Why CVS Caremark May Be Severely Undervalued

| About: CVS Health (CVS)


CVS Caremark may have reached a level of stability that it can trade above its traditional valuation.

The company is firing on multiple cylinders.

International and specialized operations may allow for steady, rapid growth for years to come.

Background: I first wrote about CVS Caremark (NYSE:CVS), on Feb. 13, 2013. The stock price was $51 then, just off an all-time high it had recently set; it is over $76 now, and achieved an all-time closing high (Friday, May 8). The title of that February 2013 article still applies:

CVS Caremark: An Investor-Friendly Free Cash Flow Generator With Strong Growth Potential. The article reviews the history and some of the special attractions of this company, and is thus still relevant; the major change from then to now is the stock price and current sales and profits. (Not to mention the company's plan to stop selling tobacco products, which I wrote about positively in March of this year.)

In other words, the company is doing very well. This article focuses on some reasons why I am so bullish on this company, whether or not the stock is a bit ahead of itself by some measures.

Introduction: CVS is a giant retailer of pharmaceuticals, health and beauty aids, and some general merchandise. It also has a very large pharmacy benefit manager in Caremark, which has surged to the fore in this past quarter to help save the quarter for the stock. I want to take a minute to tell an anecdote that exemplifies the secular trends that favor Caremark. Before doing so, it's important to mention to our younger readers that integrating a PBM with a large company is not easy. Both Walgreen's (WAG) and Merck (NYSE:MRK) failed at that effort.

In any case, my anecdote goes back to my medical internship in a New York City teaching hospital, in 1980 or 1981. I was called to the ER to see an unusual case. This was a 30-something year old thin man with a dry cough. His chest X-ray showed a form of interstitial (atypical) pneumonia. He wasn't really terribly sick, but his arteries were not carrying normal amounts of oxygen, so he was hospitalized. As the days went by, he got steadily worse. Eventually, he required a bronchoscopy, which in those days was a very unpleasant procedure both for patient and doctor. This test showed a surprise: Pneumocystic carinii, a protozoan illness occasionally picked up- our quick textbook search showed- when swimming in lakes. But this was Manhattan Island. He had not been swimming in lakes. In any case, the man passed away in the hospital. No one had thought to ask his sexual orientation, but he was single. As you very likely have guessed, he had AIDS before anyone had coined the term. (This was one of the first known cases of this sort in the United States. Happily, I did not draw his blood too often, because no one knew about universal precautions then.)

In those days, AIDS was like cancer, but killed faster and more certainly. Now, it is another chronic disease. Both Caremark and CVS are making lots of money managing (Caremark) and dispensing specialty medicines that cost a small fortune each year that keep this killer virus in check- but do not cure the disease. Gilead Sciences's 4-in-1 dosage form Stribild is said to retail for $28,000 yearly, and is not going generic any time soon. As with AIDS treatments, so with multiple sclerosis, rheumatoid arthritis, advanced psoriasis, hepatitis B, hepatitis C, paroxysmal nocturnal hemoglobinuria, various lysosomal diseases of very young children, all sorts of cancers, etc. These boons to human health are also boons to the industry. This fact exemplifies the core reason I love CVS shares: management. CVS, as was the case decades ago with Walgreen's, saw the future clearly, either through prescience or luck, and in the 1960s, shortly after getting going as Consumer Value Stores, focused on pharmacy dispensing, and the rest is history. (Walgreen's had been known for its soda fountains, but its CEO forced it to become a pharmacy chain and ditch the ice cream sodas.)

CVS recently announced a quarter that was basically in line, when adjusted for the truly miserable winter weather in much of its area. There is not a lot for me to add to what Value Investor recently reported about the company, as well (of course) as what the company says about its results, so I want to skip the mundane but strong general details and make more of a big-picture case why this Steady Eddie stock is still a strong buy in DoctoRx-land, even though it has appreciated almost 50% in little more than a year.

The bull case for CVS: CVS has had a coherent management team that has gone from success to success with one acquisition or merger after another. It has been the trite but true well-oiled machine. Its success in making the transformational deal with Caremark is a feather in its cap. I have seen the way CVS has dealt with two chain acquisitions that both had let their stores run down: Eckerd's in South Florida and Long's in California. In each case, what appeared to be expensive, non-accretive purchases made with debt (and equity?) worked out well. The stores were upgraded, employee morale and service levels improved, and presumably, profit margins, as well as sales improved as well.

The core case for CVS is that it is a Steady Eddie growth story that provides a degree of inflation protection, with great management that shows no sign of flagging.

There are several specifics which I believe led the Street to bull the stock to an all-time high, despite the mediocre Q1. These include the following.

The company continues to be the leader amongst its peers in data mining. It is reducing its reliance on print circulars and increasing its Internet-based reliance on its highest-spending clients. Over time, this has promise in pushing sales up at improving margins: a double-barreled approach.

CVS has purchased and expanded the Minute Clinic line. This is basically a physician extender organization that occupies space within a CVS store. In the era of expanded healthcare insurance we have now entered, unfortunately, the supply of physicians does not magically increase, and Minute Clinic is a growth field with numerous profitable possibilities.

Internationally, I am quite bullish on CVS, again because I believe that its management is up to the task. CVS now has a small and growing retail presence in Brazil. When asked on the conference call about this initiative, management was clear. It intends to grow internationally internally and by acquisition. It is in no rush. It sounds perfect to me: dominate the U.S., then keep on growing ex-U.S. while the U.S. is a cash cow.

As mentioned above, cigarettes and other tobacco products are going to be absent from CVS stores within months. This will take some high-margined sales away, but the company expressed deep satisfaction with this tactical move as part of its broader strategy to position itself as a healthcare company, not merely a middleman in the transit of pharmaceuticals to patients, while selling some general retail products to those patients as a side business. It never hurts when the most powerful man in the world says nice things about your business evolution!

Regarding the Caremark PBM business, it had a great quarter. The specialty pharmaceutical business is large, growing, and lucrative. Caremark will help payors save some money, and it is enjoying competitive success lately. PBM's have always been tricky businesses, but as with any business, top management succeeds, and while I have no great insight into the field of PBMs, so far, so good for Caremark. As CVS expands, its control of Caremark can represent a durable competitive advantage.

Financial considerations: Based on consensus earnings expectations, CVS is trading at or under 15X forward free cash flow (NYSE:FCF); the company has highly predictable earnings, so here it makes sense to use FCF. A reason I use FCF for CVS relates to its acquisition strategy, which involves taking on a lot of goodwill and intangibles which never really get used, the way patents that are acquired to depreciate, and thus represent a non-cash but real cost. In contrast, when CVS acquired Long's, the brand name was immediately changed to CVS; all that CVS really acquired was leaseholds. So I focus on CVS as an FCF machine. So, there is a forward FCF yield (the reciprocal of the P/E) around 7% for this stock.

I find this to be inordinately attractive. I expect that the company will continue to find ways to grow that grow the FCF. Totally arbitrarily, I assume a 5% FCF growth rate or a 7% growth rate. In the slower growth case, the earnings yield doubles in 14 years. In the faster case, it doubles in 10 years. Even a double of FCF in 14 years produces an average FCF of about 10-11% annually through 2018. And at the end of that period, one still owns a going concern, though perhaps one that is hardly growing (finally). That's not so bad, as Coke (NYSE:KO) stockholders can see. 7% annual growth in FCF produces a doubling of FCF in only 10 years. That's great, and either case is better than a bond of similar quality.

The key to the above analogy is not to assume no recessions, but rather some combination of growth and inflation, and continued strong management skills.

The above thesis bets the question: what do I think is "fair value" for CVS? On this, I will defer to the many people who specialize in that analysis. For what it's worth, S&P Capital IQ pegs CVS as having a fair value of $87. That's more like a forward FCF yield of 6%. It can be argued, though, that since CVS does all the right things with its free cash flow- rising dividend, shrinkage of the float, maintenance of investment-grade credit ratings, business expansion- that it could reasonably be valued at 20X FCF, i.e. a 5% FCF yield- or even higher. It depends how one looks at the alternatives, how quickly one thinks interest rates will rise (and to what level), etc. In my preferred view that interest rates are likely to stay lower for longer than the consensus, I tend to overweight the value of stocks like CVS versus cyclicals or commodities. But that's a view full of uncertainty.

In any case, I look at CVS as not close to "sell" territory, and that's operationally what matters most once a sizable position has been established.

Risks: CVS operates in an intensely competitive industry, especially the PBM industry. A cycle of high and rising inflation with rising interest rates could harm it in various ways, both by hurting its business and by harming its stock's P/E. Management could err or, perhaps more likely, simply be outcompeted by competing management. The government or other strong forces in the industry could impose shrunken margins on CVS.

As with any stock, shares in CVS are not guaranteed winners.

Summary: CVS Caremark strikes me as a quintessentially boring stock, a Warren Buffett-type stock that he is not known for owning much of, if any. Even as the shares hit an all-time high (again), they continue to look significantly undervalued to me when placed in comparison with alternative investment choices. It's not that CVS is all so cheap, but that most of the other choices, both stocks and bonds, are so dear.

CVS Caremark has a long history of top-notch management, and I hold the shares without a lot of worry, comfortable in the belief that its fine executive team will continue to perform well for years to come.

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.