3 Reasons CVS Offers Healthy Growth

Summary

• Though CVS's acquisitions get a lot of press, the company's stores are a focus for good reason.
• ExtraCare or CarePass, whatever you call it, loyalty programs from CVS should drive better sales in the future.
• Given the growing health and wellness industry, it's hard to imagine that CVS won't continue to outperform expectations.

CVS Health (NYSE: CVS) has merged its way from being a retail pharmacy chain to a vertically integrated health provider. With any acquisition, there are going to be investors who question the company’s strategy. Despite CVS’s goal of growing its size and capabilities, the market hasn’t rewarded its efforts. In the last five years, the stock has been essentially cut in half. What shouldn’t surprise anyone, is there are no shortage of law firms reminding shareholders that they are more than happy to sue CVS into oblivion. Even with this negative news hounding the company, there are three solid reasons to believe CVS can offer healthy growth in the future.

A massive company needs a massive market

Before we get into how CVS might offer growth in the future, it first makes sense to look at the size of the market opportunity. According to the Global Wellness Institute, the wellness industry “is approaching $4.2 trillion globally.” Given that CVS is looking to broaden its reach beyond prescriptions into whole health care, this massive market is exactly what the proverbial doctor ordered.

(Source: Global Wellness Institute Press Room)

Inside of the wellness industry, beauty, personal care and nutrition alone generate an estimated $1.8 trillion of these sales. As we will see later, there is a huge reason for CVS to reward shoppers for buying these products in the stores or online.

When it comes to CVS’s traditional pharmacy business, the U.S. pharmacy and drug store business is expected to exceed $300 billion this year alone. This industry is expected to grow by about 3% per year after posting similar growth over the last five years. The good news for CVS is according to Kevin Hourican, President of CVS Pharmacy, “we’re growing at 2x the market.” Investors should consider the implications of this comment as it suggests a pharmacy growth rate of about 6% annually.

With billions and trillions in market opportunity, there is little doubt that CVS has a long runway for growth. The only real question is, will the company capitalize on the possibilities?

So much in store for investors

The first reason CVS should offer healthy growth has to do with the company’s store business. In the last three months, the company’s Retail business represented 42% of the company’s adjusted operating income. With nearly 10,000 stores, the company is looking for ways to leverage this massive store base to improve results.

For years, CVS opened hundreds of stores annually which propelled sales growth. This pattern is clearly ending as the company said, “if you go back a few years ago, [store openings] would have been 300 per year. This year, 2019, we’ll open 100 new stores. 2020, I would project that we will open approximately 50 new stores.”

The good news is CVS’s concept called the HealthHub is slated to drive growth where new store growth is slowing down. This remodeled store aims to transform locations to health centers, instead of a pharmacy with an attached convenience store.

(Source: CVS Health Names More U.S. Cities for HealthHub Expansion)

The idea is to center the store around health and to make it a destination. HealthHub locations will offer an expanded health care clinic, a lab for blood testing, health screenings, a dietitian to consult with and more. The company found that “90% of the time patients visit a primary care clinic, a prescription will get written.” Given that CVS has 9,900 pharmacy locations, it makes sense to expand what the store offers to try and capture more prescription and connected business.

Through a HealthHub, a patient could be seen by a clinic employee, and if a prescription is needed, they can get it filled at the same place. During the same visit, the patient could consult with a dietitian and find out about upcoming health classes. CVS found pharmacy satisfaction at HealthHub stores versus the standard chain increased by more than 5%. Front store satisfaction at these locations increased by nearly 5% as well. On the sales front, CVS witnessed “upgraded locations experiencing an average sales increase of 2.5%.”

CVS said, “we announced plans to convert 1,500 locations to hubs by the end of 2021.” Not only should these stores generate better sales, but CVS is expanding geographically as well. The company will add three more metropolitan areas later this year, followed by another ten areas in the first half of 2020.

To get an idea of how these remodels might help CVS’s growth, we need to look at how the Pharmacy segment has performed. Revenue for Pharmacy was $21.4 billion with an operating margin of almost 8%. 1,500 remodeled stores represent about 15% of the company total. Fifteen percent of the Pharmacy total revenue equals about $3.2 billion. If the company continues to see a 2.5% increase in average sales, this would add about $80 million in additional revenue per quarter. Assuming the company keeps the same almost 8% operating income, this means more than $6 million in additional operating income.

This may not sound like a ton of money considering CVS’s billions in sales, but keep in mind, this represents just 15% of the store base. There is little reason to believe CVS won’t keep remodeling and creating more HealthHub stores assuming the positive results continue.

64 million is just the start

The second reason to believe CVS will offer healthy gains is tied to the one-two punch of ExtraCare and CarePass. ExtraCare offers shoppers 2% back in ExtraBucks Rewards every time they shop either in-store or online using their ExtraCare card.

The company has a separate offering called ExtraCare Pharmacy & Health Rewards as well. This piece of the program gives users credits for filling and refilling prescriptions, getting their annual flu shots and more. The company says shoppers can “earn up to $50 every year.” The third part of the program is designed to drive beauty purchases. The ExtraCare Beauty Club gets the shopper $3 in ExtraBucks for every $30 spent on beauty. The company is offering a 10% off coupon for new members, along with exclusive deals, samples, and birthday gifts.

At last count, the ExtraCare program has at least 64 million active members and it looks like this is just the beginning. The company is expanding the program with an option called CarePass. To get a sense of what CarePass does for CVS, think Amazon Prime (AMZN) for a pharmacy. The company wants shoppers to use their CVS App to keep track of their rewards and perks, fill prescriptions and access app-only exclusive deals.

(Source: CVS Mobile App)

The first positive for CarePass is the cost. Customers can choose to pay $5 a month or get the full year for $48. This cost gives the user free 1-2 day shipping from CVS.com with no minimum order. In addition, most prescriptions can be delivered in 1-2 days for free as well. The program offers a pharmacist helpline 24/7, and users get a 20% discount on CVS Health brand products.

According to the company, “average CarePass members spend three to four times more than our average CVS customers.” In addition, the company found “30% of CarePass members being new or previously unengaged customers.”

According to Consumer Reports, the firm expects “more paid loyalty programs will launch in the next few years, including programs at grocery stores and gas stations.” A quick rundown of a few of CVS’s competitors reflects this trend. Amazon Prime costs $119 per year and offers free fast shipping on millions of items, plus video streaming and more. Sephora Flash is a competitor in beauty products and charges just $15 per year for free 2-day shipping. GNC Pro Access offers free expedited shipping and more for $39.99 per year.

The point is, CVS wants ExtraCare and CarePass to lure customers into its ecosystem. Rather than buyers choosing makeup or beauty products from Sephora, CVS hopes they will buy what they need from its stores or online. Customers who already fill prescriptions at CVS may be tempted to fill some of their health food and vitamin options at CVS instead of going through GNC.

The point is, ExtraCare and CarePass offer a long runway for growth through loyalty purchases within the CVS customer base. The fact that CarePass managed to draw 30% of either new or unengaged customers is a massive opportunity for the company as well. If CarePass contributes just 5% more sales for CVS’s Retail segment, that would have meant an additional $1 billion in quarterly sales.

Surprise, surprise, surprise, surprise

The third reason CVS should offer healthy growth is the company keeps beating earnings expectations. Over the last four quarters, CVS has surprised analysts all four times. Almost a year ago, the company beat expectations by about 1%. Three quarters ago, CVS beat expectations by more than 4%. Two quarters ago, the company outperformed by 8% and last quarter it beat expectations by nearly 12%. Long-story short, CVS is not only beating expectations, it is doing so by a larger amount each time.

According to the Global Wellness Economy Monitor, the personal care, beauty and anti-aging category grew by more than 4% annually to over $1 trillion from 2015 to 2017. Healthy eating, nutrition, and weight loss grew by over 4% annually to $700 million during this same time frame. Preventative and personalized medicine and public health reportedly reached $574 million by 2017 with an annual growth rate of 3.7%.

CVS competes in each of these segments and they each grew at rates of around 4% per year. Analysts believe CVS will grow its annual EPS over the next five years by just over 3%. Given the industry growth, the company’s history of beating expectations, and new growth initiatives, it’s hard to imagine CVS not growing at a faster pace.

The company’s 2020 projected P/E sits at less than 9 and pays a yield north of 3%. Though much has been made of CVS’s debt burden, in the last six months even after dividends, the company had $4.7 billion available for debt retirement. With CVS’s payout ratio sitting at less than 22%, clearly the company isn’t lacking for sufficient cash flow.

CVS is remodeling stores which generates better sales and customer satisfaction. The company gets a massive benefit any time someone signs up for CarePass and hopes to insulate itself from some of its competition with this leverage. Investors looking for good income, and what could be surprising growth, should have CVS on their buy list.

Analyst’s 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.