Pharma/Healthcare as a sector has been a relatively stable investment sector over the course of the coronavirus crisis, as long as you've stuck more to quality than not. At times, near-peerless qualitative firms such as United Health Group (UNH), Quest Diagnostics (DGX), and Medtronic (MDT) were even decent buys to consider for your portfolio. At today's valuations, I don't see that as being the case.
Instead, we find opportunities if we accept a small bit of "less" quality in the form of slightly lower dividend safety and credit ratings, moving into what I consider to be second-class safety stocks. It is here we find the triad of undervalued stalwarts I find interesting (among others) in the sector today. These are Bristol-Myers Squibb (BMY), Cardinal Health (CAH), and CVS Health (NYSE:CVS).
Today, we're going to highlight CVS as a good prospect for investment. Because technically, as I view valuations for these companies, CVS Health is the most undervalued of the three, coming in at a yield in between BMY and CAH.
Let's give an update on just what makes this company investable.
CVS Health - How has the company been doing?
The fact is that in terms of the nominal stock price, the company is higher than when I wrote about it in the summer of last year. There was a period when - along with almost everything else - CVS recovered somewhat, but this was swiftly halted by coronavirus, driving the share price back down into the 60s and 50s. However, before we look at what we can expect, we should look at how CVS managed 4Q19 and FY19 - this is relevant to see just how the company delivered on promises to shareholders back from about a year ago.
During FY19, the company delivered:
- EPS of $7.08, 3 cents above the high end of the stated guidance range.
- Strong execution across all segments, either meeting or exceeding set expectations.
- Aetna synergies deliver above expectations - $500M the first year alone.
- Operating cash flows of $12.8B, once again exceeding expectations.
(Source: CVS Health)
In short, CVS succeeded. The company was able to, at the beginning of the year, focus on its HealthHUB-ambitions, with expectations of ~650 hub locations by the end of 2020 and nearly triple that in a year. Just how this is affected by COVID-19, we'll have to see.
At this time, the company also announced self-swabs in parking lots of via drive-through which is expected to be located at ~1000 locations across the country, with a goal of 1.5M tests per month. It's clear from this, and other news such as the fact that CVS needed to hire 50,000 new employees to fill full-time, part-time, and temp roles across the country, that the company is one of the businesses enjoying some tailwinds from this health crisis.
(Source: CVS 4Q19 Presentation)
The company did provide 2020 guidance during its FY19, but I would say as with most companies, this guidance can be considered to be only somewhat indicative of a potential trajectory at this point. There is simply too much uncertainty baked into things here. We may even put into question if the company's opening of its hubs isn't too ambitious given the current chaos we're experiencing.
Other than that, the company is targeting:
- A transformation in the company's Oncology Care program already rolled out to 14 states and 30 providers.
- Home Hemodialysis trials and chronic kidney disease care management, already available to 3.5 million people from Aetna and Caremark, with the former-mentioned machine expecting rollout in 2021.
- Improving Aetna Digital Health and increasing an already high mobile engagement of 80 million patients in the company's messaging program.
- Improve analytics and data integration even further, consolidating data centers, and rolling out additional automation of routine processes.
(Source: CVS 4Q19 Presentation)
All of this is found within the company's current growth strategy going forward. One might characterize much of this as "fluff", but the fact is that currently, CVS's strategy is showing some impressive results - and not just from M&As.
From a segment-level perspective, the Pharmacy segment saw a 6.2% YoY revenue increase and a 1.5% increase in operating income, in part due to a 10.2% increase in processed claims from pharmacies during the quarter. There was a shift from the old Aetna Mail order system and improved purchasing economics which supported trends here.
(Source: CVS 4Q19 Presentation)
In the retail/LTC-segment, prescription volumes saw a 5.6% YoY growth, complemented by a 2.5% growth in revenues. All of this was, however, pressured by a continued problem with reimbursement and increased generics dispensing, where margins are lower. This continued to weigh on segment profits, as seen above.
Retail pharmacy experienced some excellent trends during the quarter. Sales and volumes both enjoyed growth, coming to a total 3.2% increase in same-store sales on a YoY basis. In particular, CVS enjoyed sales of beauty and health products in terms of its increases, as well as cough medicines. Despite industry headwinds overall, front-store growth continued during the quarter.
The Health care benefits saw massive, 175% revenue increases due to M&A effects, but experienced strong growth in government product memberships, as well as keeping costs within guided expectations.
(Source: CVS 4Q19 Presentation)
So, much like the company communicated, all of the segments were operating within or above expectations during FY19. The company exceeded its expected cash flow, repaid nearly $8B in M&A debt, which again is $500M ahead of the investor's day target and continued to pay company dividends at an appealing level throughout the year.
So, while things for the year of 2020 - likely somehow known as the Corona-year as we go forward - the company has indeed been doing fine.
Let's see where we are in terms of valuation.
CVS Health - What is the valuation?
Valuation for CVS remains competitively appealing at an excellent degree. As I am writing this article, the markets in the US are set to open down, and Europe has opened down massively due to trade war fears - excellent opportunities may indeed present themselves going forward.
CVS Health, however, is already an excellent opportunity from many perspectives.
(Source: F.A.S.T graphs)
Let me be the first to say that there are legitimate reasons for the lower valuation we're seeing for CVS. Some of these fees are indeed potentially possible. However, I'd also like to point out that this trend began back in 2015-2016, and CVS Health has not failed to reach its target or grow earnings (or at least not decline) since that time - nor I believe, are they likely going forward to do so.
(Source: F.A.S.T graphs)
Forecasting at a conservative 5-y average normal P/E ratio of 13.8, we see a potential 24.02% annual rate of return at a return to this average valuation. Even trading less, you'll still make market-beating rates of return at an appealing yield of more than 3% that's very well-covered. The upside is most assuredly there.
My own price target for the company is even more conservative, to include some of the political risk found in the company. I think $95/share is a good target to include some of this risk - but even this depressed valuation gives us a potential upside of nearly 60% from today's share price.
Some words on quality. CVS is BBB-rated, has a dividend rated Safe, post-coronavirus and Aetna, a nearly 11.8% earnings yield, and pays out a measly 28.25% of earnings in dividends. As such, the 3.35% dividend is more than well-covered. Growth is excellent, at an average of 13% on a 5-y basis, and the company has a dividend streak of 23 years and growing. Morningstar considers the moat "narrow" but existing.
All of these numbers mean that compared to CAH and BMY, CVS has the lowest payout ratio, the highest dividend growth, and currently the highest earnings yield. It also, based on current forecasts, has a 3-year PEG ratio of 1.44, which is equally excellent. I consider the 20-24% annual potential upside from today's valuation not only somewhat realistic but really quite believable.
This is also reflected in my own scores, where CVS currently, due to valuation, scores higher than both CAH and BMY. I will still argue that BMY has the higher realistic long-term upside, nearly twice that of CVS due to the Celgene merger that's as of yet unrealized, but there's also risk involved in this - which is why BMY's overall score is actually lower than CVS at a 3.0 compared to CVS 3.3. CVS is, simply put, the safer option at this time.
This forms the continued bullish thesis I represent in this article.
Thesis
We can expect CVS to move up and down in familiar Jojo-fashion for quite some time due to macro factors, pharma/healthcare political fears, and so forth. That doesn't change the fact, however, that the company is one of the foremost healthcare companies in North America. It has excellent fundamentals, a ridiculously safe dividend in terms of payout ratio, and has proven itself to not only manage expectations including large M&A's but exceed earlier-set financial targets.
You ignore CVS only at your own peril - in this case, what I view as a stable and dependable dividend-paying company. The upside from what I consider a very conservative long-term fair value is nearly 60%, and numbers promise returns of 10-25% merely at a return to fair value. There are a few opportunities in healthcare, but CVS is certainly one of the safer of them.
Because of this, this is one of the places where my capital is currently flowing.
Thank you for reading.
Stance
CVS Health is a "BUY" with a significant upside even at conservative estimates. The potential long-term upside is 60% and the dividend is considered safe.
