As I was driving down to my office today, I passed by a CVS (CVS) store that so proudly displayed a banner that read something like this: "We welcome Express Scripts customers." The pharmacy giant has been benefiting from the fallout between Walgreen (WAG) and Express Scripts (ESRX). Having worked on many investor relations and crisis communication campaigns, I chuckled at the bluntness of the banner. Walgreen, in its failure to constructively handle the dilemma, turned matters from bad to worse.
In this article, I will run you through my DCF model on CVS and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Walgreen and Rite Aid (RAD) to increase confidence. Keep in mind that the stock has appreciated by 17.4% since I first promoted the fundamentals in detail here. Stronger upside can be found at smaller undervalued pharmacies like Assured Pharmacy (APHY.PK) and China BCT Pharmacy Group (CNBI.OB). I will further present in this article why CVS should consider acquiring Rite Aid when antitrust headwinds dissipate.
First, let's begin with an assumption about revenues. CVS ended FY2011 with $107B in revenue, which represented a 11.8% gain off the preceding quarter. Analysts model a 11.8% gain over the next few years, but I view this as somewhat reserved given that it is below industry expectations. For the sake of being safe, however, I accept the figure.
Moving onto the cost-side of the equation, there are several items to address: Operating expenses, taxes and capital expenditures. I model that COGS will eat 79% of revenue over the next few years. This figure is roughly in-line with the historical three-year average. Capex is estimated more a trend-basis, so I forecast 1.5% of revenue over the same time period. Taxes are also estimated at around 39%.
We then need to subtract out net increases in working capital: We model accounts receivables as 5.5% of revenue; inventories as 13% of COGS; accounts payable as 5% of OPEX; and accrued expenses as 8% of COGS.
Taking a perpetual growth rate of 2% and discounting backwards by a WACC of 7.8% over the next six years yields a fair value figure of $41.50, implying 7.3% downside. The stock, however, is stable with a bet of 0.8.
On the fourth quarter earnings call, management addressed the momentum off of Walgreen losing the Express Scripts network:
"Let me address what I know is the No. 1 question on everyone's mind: What benefit has CVS/pharmacy seen from Walgreen no longer participating in the Express Scripts Retail network? Well, as we have said previously, the benefit was not material to our results in the fourth quarter, although it did start to ramp up late in the year. Now since the start of this year, we are seeing a significant number of transfers from Walgreens into CVS. In fact, the amount is a bit more than we anticipated."
From a multiples perspective, CVS is fairly attractive. It trades at a respective 17.2x past earnings, but only 12.2x forward earnings. At the same time, this compares to 11.1x past and forward earnings for Walgreen. CVS merits the industry premium, especially considering that Rite Aid (which is rated a "hold" according to T1 Banker) is currently bleeding hundred of millions. I would not be surprised, moreover, if CVS considers taking over Rite Aid should the latter fail to reign in its losses as expenses. Analysts are currently expecting that the firm will still lose $0.18 per share in three years from now. Compared to CVS and Rite Aid, CVS has the best momentum in EPS with analysts expecting it to grow by a CAGR of 14.7% over the next three years.
Assuming a multiple of 13x and a conservative 2013 EPS of $3.59, the rough intrinsic value of CVS is $46.67. Consensus estimates for Walgreen's EPS forecast are that it will grow by 0.4% to $2.65 in 2012 and then by 10.6% and 7.5% in the following two years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer.