation's premier integrated pharmacy services provider."
The company has historically had a higher percentage of sales from its pharmacy than has its major competitor Walgreen Co. (WAG). It further emphasized its healthcare orientation with its acquisition of Minute Clinic. CVS has had other firsts. For example, its website states that in 2001 CVS/pharmacy introduced the ExtraCare Card, becoming the first national pharmacy retailer to launch a loyalty card.
On Feb. 5 of this year, in a well-publicized and controversial decision, came the following press release:
CVS Caremark to Stop Selling Tobacco at all CVS/pharmacy Locations
CVS Caremark announced today that it will stop selling cigarettes and other tobacco products at its more than 7,600 CVS/pharmacy stores across the U.S. by October 1, 2014, making CVS/pharmacy the first national pharmacy chain to take this step in support of the health and well-being of its patients and customers.
"Ending the sale of cigarettes and tobacco products at CVS/pharmacy is the right thing for us to do for our customers and our company to help people on their path to better health," said Larry J. Merlo, President and CEO, CVS Caremark. "Put simply, the sale of tobacco products is inconsistent with our purpose."
Merlo continued, "As the delivery of health care evolves with an emphasis on better health outcomes, reducing chronic disease and controlling costs, CVS Caremark is playing an expanded role in providing care through our pharmacists and nurse practitioners. The significant action we're taking today by removing tobacco products from our retail shelves further distinguishes us in how we are serving our patients, clients and health care providers and better positions us for continued growth in the evolving health care marketplace."
Unsurprisingly, Seeking Alpha authors and commenters addressed this decision soon after. Quoth the Raven was skeptical, Mike Young more neutral regarding the business/stock market effects of this news.
We finally have at least some hard data with which to approach this issue, courtesy of Gallup, which has posted a two-part article regarding its polling and analysis of this move by CVS. You can read these by clicking through to Why CVS May Not Get Burned by Its Tobacco Decision (Part 1) and Why CVS May Not Get Burned by Its Tobacco Decision (Part 2).
Introduction: As I discussed in my first article on CVS over a year ago, titled CVS Caremark: An Investor-Friendly Free Cash Flow Generator With Strong Growth Potential, CVS has numerous strengths. Amongst them is a (probably) best-in-class knowledge of its clientele. So my reaction as an investor to this announcement was that management likely had good reason to believe that this policy change would be good for business and good for the stock. Gallup provides evidence to support this. In Part 1 of its article, it provides analysis that Gallup describes as follows (from the lede in Part 2):
CVS Caremark's decision to discontinue the sale of tobacco products could strengthen the company's identity in the U.S. marketplace, making customers more likely to shop at CVS. Ultimately, this could lead to increased sales.
It says this in part because of these polling results:
More than eight in 10 respondents (81%) -- including CVS shoppers and non-CVS shoppers -- reported that they were aware of the company's proposed action. More than half of the respondents either agreed or strongly agreed that the decision helped them better understand CVS' mission and purpose (58%) and that the announcement helped them better understand what makes CVS different from its competitors (53%)...
The majority of consumers report that the decision to discontinue tobacco sales will have minimal impact on their shopping behavior. But shoppers who report that they are more likely to shop at CVS far outnumber those who are less likely to shop there. (Emphasis added)
Gallup continues in Part 2 of its article with an interview with a Gallup executive, Gallup Global Practice Leader Ed O'Boyle, who said this, referring to the study discussed in Part 1:
CVS customers, particularly those who are fully engaged with the brand, say they are more likely to shop at CVS as a result of the decision. And about one in three customers of other pharmacies who are disenchanted with those brands are also more likely to shop at CVS. What we're probably looking at is a "share shift" for goods that consumers were already buying. What I mean is that instead of people going to another pharmacy for the things they usually buy, it sounds as if they will give CVS some of those dollars...
Does doing the right thing actually boost the CVS brand? Will it help solidify CVS' relationships with its existing customers? Does it encourage customers of its competitors to consider doing business with CVS? The early indications are all yes.
It sounds to me as if Gallup is confident in its interpretation of the data.
Discussion: CVS has disclosed that it has led its industry in various means of communicating with its customers. I assume that it engaged in adequate polling before finalizing this discussion. It undoubtedly verified with various actual and potential business partners that the no-tobacco policy would be good for its deal flow. So I think there is some upside to existing estimates, but ignoring that upside, I still think that despite a nearly 50% total return from the stock since I first wrote enthusiastically about it, there remains worthwhile reward versus risk from it for patient investors. Here's why: CVS is a predictable free cash flow machine.
As a serial acquirer, CVS incurs a large amount of non-cash depreciation charges against intangibles and goodwill, and routine reporting of its profits ignores those. Based on that convention, the company is anticipated to earn $4.47 and $5.01 this year and next (all relevant data are per share). With the stock around $74, CVS is trading at about a 6% FCF yield (the reciprocal of the P/E). This is the sort of valuation that high-quality companies with recurring profit streams receive; it is not cheap. But it is true free cash flow, and I think it is likely to increase at a pace higher than the appropriate discount rate that bonds offer as an alternative investment. Thus I think of CVS' FCF as a coupon that is likely to increase over time.
What starting bond yield would I require if I were to buy an unsecured "step-up" bond from CVS Caremark? It would depend heavily on the growth rate of coupons. In the case of CVS, I anticipate that it can grow FCF at a decelerating pace. Having grown cash flow at around a 12% annual pace over the past 5 years, I'm going to assume that FCF grows at an 8% annual pace over the next 9 years, meaning that the FCF yield in 9 years will be 10% based on today's stock price.
At that point, my assumption is that just as CVS expanded rapidly but in an inexorable and controlled fashion throughout the United States, its incipient international expansion will be moving along rapidly and successfully, and that its transformation into a more full-fledged member of the U.S.'s healthcare system will be well-established.
CVS is in my view likely to leverage this projected growth by continuing to devote large proportions of its FCF on share buybacks. It has shrunk shares outstanding from 1.44 B in 2008 (after the Caremark merger) to 1.15 B projected for this year, with Value Line projected 1.125 B outstanding next year. Note this share reduction was accomplished while quadrupling dividends and improving the ratio between net working capital and long-term debt.
The question comes up as to what Mr. Market will require of CVS in the out years. I cannot say, but I think that an 18X multiple of next year's earnings/FCF will be reasonable next year. If the company earns $5, then $90 would be an attractive price for new entrants into the stock to join the family of CVS shareholders, in my opinion.
Many independent stock raters agree. Fidelity aggregates a number of independent stock raters and comes up with a very high average view of CVS stock of 9.6 (10 is maximal). Value Line anticipates an average annual total return of about 9% per year over the next four years, which I think is both reasonable and higher than the low-risk nature of CVS stock calls for. S&P Capital IQ uses its proprietary quantitative methods to estimate that the current value of CVS shares is over $91, which fits nicely with my view that ultimately 18X FCF or higher is a fairer, equilibrium valuation of CVS (at least, in a low interest rate, low inflation environment).
Risks: Significant general price inflation and/or rising interest rates, general margin pressures on the pharmaceutical business, failure to expand internationally, scandal, and other risks are omnipresent for CVS shareholders.
One risk that is relevant and little discussed is that CVS has $38B in book value but only $2B in tangible book value. All the rest is goodwill and intangibles, stemming from its many acquisitions and mergers. Thus there are few tangible assets underlying the stock. This FCF machine returns essentially all its free cash flow back to shareholders, meaning that it is running financially in a more leveraged fashion than many realize. [This is the opposite of Apple's (NASDAQ:AAPL) policy when Steve Jobs hoarded cash.] Thus if CVS should run into a profits squeeze, the stock could drop a lot more than one might expect.
Conclusion: CVS was one of the companies that early on saw the growth potential in retailing pharmaceuticals, which used to be a slow-growth, boring business usually left to mom-and-pops, in which "pop" was typically a pharmacist. CVS has been a single-minded growth engine in this field, and its move to ban tobacco products from its stores is consistent with its vision. All things being equal, I expect that the company will continue to leverage its leadership position in its chosen field to drive profitable growth for years to come. Certainly the stock is less compelling now than it was at $51 in February 2013, but so it goes. Given uninteresting investment alternatives, I believe that patient, conservative investors may look at CVS as an innovative growth engine that may be destined for greater things than are now embodied in the price of the shares.
Disclosure: I am long CVS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.