Adding CVS At A Great Valuation

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About: CVS Health Corporation (CVS)
by: AllStarTrader
Summary

Shares of CVS have come under pressure due to a large write-off.

The company has taken on a large debt load to transform itself in what some see as a risky move.

The shares offer a historically low valuation and high dividend yield.

Source

CVS Health Corporation (CVS) shares have recently sold off at a rather brisk pace. I started a position in the company along with shares of Walgreens (WBA) which were taken down with it. The company recently had to take a large write-off related to the purchase of Omnicare. Additionally, weak guidance caused investors to leave the stock in droves. However, this presented an opportunity to the enterprising investor as the valuation reached levels that may suggest a business model with serious issues and little value. We review the company's plan and why shares present a good value.

Performance

On February 20th, CVS reported earnings that caught investors off guard.

Source: Seeking Alpha

While the top line grew double digits and the bottom line saw a beat, there was more to the story than headlines suggest. Revenue growth while helped by all segments was boosted by the closing of the $70 billion acquisition of Aetna.

The company saw an increase in the number of pharmacy transactions for the year which is indicative of a few things.

Source: Earnings Release

CVS stands to benefit from an aging population and the need for immediate availability of medicines. Additionally, as new medicines become available, people will now have a solution for something perhaps that wasn't solved by prescription before. These are all tailwinds that will drive the largest source of revenue for CVS.

The retail/LTC segment saw an increase in revenue as well.

Source: Earnings Release

However, due to the large write-off of $6.1 billion, the company reported less operating income. The company cited lower occupancy rates and deterioration in the financially stable skilled nursing facility customers which caused this issue. This obviously hurt the company, but going forward, the company is going to be focusing on the newly acquired Aetna for improved financial performance.

This new division added $5.55 billion in revenue for the company, but the true earnings power will be seen in the future.

Source: Earnings Release

The company is guiding for a year of almost no earnings growth as it deals with the pressure in the LTC segment and the integration costs associated with the Aetna deal.

The guidance shows a rise in revenue from $194 billion to roughly $250 billion.

Source: Earnings Presentation

The problem lies in that on this additional $50+ billion in revenue the company is guiding for less in earnings. Part of this is due to the increase in shares outstanding. A worrisome sign of course, however, in the long term, it should be able to drive further earnings growth. Just looking at how the company performed versus 2017 should encourage investors to believe management knows what they are doing.

Source: Earnings Presentation

With cash flow from operations expected to be between $9.8 billion and $10.3 billion, the company is well able to continue to return cash to shareholders and pay down debt.

Source: Earnings Presentation

As management has highlighted, they will be freezing the dividend until the debt is back to a more reasonable level. However, this should only take a year or two as the company generates an impressive amount of cash flow. With the largest year of debt obligations being 2021, I presume after this, we could see a resumed schedule of dividend increases and share repurchases.

With $71 billion in total debt, investors are worried about the ability to pay this should there be an issue within the business.

Source: 10-K

But with about 20% of this debt being retired in the next two years and the increased revenue and earnings power, the company will look better balanced. This is where the opportunity lies.

The company has a business model that should not come under extreme pressure during a recession. Thus, the inherent risk now will soon diminish and those who invested while the shares are certainly riskier should see a positive return. The risk is more than accounted for in a depreciated valuation which we will review.

As the company works to transform its stores and services, it will become an advantaged player in the space it operates in.

Source: Presentation

It is going to now cut back on less profitable offerings in the store to offer health care services that will essentially create greater demand for a visit to CVS. It will also help the company offer savings by dealing with a CVS pharmacy when a customer is insured by Aetna. This is opposed to dealing with whatever pharmacy you prefer. In addition, it will be offering services to make a medical experience such as a surgery more seamless to the customer. For investors, this means more protection from the worry of online competition. There are some things the internet just cannot provide. This transformation should really make CVS an innovative healthcare provider.

Valuation

Looking at historical valuation, we can quickly see how big of a discount shares are trading at.

Source: Morningstar

The company trades at a discount to its 5-year average on almost every single metric. This should tell investors that they are getting a discount for the increased risk present in the business now compared to prior years. However, trading at almost a 50% discount to its typical P/B and P/CF seems like a bit much.

Next, looking at historical yield, we can see shares are offering a way above-average dividend.

Source: YieldChart

A yield above 2.75% has only happened 6% of the time in the last 24 years. The average yield of 1.79% is almost doubled right now with the shares yielding 3.66%. And fear not, the company can cover the dividend well with its payout ratio coming in at 30%. In time, the growth in dividends will return and give shareholders a long-time horizon and enhanced yield on cost.

A quick DCF valuation shows us the following as well.

Source: Moneychimp

I input the upcoming estimate for earnings this year, $6.90, and estimated that going forward, the company can grow earnings 5% a year. This gave us a DCF valuation of $144.90. The shares are trading below half of the valuation. Even a rise to $72 a share or 1/2 of the DCF valuation found above would give investors an impressive return.

Conclusion

While the assumption of a large amount of debt and some pressures within a segment of the company are worrisome, it has presented an opportunity. If all things were perfect, shares would be priced much higher and present little value to an investor. It is times like this that an investor with time on their hands must realize buying opportunities arise from fear and take a reasonable position in their portfolio. While the company may not fit everyone's risk profile, it fits mine. I expect a rebound within the next 12 months to $70 a share as the company proves itself to investors. The transformation underway should certainly prove interesting and truly make a superior healthcare company out of CVS. In addition, I like collecting the dividend to wait which remains safe. A historical high yield typically indicates a sign of an undervalued equity.

Disclosure: I am/we are long CVS, WBA. 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.