These M&A Stories Are Becoming Turnaround Stories

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Includes: CVS, KHC, WRK
by: Bottom Fisher Ideas
Summary

CVS Health has been unduly punished by the market due to political headlines, but its prognosis remains good.

Kraft Heinz has disappointed investors, but the new CEO is a sign that management recognizes the problems and is ready to tackle them.

WestRock has been ground down by short-term concerns about the paper packaging industry, but long-term upside remains.

Growth by acquisition is risky.

It involves a lot of debt, frequently overpaying for acquisitions, and there is always the danger that the integration of the new business does not produce the synergy and cost savings that are desired. That said, there are three M&A story stocks that are trading at historically low P/E and P/B ratios, have large dividend yields, and that have been flirting with 52-week lows. While the S&P 500 has pushed to higher highs over the past four years, these stocks have been left behind, and the market seems too pessimistic about them. CVS Health (CVS), Kraft Heinz (KHC), and WestRock (WRK) are undervalued and unappreciated by the market. If you have been a long-term shareholder in these companies, there has been plenty of pain to go around, but there is reason to believe that better times lie ahead.

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CVS Health

  • Recent Price: $56.66
  • 52 week low: $51.77
  • 2019 EPS: $6.81
  • 2019 P/E: 8.3
  • P/B: 1.2
  • Quarterly Dividend: $0.50
  • Dividend Yield: 3.5%

Most people are familiar with CVS from their front-store operations, but paper towels and seasonal candy are only a tiny fraction of CVS Health. In 2007, CVS merged with Caremark, a pharmacy benefits manager, or PBM. In 2018, CVS acquired health insurer, Aetna, although that is currently being questioned by a U.S. federal judge.

As an insurer, a PBM, a pharmacy, a clinic, and a retailer, CVS Health now has its hands in almost every aspect of healthcare. This also makes it difficult to evaluate.

No matter what you compare it to, however, CVS is cheap. According to the latest Sector Fundamentals report by Yardeni Research, the S&P 500 is trading at a forward P/E of 17.0, while the Healthcare sector is trading at a forward P/E of 14.7. Meanwhile, analysts are expecting $6.81 of earnings per share from CVS over the coming year, making the forward P/E a mere 8.3.

So why do investors have so little faith in CVS Health? While the healthcare industry has a favorable long-term tailwind in the form of aging populations in the US, there are two political threats that have been making headlines. First, there is a growing consensus among politicians that drug prices are too high, and part of that is being blamed on PBMs. CVS Health has proven to be a good actor so far with its business, sacrificing short-term profits for the health of its customers. You can see this most clearly with its decision to stop selling tobacco products back in 2014. More recently, CVS Health has been pushing back on the PBM front, arguing that this part of its business reduces costs for the consumer.

More spectacularly, some candidates for president have been pushing a Medicare-for-All plan that many fear would destroy the healthcare industry. Regardless of whether one thinks this is a good idea or not, we can try and analyze the odds of this coming to pass. There is only one major candidate who has taken the position that Medicare-for-All should entirely replace the private health insurance industry, and the top political prediction market rates his chances of becoming president at 13%. Even if this election result comes to pass, the presidency does not have absolute power. The Senate has always had a moderating influence on law-making, and it is incredibly unlikely that the Senate would pass a law that would destroy the private insurance industry. We have to look no further than Minnesota, Connecticut, and Rhode Island to see what an uphill battle it would be for a law to get passed that would eliminate private insurers.

Each of these states contains the headquarters of a major health insurer, and the passage of a such a bill would deprive these states of corporate tax revenue, put hundreds of thousands of people out of work, and have corresponding ripple effects on the local economies. At its most extreme, Congress might produce a law increasing the availability of Medicare plans, while still retaining private insurance. A more likely outcome is the bolstering of existing laws to improve the safety net, or simply gridlock and inaction. While healthcare stocks recently cratered after UnitedHealth Group (UNH) gave voice to fears about universal healthcare on its conference call and again after the House of Representatives held hearings on the subject, the odds of the worst-case scenario for insurers occurring are incredibly slim. Between handicapping the race for President and the fact that Senators are likely to work on behalf of their constituents, the chances of this coming to pass are far below 1%.

Beyond these two political concerns, there is certainly execution risk involved with CVS Health's recent acquisition of the Aetna insurance business. The latest earnings and improved guidance should put investors' minds at ease on this subject, however. The company's plans appear to be progressing well, and while there is no guarantee that this will continue, the market's fears appear to be overblown.

When stocks are beaten down due to fear of a highly improbable event, that is a prime buying opportunity. Even after the 5% jump in share price following earnings, the stock remains incredibly cheap, and the healthy 3.5% dividend will make waiting for the stock's eventual recovery that much easier.

Kraft Heinz

  • Recent Price: $32.58
  • 52-week low: $31.53
  • 2019 EPS: $2.83
  • 2019 P/E: 11.5
  • P/B: 0.8
  • Quarterly Dividend: $0.40
  • Dividend Yield: 4.9%

Investors had high hopes for the Kraft Heinz merger. Championed by famed investor Warren Buffett and managed by the whiz kids at 3G Capital, the merger of Kraft Foods and Heinz in 2015 was initially well received by Wall Street, surging over 30% in the following year and a half. Then things started to turn sour. Changing consumer preferences lead to a lack of growth for the marquee brands under the Kraft Heinz umbrella and the cost cutting that 3G Capital was known for could only do so much. By early 2019, the stock had lost 2/3 of its value from its all-time highs and Warren Buffett expressed regret about overpaying for Kraft. The company was forced to write-down the goodwill assigned to a number of its brands.

If you have been an investor in Kraft Heinz over the past few years, you are justifiably disappointed and even angry with the way things have gone. For the rest of Wall Street who has been watching from the sidelines, it has been pretty good sport to see an investing legend make a mistake of this magnitude. It is basically an American past time, rooting for successful people to fail and then cheering when they do, and the coverage of this stock is a testament to that.

If you remove emotion from the equation, either the pain of our own losses or the pleasure at someone else's, the downside for Kraft Heinz appears to be overdone. The stock price is bouncing around near its all-time low. With projected earnings of $2.83 per share, that puts its forward price/earnings ratio at 11.5. Meanwhile, the Consumer Staples sector trades at a premium to the broader market, with a forward P/E of 19.0.

Stocks are often cheap for a reason, but they are also slow to react to turnarounds and changing narratives. Besides Warren Buffett's mea culpa and the write-down of goodwill, Kraft Heinz has replaced its CEO with a fresh face who successfully reinvigorated brands at Anheuser-Busch InBev (BUD). The choice of Miguel Patricio is a clear indication that it understands the problems facing the company and plans to focus on strengthening brands and returning to organic growth.

The new CEO has his work cut out for him, but the stock is priced as if the company will continue languishing indefinitely. With a recognition of the problems facing the company by management and moves to fix it, the risk appears to be to the upside. And while we wait to see if the turnaround can take shape, we'll receive a tasty 4.9% dividend.

WestRock

  • Recent Price: $39.29
  • 52 week low: $35.20
  • 2019 EPS: $4.06
  • 2019 P/E: 9.7
  • P/B: 0.9
  • Quarterly Dividend: $0.455
  • Dividend Yield: 4.6%

While the other two stocks are household names, fewer people have heard of WestRock. Formed in 2015 from the merger of MeadWestvaco and RockTenn, WestRock has completed a string of acquisitions and has become the second largest packaging company in the US. Its latest acquisition was pulp and paper company Kapstone, and the integration of its newest takeover appears to be progressing well.

The paper packaging industry as a whole has been performing poorly lately. Wells Fargo warned on containerboard prices in January, followed by a Goldman Sachs warning about downward pressure in February, and recent downgrades by Bank of America Merrill Lynch in April sent stocks tumbling. This drumbeat of bad news has hurt every company in the area, but WestRock most of all.

While there are certainly short-term risks related to pricing power and execution of acquisitions, the valuation of WestRock has reached extreme levels. With a forward P/E of under 10 and a P/B of below 1, there is a significant margin of safety built into the stock price. More importantly, investors and analysts seem to be focused on the short-term risks and are ignoring a key long-term story.

The long-term catalyst for growth in the paper packaging industry has a name: plastic. The headlines surrounding plastic are brutal, from micro-plastics in the air and water, to islands of garbage floating in the oceans, to whales and fish dying from ingesting too much of the stuff. Following banning single-use plastic bags and restricting plastic straws, California is now proposing phasing out additional single-use plastics by 2030. Other states and municipalities followed earlier moves and are expected to do the same with his newest one. This isn't just a domestic US story, either. The EU banned many single-use plastics at the end of 2018, and many countries are considering similar measures. The latest target seems to be coffee cups with plastic components, and there appears to be no end in sight.

While aluminum and glass can serve as replacements for plastic in a percentage of packaging, paper is expected to be the biggest beneficiary of this long-term trend. Many of the new laws are designed to be phased in gradually so as not to disrupt businesses, but change is happening. And it's not just about laws, but about consumer preferences. As consumers become more aware of the dangers of plastic to the environment, this will increase demand for alternative packaging above and beyond the mandates that the new laws require.

When you combine the anti-plastic movement with the continued shift towards e-commerce, it paints a compelling picture for improving long-term demand for paper packaging. With short-term pricing pressures weighing on WestRock and a sizable 4.6% dividend yield, now seems like the time to buy.

Conclusion

It is tempting to look at past performance and extrapolate it into the future indefinitely. While these stocks have been punished over the past four years, that doesn't mean that they will continue to underperform the market. Over the past decade, growth stocks have been hot and value stocks have not been. But in the broader history of the stock market, valuation matters, and investing in stocks with low valuation has produced outsized returns. CVS Health, Kraft Heinz, and WestRock are compelling turnaround stories whose stock prices appear to have overshot to the downside and are due for recovery. There will continue to be execution risk and balance sheet risk, but with borrowing costs expected to remain lower for longer, and with the stocks priced for nothing to go right, these three stocks look like good buys.

Disclosure: I am/we are long CVS, KHC, WRK. 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.