CVS Health: Keen On The Value Proposition

Sep. 06, 2019 1:59 AM ETCVS Health Corporation (CVS)WBA123 Comments
Ray Merola profile picture
Ray Merola
13.49K Followers

Summary

  • CVS Health is one of the cheapest stocks in the S&P 500; shares sport an 8.9x P/E on 2019 operating EPS.
  • Fundamentals appear respectable.
  • The 3.3% dividend yield is 180 bps better than 10-year treasuries, and it's safe.
  • There's a "wall of worry" around the company, but most worries seem to have dissipated, appear manageable, or look to be premature.
  • Is this a Warren Buffett "fat pitch?"

CVS Health Corporation (NYSE:CVS) is America's largest retail pharmacy/healthcare chain. The company operates in 3 segments: Pharmacy Services, Retail/LTC, and Health Care Benefits. In December 2017, the company rounded out its business by acquiring healthcare insurer Aetna. Hence, the HCB segment was formed.

I contend this is a fundamentally solid company selling at an attractive valuation.

Let's take a closer look at the company and its stock through this series of gates:

  1. What's the overarching investment thesis?
  2. Does CVS have a strong franchise?
  3. Does the company have a sound balance sheet?
  4. Does CVS earn its profits largely in cash?
  5. Is management competent and shareholder-friendly?
  6. What other facts and developments color the thesis?
  7. Does CVS stock offer a compelling value proposition?

CVS Health Corporation Investment Thesis

A good investment thesis should be concise; limited to no more than a handful of bullet points.

  • Within its space, CVS Health owns a strong and unassailable franchise. No other domestic pharmacy/healthcare chain can duplicate the company's span and scope.
  • CVS operates within a recession-resistant sector, and operates a cash-rich business model. This low-beta domestic company is less likely to be impacted by the economic business cycle and/or global geopolitics.
  • The stock is trading at a deep discount versus historical valuation multiples. The current 3.3% dividend yield is some 180 bps higher than the 10-year Treasury note and the payout is safe.
  • CVS senior management is re-imagining the business. They see CVS as a full-suite retail healthcare services company. Stores are being converted into “HealthHUBs,” including digital tools, on-demand health kiosks, professional advice and personalized care (MinuteClinics). This differentiated strategy may provide a strong investment catalyst.

Now we will drill down a little deeper.

The CVS Franchise

Founded in 1963, the corporate franchise is strong and unassailable. It is by far the largest in the space.

CVS operates more than 9,900 retail locations, approximately 1,100 walk-in healthcare clinics and is a leading pharmacy benefits manager with more than 92 million plan members. CVS operates in 49 states and the District of Columbia. CVS filled prescriptions accounting for 26% of the U.S. retail pharmacy market. CVS's pharmacy services segment provides a full range of PBM (pharmacy benefit management) services. The new HCB segment (previously Aetna) is the third-largest healthcare benefits provider in the U.S., serving an estimated 38 million people.

Here's a graphic showing the magnitude of CVS's drugstore chain business versus competitors:

Year-end 2017 figures

Since 2017, CVS has grown market share. Walgreens (WBA) is a distant second. Subsequent competitors are single-digit players. The pharmacy/retail business tends to be lower-margin whereby size matters. Bigger is better.

Does CVS Have A Sound Balance Sheet?

The current balance sheet is marked by post-acquisition weakness. However, there is clear evidence management is focused upon addressing it. While there's work to be done, I see no overwhelming financial risks. Debt and leverage are elevated, but trending down. Cash on hand is rising. Liquidity is adequate. CVS enjoys consistently high cash flows, which in turn permits management the flexibility to improve the balance sheet. Indeed, the current balance sheet isn't as strong as I'd like to see, but the current situation is improving and transient. As an investor, I can accept it.

Management Focus: Debt And Leverage

After acquiring Aetna for $68 billion, CVS's balance sheet was weakened materially. This has been an overhang on the stock. However, management readily acknowledged the situation, and pledged to focus efforts upon reducing debt and leverage.

Prior to the Aetna acquisition, CVS total debt position was $27 billion. Afterwards, debt ballooned to over $73 billion.

By mid-year 2019, total debt eased to ~$71 billion.

The debt-to-capital ratio is 55%.

CVS should have no problem servicing the debt. The interest coverage ratio is 3.9x.

Importantly, as management promised, debt is coming down.

CVS Health Corp. – Total Debt and NPV Lease Liability ($B)

12/31/18

06/30/19

12/31/19 E

Total Debt + Lease Liability

89.4

87.2

85.1

Source: SEC filings

In conjunction with debt repayment and EBITDA improvement, the leverage ratio is trending lower. Including the net present value of operating lease liabilities, the current leverage ratio is ~5.3x. By estimating additional 2019 debt repayment, and considering management's full-year operating income and D&A estimates, YE 2019 leverage may fall to 4.9x. Management targets a low-3x leverage ratio by 2022.

Note: CVS investor relations clarified how leverage is calculated. Leases are considered in the computation. Balance sheet cash-on-hand is not considered an offset to total debt.

Meanwhile, the company is building cash on hand. At the end of 2Q 2019, total cash and investments reached $8.53 billion, or $6.56 per share. About 11% of the stock's value is now in cash.

In addition to debt, recent acquisitive activity has created a balance sheet heavily weighted by intangible assets and goodwill. Currently, a little over half the total assets are categorized as such. Generally, it's a yellow flag when goodwill is greater than 20% of total assets.

In 2018, CVS management took a $6.15 billion impairment charge on the 2015 Omnicare (long-term healthcare facilities) acquisition. That deal went south quickly; about half the cost of the purchase has been written down. It remains to be seen whether the Aetna deal will require any write-downs. I am cautiously optimistic it will not. Nonetheless, asset impairment charges should be monitored carefully.

Profits In Cash? Yes!

CVS is a cash machine.

A key investment attribute I seek is a company that earns its profits in cash. CVS does this in spades. The company enjoys high operating cash flow, and relatively low capex. Indeed, the company generates cash flow well in excess of adjusted profit.

Here's a first half 2019 versus first half 2018 summary:

CVS Health Corp. – Prodigious Cash Flow ($B)

1H 2019

1H 2018

Adjusted Net Income (Profit)

4.57

3.23

Operating Cash Flow

7.29

5.29

Free Cash Flow

6.00

4.38

Source: SEC filings and company reports

The chart tells the story. The Aetna operations are contributing considerable incremental cash flow.

A Few Words About Management

Senior management evaluation includes subjective elements. Of course, there are always puts and takes. On balance, I view CVS management as competent and shareholder-friendly. Supporting this conclusion, some data points are listed below.

Management Sets and Tracks Measurable Goals

I value a management team that shares measurable goals and objectives, then provides investors with performance metrics versus these milestones. Strong management teams meet their objectives, or fully explain why they could not. CVS does this. Currently, CVS leadership is tracking its goals well.

Source: 2Q 2019 earnings presentation

Management Obtains Acceptable Returns

Good management demonstrates solid or improving returns. While there are several ways to measure effectiveness, I like to review ROIC (return on invested capital) and Earnings Yield. These measures were highlighted by investor Joel Greenblatt in, “The Little Book That Beat the Market.”

At times, I modify his original formulas based upon specific circumstances however, I attempt to preserve the crux of his approach.

In the case of CVS Health, I offer my findings:

ROIC = EBIT / Total Assets less Current Liabilities less Cash

CVS 2018 full-year ROIC = 7.0%

CVS 2019 ROIC (first half) = 9.5%

Through the first six months of this year, we find a clear move up versus full year 2018. According to gurufocus.com, CVS Corp.'s WACC is ~5.0%. Therefore, management is earning returns significantly greater than the cost of capital, thereby creating shareholder value. For comparison, Walgreens records a 14% ROIC and a 5.8% WACC.

Note: Unlike Greenblatt's original ROIC formula, I elected to use adjusted EBIT (accepting management's unaudited financials) in lieu of GAAP figures, and did not elect to exclude Goodwill and Intangible Assets from the asset base. This has the effect of making the base higher, and thereby lowering returns.

Earnings Yield = EBIT / Enterprise Value

CVS 2018 full-year EV = 6.8%

CVS 2019 EY (first half) = 9.3%

We find another good bump. Generally, the Earnings Yield calculation is similar to an E/P earnings yield, but stows debt into the equation. These figures indicate management is improving earnings yield even when debt is considered. For comparison purposes, competitor Walgreens offers a 9.5% Earnings Yield.

Note: Consistent with my note pertaining to ROIC calculation, I used management-adjusted EBIT.

Management Presents Operational And Financial Data Clearly

Shareholder-friendly management teams report earnings clearly, highlight appropriate financial adjustments (if any) to GAAP data, and describe return-of-shareholder-capital plans. The CVS team does this. I find CVS financials straightforward, and adjustments to GAAP figures are reasonable.

The company has a long dividend history. Since the Great Recession, dividends increases averaged over 20% a year.

Source: fastgraphs.com

Nonetheless, since 2017, dividend growth has been static. (Despite the chart, the payout has remained $0.50 per quarter, it wasn't cut). In conjunction with the Aetna acquisition, management stated its intent to pay down debt, reduce leverage, and thereby suspend dividend increases. I do not fault management for this; I applaud it.

Other Facts And Recent Developments

Before opening a discussion about CVS stock valuation, there are a few other facts and developments worth mentioning.

Overall Margins Are Improving Due To The Aetna Contribution

CVS's Pharmacy Services segment has long experienced relatively low margins. This tends to hold down overall corporate margins. This appears to be changing. Through the first half 2019, here's the operating margin scorecard:

CVS Health Corp. – Segment And Overall Operating Margins (%)

First Half 2019

First Half 2018

Pharmacy Services

3.3

3.3

Retail / LTC

7.4

8.9

Healthcare Benefits

8.5

NMF

Total CVS Corporate Margins

6.1

5.3

Overall operating margin improved as a result of the Aetna acquisition. Pharmacy margins remain flat. Retail margins compressed as a result of the continued deterioration in the Long-Term Care business (Omnicare acquisition), and increased employee payroll/benefit costs.

Court Signs Off On Aetna Deal

On September 4, federal judge Richard Leon signed off on a settlement reached between CVS and the DoJ permitting CVS to purchase the Aetna Corporation. The ruling removed a nagging overhang on the stock.

Personal HealthHUB Visit

As a soft due diligence point, I've visited several of the new CVS HealthHUB locations in Houston, Texas. I looked around, observed healthcare customer offerings, watched store traffic, and even chatted briefly with a couple of store managers. I came away with a favorable impression. The one-stop approach to healthcare is impressive. The new stores are well-designed and clean. I was particularly impressed with the MinuteClinics embedded within the same store. MinuteClinics feature quick, relatively informal healthcare services, checkups, and advice administered by qualified professionals. Indeed, prescription medications and equipment, if recommended, are located just steps away inside the same store. Most major insurance companies cover MinuteClinic visits.

Rising Same-Store Sales

A key operating metric for the retail business is same-store sales. Growing S/S/S is critical. It implies greater underlying customer foot traffic through existing operations; which often maps to improving top-line growth and growth in market share. The following 2Q 2019 presentation slide highlights CVS Retail Pharmacy S/S/S.

These figures may be considered strong.

Over the past 2 fiscal quarters, competitor Walgreens (WBA) experienced domestic retail pharmacy same-store sales growth of only 2.3% and 1.6%, respectively.

The Technical Chart Looks Good

While I concentrate upon fundamental analysis, I do not reject technical analysis out of hand. One can make a good case the three-year weekly chart and associated studies are favorable. You be the judge:

Source: ameritrade.com (Think or Swim)

Nearly all the chart patterns and studies appear to be trending positive.

Stock Valuation

A primary component of the CVS investment thesis is the stock appears to offer a compelling valuation. Indeed, it's one of the cheapest stocks in the S&P 500. A F.A.S.T. graph illustrates the long-term relationship between price and earnings.

Immediately, we notice a stock with a historical 16x P/E now trading for less than 9x. This may be partly explained by examining past versus projected future earnings growth rates.

The slower forward growth rate may likely result in valuation multiple compression. However, by almost any reasonable measure, a 9x P/E is too low. Such a multiple suggests CVS will be unable to generate any forward EPS growth in the foreseeable future. This isn't a reasonable assumption.

If we assume a 4% forward growth rate, and use the modified Graham Formula (expected PE = 9 + 0.5 g; where g is the EPS growth rate), we arrive at a more reasonable 11x P/E. This is still 5 turns less than the historical average.

Management forecast full-year 2019 $6.95 operating EPS. Applying an 11x multiple indicates a $76 stock. Currently shares trade ~$62. If CVS generates operating EPS in 2020, an 11 handle suggests a $79 stock.

An 11x P/E isn't burning up the track, either.

Additional F.A.S.T. graphs highlighting P/FCF and EV/EBITDA yield similarly undervalued results. For your review and perusal:

Contributing factors to such low common stock valuation may include:

  • Fears of a healthcare overhaul, including the potential collapse of the private healthcare industry, up to and including a government-run single-payer system. Certain 2020 Democratic presidential candidates are touting such a system.
  • Ongoing concerns about management's commitment to pay down debt and leverage
  • Fears of the Amazon (AMZN) “death star” ruining CVS's PBM business model.
  • Judge Leon's ruling that could have unwound the Aetna acquisition (this overhang since removed)
  • The “Rebate Rule” affecting government-driven drug pricing disclosure (recent legislative withdrawal of the proposal relegates this item to a lower-tier worry)

While I consider the first bullet point to be a concern, experience tells us what candidates say on the campaign trail and what they attempt to accomplish (or have the wherewithal to accomplish) if elected are two different things. In addition, good American businesses don't sit still. These companies adjust and adapt to change. Sans rescinding the current private insurance model for all Americans, I discount punishing CVS shares to a 9x P/E over this matter.

The second bullet appears well in hand. I contend management is quite focused upon reducing debt and leverage, as exhibited by recent actions and results. I do not see CEO Larry Merlo re-trading this promise to investors.

The third bullet cannot be dismissed, but given low PBM margins and general financial, legal and regulatory barriers to entry, I cannot trash CVS over it. On the retail front, Walmart (WMT) has demonstrated it can go toe-to-toe with Amazon. On the PBM front, I contend CVS can go toe-to-toe with Amazon, too.

The fourth and fifth points have been mitigated or eliminated.

Final Thoughts

Walgreens is a solid competitor. Its management team is capable, and affords investors good current returns. The company has taken a somewhat different strategy versus CVS: staying the course and focusing upon its core pharmacy and retail store business model. I have no objections to this approach.

However, given Walgreens' far smaller footprint and unclear catalyst, I believe WBA stock and its likewise low valuation lacks a strong reason for owning it versus CVS Health. CVS enjoys far greater span, scope, and long-term potential than Walgreens. In addition, CVS has its new HealthHUBs and Aetna acquisition; both visible and potential catalysts.

Other CVS competitors do not control enough market share to disrupt CVS; with the possible exception of Amazon. However, even here Amazon's sphere of influence (if any materializes at all) appears limited to the mail-order pharmacy PBM business. This is a relatively small, low-margin part of the CVS model.

Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2019 investments.

This article was written by

Ray Merola profile picture
13.49K Followers
Individual investor focused upon a limited number of diversified stocks. Seeks stocks selling below fair value estimates; favors dividend growth and/or income. Advocates fundamental investment analysis, supplemented by the technical charts. Options strategies primarily employed to generate additional income or hedge risk. If interested, you may find out more about my investment philosophy in the I.S.S. (Investment Strategy Statement) found in my listing of published articles.

Disclosure: I am/we are long CVS. 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.

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