By Jonathan Weber
CVS Health (CVS) trades around five-year lows due to uncertainties about the company's future growth and worries about its rising debt. The company's acquisition of Aetna was strategically sound, however, and strong cash generation should allow CVS Health to reduce its leverage substantially over the next couple of years.
Still, the market remains pessimistic. CVS shares have declined ~16% year-to-date, compared with a 19% gain for the broader S&P 500 Index. As a result, we now view CVS as one of the most undervalued healthcare dividend stocks in the S&P 500.
Once acquisition synergies have been captured and interest expenses are declining, earnings should grow steadily. And thanks to strong free cash generation, CVS Health should be able to ramp up its shareholder returns to highly attractive levels. This makes CVS Health a good pick for income investors as well as for total return oriented investors with a long-term mindset.
Why The Takeover Of Aetna Was A Smart Strategic Move
When CVS Health announced the Aetna acquisition, CVS stock traded at more than $70 per share, whereas its share price has declined to just $55 right now. One could thus assume that the acquisition was not a smart move, but that is not true, I believe.
The takeover of Aetna has broadened CVS' reach in the healthcare industry, and it allowed the company to create new types of offerings to consumers and patients.
Source: CVS Aetna takeover announcement
The original intentions that made CVS acquire Aetna included the integration of two existing separate businesses in order to reduce costs, which would result in lower expenses for customers. On top of that, quality of care would improve as well, and consumers would have better access to health care services, both regarding time and space.
CVS has touted the benefits for its customers/consumers from the beginning, but that was not the only reason for CVS to take over Aetna; financial benefits such as stronger cash flows and earnings accretion were major motivations as well.
Source: CVS Investor Day presentation
The acquisition of Aetna allowed CVS to offer new services to its customers, such as HealthHUBs. The roll-out of CVS' HealthHUBs in test markets has been highly successful according to CVS' management, and the company plans to increase the number of locations to 1,500 over the next 2.5 years. This will not only provide value for customers, but it will also drive sales for CVS. The introduction of offerings such as HealthHUB will likely increase CVS' market share and bind its customers closer to the company.
Thanks to the takeover of Aetna, CVS thus has the potential to become sort of an all-in-one provider of healthcare solutions in the United States, which provides vast competitive advantages over peers that only offer partial solutions to customers'/patients' problems.
The Cost Of The Takeover: A Damaged Balance Sheet
The takeover of Aetna made a lot of sense, both to reposition the company strategically, as well as financially, as the takeover will be accretive to earnings and cash flows. The market focuses on something else right now, though, which is the company's high leverage.
CVS took on a lot of debt to finance the takeover of Aetna, and its balance sheet is levered to a significant degree:
Source: CVS Q1 2019 10-Q filing
At the end of the first quarter, CVS' net debt (short term debt + long term debt - cash) stood at $65 billion. This was down from $68 billion at the end of fiscal 2018, but CVS nevertheless is a heavily indebted company. Just for comparison, its market capitalization is $71 billion, which means that CVS' net debt is almost as high as its equity value.
The market does not like that CVS' debt is this high, as articles such as this one show. The fact that CVS is heavily indebted right now does not mean that this will always be the case, though. CVS' management has plans to reduce the company's debt pile considerably over the next couple of years. This is, in fact, the top priority of executives; they even were willing to stop raising the dividend and to stop all buyback activity in order to get debt levels down in a short period of time.
Source: JPM Healthcare conference presentation
The company will not make any share repurchases, and not raise its dividend until the target leverage ratio (debt to EBITDA) of 3 or slightly more than 3 has been reached.
To some degree, it is unfortunate that CVS will not make any buybacks right now, as those would be highly accretive thanks to the shares' low valuation, but management has stated that debt reduction would be the focus, thus it would likely not be well-received if management did not follow through on its original plans.
Data by YCharts
Analysts are forecasting that CVS will generate EBITDA of $17 billion to $18 billion in 2019 and 2020, respectively, thus management's goal of reducing the leverage ratio to the low 3s would be achieved if the company's net debt was reduced to ~$55 billion (which would equal 3.1 times EBITDA of $18 billion).
We can thus assume that CVS wants to reduce its net debt by $10 billion before resuming dividend increases and share repurchases.
Source: CVS Investor Day presentation
CVS' management believes that the company will have $4.4 billion of cash that can be diverted to debt reduction once capital expenditures and dividends have been financed. Cash available for debt reduction will likely be higher in 2020 and 2021, due to factors such as organic growth synergies, and lower interest expenses (due to ongoing debt reduction), but in order to be conservative, we can assume that CVS will reduce its debt by only $4.5 billion a year going forward. It would take CVS a little more than 2 more years until the $55 billion net debt level has been reached. CVS will thus likely hit its debt reduction goals in mid to late 2021.
Shareholder Returns Could Get Ramped Up In The Early 2020s
Once CVS has hit its debt reduction goals, a lot of cash will be available for other purposes.
Data by YCharts
Analysts are forecasting EBITDA of more than $19 billion in 2021, which means that EBITDA would grow by roughly $2 billion from 2019 to 2021. On top of that, the debt reduction over the next two years (~$10 billion) will reduce CVS' interest expenses by roughly $500 million, based on a weighted interest rate of 4.8% (according to 10-Q data). Pre-tax profits could thus rise by $2.5 billion through the next 2 years.
Adjusting this for taxes (~20%), and assuming that the cash flow to operating profit ratio stays the same, CVS' free cash flows could rise by $2.0 billion through 2021.
The $4.4 billion that CVS will put towards debt reduction this year, plus the $2.0 billion in additional cash flows, would be available for shareholder returns once the debt reduction goal has been reached. In two years, CVS could thus ramp up its annual shareholder returns by $6.4 billion annually, on top of the $2.6 billion that the company pays in dividend right now.
Total shareholder returns could thus total $9.0 billion annually 2 years from now, which would result in a shareholder yield of 12.7% relative to the current market capitalization of $71 billion.
CVS: Attractive Value & Income Stock
CVS Health’s shares are trading at $55 right now, which means that the company is valued at just 8 times this year’s net profits right here. We believe that CVS’ valuation could expand meaningfully over the coming five years, to the low double digits.
If CVS would trade at an 11 times earnings multiple in 2024, multiple expansion alone would allow for total annual returns of 6.5%. When we add in the dividend, which yields 3.6% right here, and some earnings-per-share growth, due to organic growth, lower interest expenses, and share repurchases, which should be resumed in the early 2020s, CVS could generate annual returns well above 10% over the coming five years.
We forecast earnings-per-share to grow by 5% annually in the long run, which is much less than management’s goal of growing CVS’ earnings-per-share by 10%+ a year. Even with earnings-per-share growing at just 5% a year, total returns, factoring in dividend payments and multiple expansion tailwinds, would total about 15% a year through 2024, which we deem highly attractive.
Shareholders will have to wait for 2 more years until CVS has hit its debt reduction goals, and in today's short-term focused equity markets that means too much of waiting for many investors.
Long-term oriented investors could be very happy with their CVS shares when they buy at today's price a couple of years down the road, though: CVS will profit from organic growth thanks to growing healthcare spending and the roll-out of new services such as its HealthHUBs, and at the same time CVS will be able to finance massive shareholder returns through dividends and share repurchases in two years, which should result in strong total returns for those who buy CVS right here, at just 8 times this year's net profits.
In the meantime, shareholders get a safe dividend yielding 3.6%, which is much more than what investors can get from the broad market or from government bonds.
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.