Can CVS Caremark Corp’s (CVS) promise of rising dividends and share buybacks make up for its seemingly interminable struggles with a four-year-old acquisition?
It hasn’t so far. Investors clearly are fed up with the drug store company’s inability to properly integrate Caremark, a pharmacy benefits management company it purchased for $21 billion in 2007. Last month’s announcement of disappointing annual CVS earnings – held down once again by Caremark – led to familiar post-results selling in the shares.
But these shares are undervalued, according to YCharts Pro. In fact, our Large Cap Value model shows CVS, market cap about $45 billion, as one of the most attractive of the major shares today. Management’s plans to fork over a lot of cash to shareholders over the next five years, plus signs of improvement at Caremark, lead us to agree.
CVS’s store chain, which with 7,000 outlets is second only to Walgreens (WAG) in number, has historically produced solid earnings. Last year marked increased per store foot traffic, market share and operating margins. The stores lately are attracting more convenience shoppers, thanks to a reformatting program that’s put more groceries and incidentals on their shelves, and that helps CVS revenues.
But this beautiful performance gets buried in the company’s overall results because the Caremark side of the company drags down the numbers. Consider overall gross profit margins. That cliff and subsequent low-level plateau represents the Caremark purchase.
Why would a company do this to itself? In 2006, drug store customers were discovering cheap mail-order prescriptions and $4 generics at Wal-Mart (WMT). Caremark offered CVS an established mail-order business as well as a new revenue stream from insurers and employers that would pay the company to administer prescription drug plans.
The deal was ground-breaking at the time, but industry insiders saw problems from the beginning. For one, it was tricky for a company that owned pharmacies to convince insurers and employers that it could negotiate good contracts for them with pharmacies. Last year, Caremark managed to increase its contract revenues but for lower returns than expected, a squeeze that will lower operating profits this year.
CVS management touts 2011 as the year Caremark will “turn the corner.” Synergies between the stores and Caremark will finally kick in, and revenues from major new contracts will help the bottom line. A flood of brand drugs going off patent in 2012 will allow Caremark to sell more, higher margin generic drugs.
Meanwhile, management hopes to mollify investors with shareholder enhancement programs. The company plans to raise its dividend until it reaches a 25% to 30% payout ratio by 2015, compared to about 17% last year. That ought to push the CVS dividend yield beyond today’s stingy level. We can see here that historically, earnings could have covered much higher dividends.
But the most reassuring item in the financials right now is the large CVS cash bucket. CVS’ free cash flow is the best in the industry, and it’s growing. It’s a good indication that the company will be able to fund the shareholder benefit plans as outlined.
Four years is a long time for a company to struggle with an acquisition, but Caremark appears set to pull its own weight in 2012. Meanwhile, CVS is eager to make nice with shareholders. The company has a pile of cash and a growing retail business to fund a few investor perks. With shares undervalued, it’s a good time to take advantage of the handout.