CVS Caremark: Earnings Up, Valuation Up Even More, But The Stock Remains Attractive

| About: CVS Health (CVS)
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Almost three months ago, following its Q1 earnings report, I wrote a Seeking Alpha article about CVS Caremark Corporation (NYSE:CVS) titled CVS Caremark: An Investor-Friendly Free Cash Flow Generator With Strong Growth Potential.

Then, the stock traded around $51 per share. Following its strong Q1 report, it now trades just below $59. Its trailing P/E is close to 20X. Sales were actually down marginally versus the year before, while operating profit increased 21%. The company's sales of generic drugs surged, and these products embody much higher profit margins than do the sales of branded pharmaceuticals; that shift largely explains the disparity between earnings and sales. A strong flu season also led to additional cough/cold sales.

Does the stock continue to embody good relative value given how fast the price has risen in only three months?

Basically, I think it does. As a reminder, CVS and the analytic community focus on this company's free cash flow rather than GAAP income, which is somewhat lower than the preferred non-GAAP measure. The reason to focus on non-GAAP earnings is that CVS has grown as a serial acquirer (a roll-up or consolidator strategy), and the charges to earnings for depreciation of its intangibles and goodwill asset values (all of which involve no cash) are irrelevant in most observers' eyes. On the basis of cash earnings, the company is now expected to earn at least $3.90 and more likely $4.00+ this calendar year. Assuming some growth in earnings in Q1 of 2014, its 12-month forward earnings may be $4.10+. Thus the forward P/E may be only somewhat above 14X. This would translate into an "earnings yield" of about 7%. The company gives virtually all of this back to shareholders through dividends (current yield of 1.6%), and accretive share buybacks. The company anticipates that dividends will now grow faster than buybacks.

My prior article describes several aspects of corporate history and strategy. It also has several links to very useful descriptions of the company that are found primarily on different parts of the CVS website. Ongoing or prospective CVS investors may wish to study these documents. This article is much more conceptual than that; there is no need to repeat much, as CVS is not Google (NASDAQ:GOOG) or Yahoo! (YHOO); it is not a biotech stock; not a lot changes from quarter to quarter in its business model or its products.

The recent run-up in the stock price has largely been due to a combination of improving earnings and declining competing interest rates. Standard & Poor's stock rating service has recently increased its estimate of the fair value of a share of CVS stock to about $74 per share while increasing its 12-month target price (post-earnings) by a large $6/share to $68.

Another independent rating company, Value Line, believes that a fair value for the shares is 11.5X cash flow; this would put current fair value right around $70. Separately, Value Line's seers suggest about a 12% per year total return from the shares over the next four or so years. Typically Value Line is overly-optimistic by about 5% per year, and if so, that would suggest more like an annual 7% total return. This is higher than most weak junk bonds. Given CVS' very high ranking for both earnings predictability and financial strength, with interest payments covered by a factor of more than 14X, I think that the shares are highly competitive with those of virtually all competing investment classes as well as those of most stocks.

CVS appears to be executing well in every important respect. Its international strategy is just getting going in Brazil. This is likely to be a growth area for years to come. CVS benefits from deflation due to generic drugs, thus allowing earnings to grow even as gross sales do not, and its share price benefits from general inflation as long as it maintains and enhances its competitive advantages. Thus, the existing macro trends are in general good for the company. It is the mark of a great company that it tends to position itself to perceive the future before it happens and to create its business model based on that belief. CVS has, over the years, done a stellar job in that regard.

As the Q1 earnings press release and Seeking Alpha discussion of earnings discuss, CVS is in the thick of improving people's health while assisting in and benefiting from the transformation of the US healthcare and reimbursement systems.

There are, however, significant risks both to the business and to the stock price. "Too much" deflation in drug pricing will not allow CVS to grow profits at a rapid rate, and could cause them to decline. Its very large (Caremark) pharmacy benefits management business is extraordinarily competitive. Investors may at any time receive an unpleasant surprise out of that division with no warning.

Another risk is the opposite one, namely of accelerating general inflation, rising interest rates, shrinking overall margins, and resultant drop in CVS' price to earnings ratio.

A different type of risk is a balance sheet one. Since there is no free lunch in finance, if one takes the conventional way to value CVS and excludes depreciation of intangibles and goodwill, then one should exclude them from a calculation of book value. This exercise reveals that CVS has almost no tangible book value. CVS has, over the years, issued debt and equity to acquire operating, generally-underperforming pharmacy chains (plus the PBM Caremark). It has eliminated their brand names, taken over their leases and any other assets, and consistently improved their profitability. Because of this strategy and the financial strategy of spending cash on shrink share count, the company has little financial cushion should business turn down. This adds an element of risk that is often unappreciated for this particular stock, given how well-run it has been and how little business risk shareholders have had to deal with.

CVS is much more tied into healthcare rather than general retail than its major competitors. This makes it more dependent on reimbursement policies of insurers, whether governmental (i.e. Medicare and Medicaid) and private insurers. With Obamacare coming into effect soon, unknown ramifications may ensue.

The reasons I spent this amount of time on the risks is because CVS has been having trouble growing sales, yet the P/E is high. A year from now, it would not be surprising for the company to be as well-run as ever, but to see the share price lower because of any of the above factors, or simply for random stock market-related reasons. If so, the company likely would simply be a better buy than it is now, but one never can know for sure. I like the stock, but it is no longer cheap in my opinion.

Ultimately, my faith in CVS stock comes from what I view as its extraordinary set of accomplishments. The company has grown steadily from startup to giant in four decades. It is innovating in various spheres. Its strong finances allow it to expand vertically or horizontally in the US as it sees the opportunities. Its expertise as a serial acquirer will stand it in very good stead as it moves on to the international arena.

So long as management continues to execute well, which I am optimistic will be the case, I anticipate that CVS is going to emerge as a major international healthcare company with decades of profitable earnings and dividend growth ahead of it.

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.