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Summary

  • Strong industry tailwinds and Obamacare create a long term growth trend.
  • Investors are unnerved by short-term concerns about competition, poor weather and a mild flu season.
  • Despite growth and fair valuation I remain reserved due to strong recent momentum and pressure on health care costs.

CVS Caremark (NYSE:CVS) continues to trade near all-time highs as structural tailwinds for the industry outweigh short-term concerns regarding competition, weather and a mild flu season.

While growth is impressive for a company the size of CVS and the valuation is reasonable, I remain a bit cautious at current levels. Strong momentum in recent years combined with a valuation multiple expansion and pressure on the healthcare industry to contain costs, are my main reasons to be a bit reserved.

First Quarter Takeaway

CVS reported first quarter revenues of $32.7 billion which represents a 6.3% increase over last year.

Reported earnings came in at $1.13 billion, up from $954 million reported last year. Diluted earnings were up by eighteen cents to $0.95 after the company repurchased roughly 4% of its shares outstanding over the past year.

Sales Growth Driven By Healthcare Demand, Pricing And Acquisitions

Pharmacy service revenues rose by 10.3% to $20.2 billion driven by growth of the healthcare sector, strong pricing and the acquisition of Coram. Network claims rose by 0.4% to 208.0 million. Operating profits from PBM rose by 28.5% to $640 million as a result of topline growth as well as margin expansion.

The retail business was the biggest contributor to earnings with operating earnings increasing by 14.2% to $1.75 billion. Revenues for the business were up by 2.7% to $16.5 billion.

While the PBM business continued to move along just fine after posting 10.3% revenue growth which is an impressive result, the total earnings picture was a bit soft. The company suffered from the harsh weather as well as a soft flu season.

Consequently, front comparable store sales were down by 3.8% compared to last year, partially the result of the shift of the Easter holiday. While comparable sales are expected to improve going forward, the announcement to stop selling tobacco will have a drawback on the business.

Cash Flow Machine

The growth in topline revenues and margin expansion bodes well for CVS's cash flows. While reported earnings at $1.13 billion were solid, the company announced a 35.3% increase in its free cash flows which came in at $1.79 billion. Sale and lease back constructions boost cash flows in the short term.

For the entire year of 2014, the company foresees free cash flows of $5.5 to $5.8 billion, the equivalent of roughly 115% of expected GAAP earnings.

Impact Of ¨Obamacare¨

CVS notes that some 8 million individuals have enrolled in the so-called public exchanges despite all the technical difficulties. 3 million consumers have gained coverage from the Medicaid expansion with the company being well-positioned to benefit from the increase in the potential market.

Cardinal Health Venture

CVS updated the market as well regarding the venture with Cardinal Health. Both companies have formed a ten-year agreement thereby forming the largest generic sourcing business in the US. The partnership is expected to be operational as of July of this year.

Looking Into 2014

CVS confirmed its full year guidance for GAAP earnings of $4.09 to $4.23 per share. Adjusted earnings which are a non-GAAP earnings metric are seen twenty-five cents higher. The difference between both earnings metrics is largely explained by expected amortization charges.

For the current second quarter, GAAP earnings are expected to come in between $1.01 and $1.04 per share.

These earnings projections are based on anticipated revenue growth of 5.25 to 6.5% driven by the PBM business which is expected to show revenue growth between 8.75 and 10.0%.

Valuation

During the first quarter, CVS has repurchased about 11 million shares at a total cost of $801 million. For the full year, it anticipates $4 billion in share repurchases to be financed by the expected $5.5 to $5.8 billion in anticipated free cash flows for this year.

Trading at $74 per share equity in the business is valued at around $88 billion. Note that this excludes the $10.6 billion net debt position held by the company. Given the company's outlook, revenues of $135 billion might be attainable this year as GAAP earnings are expected to approach $5 billion.

Based on this outlook, equity in the business is valued at roughly 0.65 times annual revenues and 17-18 times annual earnings.

The quarterly dividend of $0.275 per share provides investors with a dividend yield of 1.5%. Cash returned through repurchases are expected to reach 4.5% per annum this year.

Implications For Investors

CVS continues to grow in an industry which is seeing structural tailwinds by the growth for healthcare, a trend which is accelerated by the Affordable Care Act.

The retail business of CVS which reports gross margins of 31.5% saw struggles during the quarter on the back of a mild flu season, the harsh weather and the timing of the Easter holiday. Other headwinds include aggressive competition from the likes of Walgreen (NYSE:WAG) and Rite Aid (NYSE:RAD) and the potential impact of exiting the tobacco sales, a move applauded by President Obama.

The PBM business continues to grow at a much quicker pace and witnessed modest margin expansion as well. Despite a 45 basis point improvement in gross margins, those margins came in at just 4.6% of sales. The growing importance of generic drugs continue to be a driver behind margin expansion of the business.

Shares in CVS have traded in a $20-$40 trading range for most of the past decade. Following the strong momentum created by the Affordable Care Act, shares broke through the $40 mark at the start of 2012 after which strong momentum pushed up shares to current levels at $74 per share.

Source: CVS Caremark: Short-Term Concerns, Long-Term Tailwinds