The Investment Case For CVS

Summary

• Fundamentals suggest a stable company with continued growth.
• The Aetna acquisition demonstrates that management is creative and proactive.
• CVS can take a page from Amazon's playbook.
• Pursuing additional opportunities could produce great returns for shareholders.

Despite the retail pressures, the recent sell-off in CVS (NYSE:CVS) presents a buying opportunity. To be fair, CVS has received some deserved, negative sentiment due to some changes in retail and healthcare. However, the company is at a pivotal point in its future. First, the company has excellent fundamentals, showing net income and earnings growth over the last five years. Second, the acquisition of Aetna (AET) and other innovative developments demonstrate management's commitment to evolve the company for the future. I believe more capital investment will have to be made, but CVS is transforming into a concept - not just a store. I like investing in the innovator, and I believe CVS is trying to revolutionize the doctor-patient-pharmacy relationship, and using its convenience store appeal to support it.

CVS Fundamentals

CVS has attractive P/E and PEG ratios. This doesn't tell us much about long-term trends, but it's an easy place to start.

It's P/E is significantly below it's 5-year, historical average. Additionally, it's PEG is .91, which is below its 13-year median of 1.32. These ratios suggests the stock is currently undervalued compared to historical earnings and expected growth. That's just math, though. Let's dig a little deeper.

Leverage is 2.25x, but stands to increase to 4.6x after completing the Aetna acquisition. I believe that to be pretty fair, since I believe the acquisition will be accretive long-term. Nearly $2B in cash provides further investment opportunity. Price/Book is <2. Its ROIC of only 12.6% tells me that it's dividend is currently more attractive than its fundamental growth. With nearly a 3% yield at a payout ratio of only 30%, this dividend achiever has an attractive dividend. The company will maintain its current dividend and cease buybacks until leverage is below 3x, but management has committed to paying down the debt quickly. Despite the pause in dividend growth, its yield is still healthy and attractive. Yield Strategist provided a thorough analysis of the dividend post-merger. Post-acquisition, CVS could become a more attractive growth play with a comfortable dividend.

The share price does not reflect the continued growth of earnings or revenue. This may suggest the market perpetually views CVS negatively, and the feedback about the merger has been mixed. That's not good news, but I believe the company is structurally changing. On a positive note, the company has overcome retail headwinds to continually grow revenues.

What's a CVS Article Without an Aetna Mention?

The acquisition of Aetna provides CVS a more diverse revenue stream to compliment it's PBM, retail, and pharmacy. This is a move that could serve as the beginning of some revolutionary changes to the company.

As a consumer, what I find most appealing about the merger is accessible, affordable, and convenient health care. While the MinuteClinic may not be a full-fledged urgent care, enough investment may turn it in to one. It's sufficient for simple check-ups, preventative care, and minor injuries and illnesses. Having the insurer, doctor, and pharmacist in a single location creates a localized, efficient, health care provider. Everything under one roof significantly reduces the costs of information collection, transmission, and time. This may lead to savings on complete health care costs, reducing costs to consumers. It also means convenience for me. No more having to run to another pharmacy. I can get my prescription and some household necessities on my way out. It's vast, geographical presence also suggests that it would be in a convenient location to quite a lot of people. No more finding a doctor or filling out information if I'm moving or traveling. I simply go to my nearest CVS. It's even open later than physicians' offices, so I can go after work.

As an investor, appeal can be found in efficiencies and related effects to its financial performance. The deal provides me confidence that management is committed to long-term vitality and growth. I'd like to see increased capabilities at the MinuteClinic, investment in technology, and a reorganization of the convenience products. CVS can position itself as an efficient, commercial partner, as well as a more convenient, modern necessity for its local consumers. My perspective on the acquisition is mostly about growth opportunity and proactive management. For a skeptical perspective, John Rhodes provided some good commentary and additional details.

Can CVS become an Innovator?

Fast Company, a media firm, placed CVS on its Top 50 Innovative Companies for 2018. The accolade was supported by a few things including ScriptPath, a consumer-freindly, "first-of-its-kind" prescription management system. Other notable items include additional services through its Pharmacy Benefits Management (PBM) system benefiting patients with diabetes. Another, less-well-known innovation is its introduction of health products vending machines being tested in 75, Northeastern U.S. locations. These would be useful in many locations, especially office buildings, apartment complexes, universities, and airports.

CVS reportedly faces competition with the greatest, retail innovator. Amazon's (AMZN) Jeff Bezos talks a lot about prioritizing the consumer. In his effort to maintain a "Day 1 Company", Amazon focuses on making the experience better for the customer. For Bezos, this means improving efficiencies in logistics, shorter delivery times, and generally being a part of every consumers' lives as a convenience. It's a daunting, but vital task, for any business to which Amazon poses a threat. To provide complete convenience to the public, it may soon provide an in-house, health care system. From insurance, to doctors' visits, to pharmacy, everything is conveniently located in a vast geographic empire of noticeable, retail locations. This innovative style of management will pay off in loyal customers, just as it has for Amazon. However, innovation is an ongoing process and can go beyond in-store health care.

The transformation in the grocery world is happening fast. While Amazon has caused some of the negative sentiment in the stock, I believe the CVS management knows it can take a page from Amazon's playbook. All this talk about convenience and accessibility is exactly what Amazon does. Need something in 2 hours? Prime Now. Need groceries delivered? Whole Foods. On your way somewhere and need a quick snack without the hassle of check-out lines? Amazon Go. CVS has these same opportunities if management wants to pursue them.

It's geographical spread and urban locations offers an easy delivery option for household necessities through services such as Door Dash or Uber Eats. It would not be difficult to develop a Jimmy John's-esque bicycle delivery option, either. If you're diagnosed in the MinuteClinic, you can just grab what you need on your way out.

Significant investment could yield another attraction to the urban hustler. Amazon, Alibaba (BABA), and JD.com (JD) have made a push into retail utilizing digital tools, information, and convenient locations. Knowing popular products and offering easy layouts to these people allows a quick, non-human exchange for healthy bites and every-day necessities.

CVS could make this transformation by reorganizing its stores, introducing a self-check-out, and including more healthy food options. For CVS, pre-made food options could be an easy addition, too. It would certainly benefit the business professional visiting a doctor during lunch, among others. Although Amazon Go just got started and doesn't have a pharmacy, the company moves fast. Fortunately, CVS already has the broad, retail landscape and pharmacy established.

Investor Takeaway

CVS has the fundamentals of an attractive investment, an innovative management team willing to evolve its business, and the geographic and services capacity to compete with Amazon. As a growth investor, the merger has me changing my perspective on the company. I'm even considering its investment thesis if the U.S. health care system evolves more in the future. For instance, in a two-payer system, the government and a private insurer provide coverage. In similar circumstances, CVS would become a logical choice for its geographic footprint and all-in-one model. Under a single-payer system, the all-in-one model provides reduced administrative expenses to make it a premier choice for publicly-funded services.

5-year RSI is slightly under 40, suggesting that CVS is oversold. I find CVS to be a decent value below $70, a price it hasn't seen in four years. In 2014, EPS was 42% lower than today. I think the $57-60 mark would be an ideal entry point. I may consider initiating a small position, and adding on further downside. With its growth prospects and pending acquisition, I believe its 3% yield is an appropriate measure of market risk and substantial compared to market. This is an opportune time to buy the stock pre-acquisition.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CVS over the next 72 hours. 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.

I am Long AMZN and JD.

Comments

[carlson73]

Thanks for the answer. In your view would several, let's say 5, completely vertically integrated health care companies be able to greatly reduce the cost of providing affordable quality health care without seriously reducing patients choices?

[Andrew Hesch]

Wow, that's a loaded question! I will do my best to answer it objectively, sans politics. To do so, I'll answer everything in the aggregate. My statements may not apply to every individual. It seems there are three factors of the health care system you are asking about: affordability, quality, and choice. All have multiple interpretations, so allow me to clarify how I'm interpreting them prior to addressing each. For a more direct, brief answer, refer to the bottom.

What's "affordable" is unique to everyone's individual financial situation. In the case of health care, costs generally increase, so I'll focus on what increases costs the slowest as a means to find what's most affordable to the aggregate. Cost increases slower with larger risk pools (fewer payers or groups of payers), a focus on low-cost treatment (not prioritizing tech and prescriptions), and with fewer parties delivering services (as described above). The fewer payers in the system, the more purchasing power each group (payer) has to dictate prices. Tech and prescriptions are higher cost than vitamins, diet, and exercise. Paying only one firm for your doctor, your prescription, and your insurance reduces the administrative expense. This is more true when the priority is life and access, as opposed to what's most economically efficient for the system. It would seem that cost and choice have an inverse relationship in health care. Therefore, I might suggest that a single, insurer/pharmacy/physi... office may be the least costly.

Quality may mean "most often has good outcomes", but it may mean "fastest at treating symptoms" or "correctly diagnosing illness". It may be measured in aggregate societal health factors such as lowest chance of illness, shortest wait time, rate of obesity, or childhood mortality. Among a number of interpretations, the U.S. does not have the best quality or most quickly improving health despite having the highest and most quickly increasing expenditure. Quality may be more related to the supply of doctors to reduce over-work or other non-health factors. Therefore, I might suggest that these vertical consolidations may have not an effect on quality with an adequate supply of doctors in efficient locations and good pay.

"Choice" most obviously alludes to "options". If all these options are bad, does it matter how many options exist? Perhaps that implies that you don't know your health needs or what's best for you, but you are seeking a doctor. What is clear from the previous subjects is that choice comes with additional costs (more plans, more risk pools; more providers, more admin; more treatments, more tests, more prescriptions; etc.). Therefore, I might suggest that the most efficient amount of choice provides the best quality care to the aggregate at the lowest possible cost to the aggregate. Implicit from the prior subjects is that the least expensive care has the fewest choices, and that quality may be maintained with few choices.

In concession, choice may maintain some essence of quality. For instance, quality may have a different interpretation if run by Starbucks as opposed to a financial advisor. One may make sure everyone is served despite some inconsistent services or products. The other may take more time and have limited availability, but deliver fewer errors. I'm not a doctor and don't know what is the best for your health. I don't know if the classic magazine subscription experiment is an efficient model for health care (people will pay extra to have an additional option, even if they don't use it). I presume that the wealthiest will still pay up for more exclusive services. I understand that systems are only efficient long-term if they are sustainable. I believe non-health factors play roles in these subjects.

TL:DR - I don't know if five health care providers is optimal. If run or regulated effectively, one may be sufficient. Perhaps three sufficiently eliminates collusion and guards against system failure. Maybe there are non-health solutions to improve inefficiencies.

[carlson73]

I am still trying to figure out what CVS is trying to do by buying Aetna. I do not understand the synergies, or the strategic positioning in the market as something that will change the economics of the industry. If someone understands that, besides being "strategic or Creative", I would appreciate an explanation.
The author's explanation of the changes he would like to see at CVS is more informative than anything I have read about the strategy of the acquisition.

[puffnstuff]

I think the idea is that by linking all facets of preventative care, pharmacy, check ups, and geographical convenience, they are betting that they can manage peoples conditions cheaper and use the combined data of all facets of care to reduce costs and more accurately price insurance. They can price medicines for cheap and then get their doctors to proscribe that one and have their patients pay more if they don’t use the recommended one.

[Andrew Hesch]

puffnstuff got the gist of it. I'll try to expand.

The health care system is a web. The easiest way to reduce the ever-increasing costs of health care is to consolidate/eliminate the third, fourth, fifth, and sixth parties between your doctor and your prescription. These parties are insurance companies, drug distributors, pharmacies, and PBMs. For insurance companies to reduce costs, they needed to expand their risk pools (i.e. acquire and regionalize) or reduce extraneous costs that insurers ultimately pay for (i.e. acquire/build a PBM to cut out a middleman). Most recognized this and implemented those steps, but insurers are still a fifth party. Presumably, CVS/Aetna could incorporate its national presence into the largest insurance pool. It has doctors, a PBM, and a pharmacy, already. CVS/Aetna would make health care a two-party system. Bonus: it's reducing costs for other insurance companies, too.

The real question is whether the regulators will allow all those middlemen to be cut out. It's anti-competitive in pharmacy, but it's pro-competitive in insurance. Plus, the model benefits consumers. This uncertainty is why Aetna trades at a discount to the merger value.

Hot take: these efficiencies and its geographic presence would make CVS an ideal candidate for a privately-run, single-payer system, should that ever come to fruition.

[Floyd410]

Wouldn't it be better to buy AET right now? Trading at 174.32. You are going to get 145/shr in cash and 0.8378 shares of CVS. CVS can go all the way down to 35 (35x 0.8378= 29.32) for break even. Doubt that will happen. About a 15% upside from now until deal closes

[Andrew Hesch]

In the spirit of full disclosure, this is the route I chose. Ultimately, my investment thesis is predicated on the merger, so I decided to play the opportunity you and a couple other authors outlined.

[User 43623446]

I added a little more CVS today.

[baystateart]

Dump cvs, will choke on Aetna deal destroys shareholder value and will take years to unlock and integrate

[Google is Golden]

you probably said he same thing when wal mart acquired jet.com.

[JDoe20]

Chris, a very good comparison. Very similar buys by capitalization, revenues and debt levels . . . .

[Google is Golden]

This is a great company in a great sector.

I think it’s narrow minded to think that you have to “be in this name long term to get your return”. Hell, the name was at 80 1.5 months ago until Amazon was going to self insure their own employees....(I have no idea how investors can surmise that this affects CVS, even with Aetna?)

The stock has huge FCF, growing EPS, growing their PBM and will have huge competitive advantages with Aetna acquisition. For this name to be trading in the 60’s is a great opportunity for investors.

[ajbrlbmbb7]

Some hopefuls are waiting for CVS to get to the $65 or below level to go in. Personally I'm not waiting that long. This is an innovative company that is here to stay. Maybe it'll take some time to get back to the $112 level but I say go long & reap the rewards.

[baystateart]

So you have an opportunity cost, while this dog lays down, other companies are growing and building wealth. The corporate office is a mess, walk into a pharmacy and talk to an employee........buy at 55

[ajbrlbmbb7]

I see that some hopefuls are waiting for CVS to go to $65 or below to jump in, I'm not waiting too long. I think it's an innovative company that's here to stay.

[ogmarti]

I like CVS, I really do, but the market seems to consider them as out-of-favor for now. Hopefully it’ll all come around in time.

[Ikechowanec]

short term: worst investment of 2017 in at $85+. long term fingers crossed, thinking of averaging down a bit.opinions????

[Brian Soule]

I am also thinking of averaging down here. Not sure I'll pull the trigger since JNJ also looks enticing at these levels and I might add there instead, but I'm definitely thinking about it.

[Andrew Hesch]

I own JNJ at $95, so I'm not looking to increase my cost basis given my portfolio concentration. However, I don't own any shares in CVS.

I've started answering the average down question by asking myself if I intend to hold until it recovers or if I'd be ok taking the loss. If I'd hold and I'm considering a larger position, why not average down? If I'd take the loss, but my original thesis hasn't changed, I'll just hold.

[Brian Soule]

Fair enough Andrew,
I'm the reverse of that sort of. I don't own any JNJ (in the portfolio I write about) but I do own CVS. I bought CVS in the low 80's and if I doubled my position here it would bring my cost basis down to the mid-70's or so, which would be acceptable.

Getting JNJ closer to the 52 week low than to the 52 week high has historically been a very good idea. And JNJ with a 2.6% yield...? Nice.

Best of luck!

[Yield Strategist]

Great article! I do think CVS will continue to be an innovator, and this creative acquisition will be a great long-term strategy play. I am a big fan of what CVS is doing, it is not playing out well in the short-term, but they are poised for continued success. I just wish going into a CVS was as pleasant of an experience as going in to a Walgreens. They need to make some minor operational improvements to win against its current competition while not taking its eye off of Bezos.

[Andrew Hesch]

Thanks for the feedback. Both stores' downtown locations are right across the street from each other. I find most of the time they're pretty identical. I decide which I'm going to depending on how I time the crosswalk lights.

[ndisang]

appears im now stuck with this...can't imagine i didn't sell when I was some 39% up...

[JDoe20]

$112 to $68 in 2 1/2 years and now they take on another $44B in debt. Frozen buybacks and frozen dividends. Boy did this management do a 180, and with no clue given to shareholders.

Another “opportunity” to learn . . . . . . . should have sold on the merger news.

[Hersh82]

This has been the worst investment I have made in the last two years. Bought it originally in the low 80’s as a DGI position but the merger put a stop to that. It seems as if every time the stock gets some momentum it gets hammered back down. I’m holding it in hopes that they can create synergies that create some long term value but this stock is dead money until the merger goes through and management can show the debt load was worth it.

[WinGreen]

Patience is called for. I’m going to purchase some more if it keeps falling, then sell my higher cost basis for a tax loss (after 30+ days).

[Paper_stax]

Hersh82,

synergies is what the whole deal is about. Sure it's gonna start off rocky but once the merger is complete and starts to be accretive, they'll be in better shape than they previously were.

[Paper_stax]

WinGreen,

I'm currently doing that with my recent purchase of PG, then I'll move to CVS if they fall further. I bought in at $70 so I'm fine for now.

[cemanuel]

I added more last week at $67.97. Yield is decent even if temporarily frozen.

I expect another dip on debt fears when the Aetna deal closes and am planning to add more then.

[C.N]

Earnings on the 30th of April, still 7 weeks away..stock approaching 52 week low..will wait till after the earnings or new 52 week low is established, low 60's.

[Butch Cassidy, CFA]

Creative and proactive management too often means over-paying for perceived strategic benefits that frequently fail to materialize. Meanwhile, the stock is burdened by debt costs, cash flow pressure, and eventual goodwill write offs. This is my assessment of CVS’ Aetna acquisition. Risk is very elevated. Any above market return is way off in the future, at best. Wouldn’t go near it.

[a_zaks]

"Creative and proactive management too often means over-paying for perceived strategic benefits that frequently fail to materialize."

Could you clarify whether this refers to the purchase of Whole Foods or Ring? Which one was overpaid for, or was it both?

[vooch]

CVS is the Blockbuster Video Rental of the future

[Happy Penguin]

silly

[Ziyaad Manie, CFA]

"Leverage is 2.25x, but stands to increase to 2.9x with Aetna's debt upon merger completion."

Is CVS not raising $45bn in debt to fund the cash portion of the debt? I can't remember the figures off hand, by my sense was that gearing would increase to about $80bn post merger against an merged EBITDA of ~$18.5bn. This would be around 4.4x. Then they would put off share repurchases and dividends till they had de-geared to about $64bn, which would take 24 months post-deal closing.

I like CVS Health's fundamentals, but you have to be in for the long-run here to get your return.

[User 49180121]

didn't they say they were just freezing dividend raises, but still pay out the standard dividend?

[bec9000]

According to slide 18 of the investor presentation from December 4th, "New debt of $45 billion will result in pro forma leverage of approximately 4.6x".

Share repurchases are suspended and the dividend will remain flat "until leverage is down to low 3x".

http://bit.ly2ekWWyD~/media/File...

[Andrew Hesch]

Thanks, everyone. I got that notification this morning, and regretfully overlooked it prior to publishing. Let me make some amendments.