CVS Is Attractively Valued And Bottoming

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About: CVS Health Corporation (CVS), Includes: AMZN, NFLX
by: Jesse Cash
Summary

Aetna merger costs are hurting shorter-term earnings.

Stock is suffering from what I believe is a market overreaction to the poor earnings report of February 2019.

Management continues to move the company toward a return to profit growth.

Continues to be protected from trade issues, and should be well positioned to survive an eventual recession and market pullback.

Valuation is far too cheap to be ignored.

CVS (CVS) is going through a bit of a tough spot. Winter is coming? No, according to the panicked sell-off of the company's stock since February of this year, Winter is here! However, my analysis of the company leads me to believe that the market reaction is short-sighted and overly-harsh, and thus this is a perfect buying opportunity.

When I last wrote about CVS in April of 2018, the stock was at $64 per share and trading at a PE ration of 9.88. In the months that followed the company rose to a high of $80.34 in November 2018 around the time of the completion of their merger with Aetna (completion announced November 28, 2018) In my April 2018 article CVS, The Right Prescription for a Trade War I argued that CVS was an excellent buy and should continue to be able to grow their businesses and profits over the long term. I still believe that to be the case, and feel that the financials will continue to be strong for the long-term (even while showing temporary weakness in the shorter time horizon).

Bad News Panics The Street

When CVS reported their Q4 results in February it was a bit of a brutal call. They revealed several pieces of information that troubled the Street. First they adjusted down their EPS and revenue forecasts for 2019.

For the full year of 2019, CVS forecasts adjusted earnings of $6.68 to $6.88 per share, below the $7.41 per share analysts polled by Refinitiv had expected. The company expects revenue in the range of $249.86 billion and $254.29 billion, according to slides from CVS’ conference call with analysts. The Street had expected $247.61 billion for the year. (Source: CNBC)

They also announced that while they expected synergy savings from the Aetna merger (The street expected between $300 million and $350 million worth.) they planned to spend between $325 million and $350 million on "incremental investment spending", which apparently caused some to believe that this spending indicates they are playing defense and the merger was a defensive move. I do not agree with that analysis.

Finally they announced some declines in earnings in a couple of key units. They stated that their long-term care business would likely see 2019 earnings fall by around 10% due to changes in the long-term care business and investments made by the company after the Tax Overhaul. They also said they predicted low single digit drops in their profits for their biggest unit, their Pharmacy/Pharmacy Benefit Manager unit (which accounts for roughly 75% of their total earnings). They "cited lower brand inflation — drugmakers not hiking prices of prescription drugs as they normally do — as a factor affecting its outlook," according to CNBC.

This combined with a loss of $0.37 per share in Q4 (compared with a Q4 profit per share of $3.44 in 2017) and the Street was running for the exits.

So the news was not great, and the street panicked. As you can see in the chart below, the stock got crushed.

Chart of CVS (Source:Zacks.com) Weekly Chart: The stock can be seen falling immediately following the earnings announcement in February.

Before the earnings announcement, CVS had already pulled back from it's recent November high (likely in the typical "buy the rumor, sell the news" pattern) and had fallen to a range between $65 and $70 (with a pre-call peak of a $70.32). From there it continued to fall until it bottomed at an intraday low of $51.77 on April 2nd. From there it has retested the lows a couple of times and seems to have put in a bottom.

I believe now is the perfect time to buy.

Financials

While the shorter term earnings have suffered, I believe that the broader financial picture is still strong and merits investment.

Revenue

Revenue continues to improve. In the last several years, the company has continued to grow their revenue year after year. The 2018 number is more than 3 times higher than it was in 2008 ($60.8 billion).

2014 2015 2016 2017 2018
$139.37B $153.29B $177.53B $184.77B $193.92B

According to the company's own figures revenue for the 2019 year should fall between $249.86 billion and $254.29 billion (which is above what the street had expected) and shows a 28.8 - 31.1% year over year growth.

Earnings

Earnings in 2019 and 2020 are expected to return to levels from before the merger. The consensus for 2019 is an EPS of $6.86, and a 2020 consensus EPS of $7.15. This compares nicely to the 2017 (pre-merger) EPS level of $6.47.

Dividend

The dividend has remained at the $2.00 level, and at current prices ($55.57 as of this writing) that represents a yield of 3.6 percent. When I wrote about this company in April of 2018 I felt that the then 3.13% yield was a huge selling point. Today's yield is almost a half percentage point higher. This places the stock back into Jim Cramer's category of unintentionally high yielding companies. I feel strongly that a yield of 3.6% is a wonderful source of income while waiting for the company to get past their recent stumble. That combined with the fact that CVS had previously raised their dividend for 14 years straight (before freezing it for the Aetna merger), makes it seem quite likely that increases will resume within a couple of years.

Valuations

Finally on the financial side, the company currently has very attractive valuations. At today's price, the company has a forward looking price to earnings ratio of only 8.1 which is lower than the attractive 9.88 at the time of my previous article. If the company is able to hit the 2020 EPS target of 7.15 today's price would equal a PE of 7.77. That seems quite possible as on the most recent earnings announcement earnings and revenue both surprised to the upside. Considering that the historic average P/E over the last 10 years has been over 13, a return to normal could spell large scale stock price gains in the years to come.

Protection From Trade and Recession

One aspect of the CVS business model makes them very attractive at the moment is the fact that they are almost totally insulated from trade tensions, that continue to escalate globally. One hundred percent of the company's stores are located in in the U.S. This combined with the fact that 75% of their profits come from their pharmacy unit, means that tariffs should largely continue to be a non-issue in the coming years. Considering that the trade situation has continued to intensify in the last year, this is a comforting thought.

In addition, they should be largely protected from any future recessions. The United States just marked the longest economic expansion in our history. And while that is nice, nothing lasts forever. Storm clouds are starting to be visible on the horizon. The number of people now 90 days delinquent on their car loans is rising. The real estate market is cooling in many areas. Personal credit levels continue to climb. I do not know when the recession will arrive, but one day it will. CVS has many qualities that make it an excellent investment for such a time.

Their low current valuation is in stark contrast to the high to soaring PE ratios of companies like Facebook (FB), which is at 29.18, and Netflix (NFLX), which is at 135.9. These companies are far more likely to suffer multiple contractions when the market and the economy finally turn. Many other companies will lose business as people struggle more and more to meet their basic needs. However, CVS should be largely immune to that. People will spend their money for their medications in good times and bad. And because CVS gets 75% of their profits from their pharmacy division, their largest source of income should continue to flow. The new Aetna division will also likely continue to succeed even when tough economic times arrive. Insurance is largely a regular expense. It is not usually something people look at cutting to make ends meet. So VC I believe that even if a real downturn were to occur, the company should continue to succeed.

Possible Causes of Alarm

There has begun to be concern that Amazon's (AMZN) entry into the health arena will eventually hurt CVS and companies like them. The concern (as outlined in this article by Christina Farr of CNBC) are that Amazon will negotiate straight with insurers and cut out the lucrative Pharmacy Benefits Units. While that is certainly possible, it does not seem to be based on facts currently on the ground.

Walgreens CEO Stefano Pessina told investors on the July2017 earnings call, “I honestly don’t believe that Amazon will be interested in the near future in the next few years in this market."

Likewise, CVS's CEO stated last August,

“I think we have a lot of capabilities and a value proposition that can compete effectively in the market,”

Both men would be wise to keep an eye on Amazon, but I do not believe that the facts on the ground today are a fundamental threat to their core business.

As for Amazon's part, they state:

"the company had 'no immediate plans' to compete with CVS Caremark’s core offering, its PBM.

and

“It is important to keep in mind that what’s being reported here is another company’s speculation about our business strategy..."

(Source: CNBC)

For the moment, it does not seem that this should be a major source of concern, but the company should definitely keep an eye on Amazon, and adjust and adapt as needed along the way, as the online behemoth certainly could disrupt.

The other area of concern for me is the company's debt. As of the most recently reported quarter, CVS's Total Liabilities have reached a high of 159.76 billion dollars. While much of this debt was associated with completing the Aetna merger, it is still an area of caution. This number is way outside of my normal comfort zone. I prefer for companies to be able to pay off their debt (if needed) within five years, using net income. This amount of debt would take ages longer than that. However, I am willing to give management some time. First, it is hard to know what the end result will be of the merger, in terms of adding to earnings. It is possible that within a few years, the earnings will have grown substantially. I am willing to wait for a while to see. In addition, as the merger continues to be digested, I believe it is likely that operational redundancies will continue to be eliminated, and CVS should be able to reduce debt through selling off unneeded assets and through cost savings. That being said, I will be looking to see that the debt levels are moving consistently downward over the next several quarters and years. If management fails to reduce debt, while improving earnings, I may reconsider.

Outlook Summary

While I do believe that the company will continue to have growing pains in the next couple of years, as they digest the Aetna merger, I feel that they will continue to point the ship toward success and further growth in the years to come. They have completed large acquisitions before and continued to grow and expand. The incredibly low valuations, and continued long-term success of the major businesses make me confident the company will continue to be the well-run machine it has been for years. If one considers the possible (and likely) boost to earnings of some of their new projects (like their project to provide in home dialysis to patients), it seems very likely the company will grow its earnings, and stock price in the coming years.

While the short-term road could be a bit bumpy, it is likely that over the long-term, this pullback will represent a fantastic buying opportunity. I do not currently hold shares (as I sold out in November), I do plan to invest after the 72 hour waiting period has elapsed.

Strategy Going Forward

I would approach this investment in a few possible ways.

First off, if you currently have a long position in CVS, I would definitely look to increase it here. That will average down your overall cost, even if you purchased after reading my last article (at around $64). As always, I suggest putting your money to work in bites. Don't go all at once. If you are looking to add 200 shares, I would maybe plan to break that up into 4 buys of 50 or 5 buys of 40, so that you can take advantage of fluctuations in price.

If you do not currently have a position, but would like to start one, I would again look to spread your buying out. This allows you to take advantage of spikes and drops that may occur. Again using the 200 share goal, I would look to buy in segments. That way if the stock runs, you are in and can benefit. Likewise if the stock continues to consolidate, you have powder dry and ready for action and can take advantage of your luck. This type of buying also allows you to trade around a core position. If you buy at $55 and the stock runs to $80, by all means take some money off the table. Then when it pulls back, buy some shares back.

My own plan of attack will be something like the following. I am thinking of adding 300 shares. I will likely start by buying 100 at the current price (around $55). Then I will look to sell a cash-covered put on CVS below its current price. As of today, the October $52.50 strike put is selling at $1.88 and the October $50 put is selling at $1.13. I will sell 1 contract (100 shares) of the October $52.5 put and pocket the $188. If the stock moves below $52.5 I will likely have the shares put to me (meaning I must buy them) at $52.50. However, it gets even better than that. Because I collected the premium on the sale of the put, my actual cost basis of those shares would be $50.62 (not counting commissions). So, if the scenario played out this way, I would be able to buy another 100 shares of a stock I already really like at almost $5 below the current cost.

As for the final 100 shares, I will likely repeat the put selling process to maximize income and get the best price.

Whatever your preferred approach, please spread your purchases out. This stock could bounce around and you may miss great buying opportunities if you commit all your cash at once.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.