CVS Health Corporation (CVS)

[FUNMAN]

Can CVS Stock Reach $100? Pounding The Table On My Top 2021 Pick

Aug. 24, 2021 12:20 PM ET
CVS Health Corporation (CVS)

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https://seekingalpha.com/article/4451526-cvs-stock-reach-100-top-2021-pick?mail_subject=cvs-can-cvs-stock-reach-100-pounding-the-table-on-my-top-2021-pick&utm_campaign=rta-stock-article&utm_content=link-0&utm_medium=email&utm_source=seeking_alpha

Summary

* CVS Health trades for around 10x 2022 earnings estimates and even less when valued against free cash flow, but Wall Street is ignoring it in favor of high-flying tech names.

* CVS is using earnings to pay down debt, but soon should be able to put through a dividend hike and buyback program.

* CVS has problems, but they're temporary and fixable. The valuation more than covers the known issues in the stock.

* Why I made CVS my top 2021 stock pick and how the thesis is playing out?

The Island of Misfit Toys

People are overlooked for a variety of biased reasons and perceived flaws. Age, appearance, personality. Bill James and mathematics cuts straight through that. Billy, of the twenty thousand knowable players for us to consider, I believe that there is a championship team of twenty five people that we can afford. Because everyone else in baseball undervalues them. Like an island of misfit toys.

-Peter Brand, Moneyball (2011)

I named CVS Health Corporation (NYSE:CVS) my top 2021 stock pick in March, citing free cash flow, debt paydown, and the probability of future buybacks and dividend increases. Since publication, the stock is up roughly 19 percent including dividends. CVS Health's business plan seems to be on track, with the company slightly raising 2021 guidance in August, calling for $7.70 to $7.80 in earnings for the year. The stock briefly tanked after earnings after a CNBC article stated that the company would not focus as much on dividends or share buybacks as expected (the article was later edited, but after reading the conference call, you have to wonder whether the reporting was actually too speculative or the facts were inconvenient for the CVS IR team). If you've been a long-time CVS shareholder, you understand the frustration. The cash flow is clearly there, though. If you can buy enough businesses priced the way CVS is, you'll make plenty of money off of your less patient peers.

Paying down debt/deleveraging is always a lengthy and frustrating process, but when the management of your stock focuses on their "woke" corporate policies in the quarterly conference call while refusing to give 2022 earnings guidance to analysts, it's hard to feel like you're valued as a shareholder. But ironically, this is exactly why the opportunity in CVS stock exists. In the same way that Oakland A's manager Billy Beane and Peter Brand (a.k.a. Paul DePodesta) built a goofy but winning "Moneyball" baseball team with a small-market budget, you too can find winning stocks, not by buying companies with star CEOs for 50x earnings, but for buying hated companies with temporary problems for low valuations. CVS's valuation is so low that even if everything that reasonably could go wrong in the short run does go wrong, shareholders are likely to still see good returns.

Is CVS Stock A Buy Despite Its Issues?
CVS stock is unloved, but the price action has been driven by a steadily declining P/E ratio (but not declining earnings) and by questionable decisions that their management has made, especially around acquisitions. The trick to value investing, of course, is to buy companies whose stocks are undervalued relative to their businesses. When you buy companies for 10x earnings when the S&P 500 trades for over twice as much, you're going to have frustrating moments, but when done right, the lower valuation will make up for the problems and then some. CVS has plenty of problems, but most of the problems are either temporary or misunderstood. The issues are so blown out of proportion compared to the valuation that I have to pound the table here to tell people to keep buying, even through the frustration.

Problem 1- Debt Load (temporary)

If you listen to CVS conference calls or even read Seeking Alpha comments on CVS stock articles, one of the biggest concerns for shareholders is the self-inflicted debt load. Rating agencies have essentially blocked CVS from making significant share buybacks or raising the dividend by threatening to downgrade CVS's investment-grade credit rating to junk. Things are turning–over the last twelve months, Moody's upgraded CVS's outlook to stable, while S&P upgraded CVS's debt outlook to positive. CVS has a target of roughly 3x debt to EBITDA, which could be achieved either by growing EBITDA, paying down debt, or some combination of the two.

When CVS made the Aetna acquisition, the company took on a significant amount of debt. The market perception was that CVS may have overpaid for Aetna, but I actually think the acquisition makes longer-term sense. CVS noted in the conference call that they paid down $2.4 billion in long-term debt in the last quarter, and have paid down a net of $17.6 billion since the Aetna acquisition. CVS additionally just announced a tender offer for over $2 billion in debt due in 2028.

A quick look at CVS's balance sheet (from June 2021) shows net debt at ~$69 billion (EBITDA is at about $18 billion). CVS probably has about $10 billion more of debt to pay down, which means that they should be able to hit their leverage target sometime in the spring of 2022 if EBITDA is stable or rises slightly. Despite all of the drama, I would expect them to raise the dividend by at least 20-25 percent then (if historical payout ratios are any guide) and initiate a share buyback. The collective fear from shareholders is that CVS management will go out and go get more debt to make a questionable acquisition and start the process all over again, but even in that worst-case scenario, your downside would not be too severe.

Problem 2- Labor Costs (temporary)

CVS recently raised its minimum wage to $15 per hour. Translate corporate doublespeak into reality on the ground, and this means that the company is quietly making a big push towards self-checkout and automation. Labor costs have been interpreted as a negative for retailers–and they are in the short run–but the deflationary impact of technology is likely to mean better profit margins for retailers like CVS. CVS has close to 10,000 stores, so the impact of automation can lead to an accumulation of earnings growth over time that can be used to pay dividends, buy back stock, or, in the present case, to pay down their debt. CVS wants to avoid the optics of layoffs but will use the natural turnover of workers to rapidly bring down their cashier headcount over time.

Problem 3- Margins (misunderstood)

Health insurance companies had a pretty good year in 2020, as customers deferred nonessential care, companies' actuarial estimates of how much cost the companies would incur ended up being way too high. Now, health insurance costs are normalizing, and may even run above normal for a few quarters. On the other hand, CVS benefits from having an efficient distribution network to give COVID vaccines and makes money from each and every vaccine and test at its locations. CVS thought more people would get the vaccine than actually did, forcing them to adjust their guidance slightly downward. These pandemic-related factors should mostly cancel for CVS in the long run, and to the point of problem 2, when the pandemic finally does end, CVS should be a more profitable company than before when everything nets out. Another issue is the gap between CVS's GAAP earnings and their "adjusted earnings," the main differences between the two being the integration costs of CVS's past acquisitions and noncash amortization expenses. This too should prove temporary and is one factor in CVS's free cash flow greatly exceeding earnings.

CVS Stock Forecast
CVS stock currently has an annual earnings yield of 9.7 percent based on their 2022 consensus analyst earnings estimate, giving plenty of compensation for the risk you take by buying the stock. If CVS is able to grow earnings per share at even 5 percent (analysts expect more for the medium term), this would imply a total return of 14.7 percent annualized over the next few years, close to double the return I expect from the S&P 500 from my capital market assumptions. Despite all of the drama and all of the uncertainty, CVS is one of the best large-cap value stocks in existence right now. And if the company does somehow do the smart thing and uses excess cash flow to buy back the stock, returns could be closer to 20 percent annualized.

Making a forecast for value stocks like CVS is relatively straightforward. Growth stocks tend to be long-duration investments in nature– this requires you to deeply analyze the future prospects of the business to see if the (usually high) valuation is justified. In 2015, these same investors significantly overestimated how quickly CVS could grow. What's the highest CVS stock has ever been? If you're curious, the stock hit nearly $114 in July 2015 when the market was convinced of its growth potential, before getting cut in half 5 years later. For value stocks like the CVS of today, all you really have to do is find the earnings yield, see if earnings can grow, and then balance the risk premium the valuation gives you off of the risks in the business.

For CVS, there are a few long-term risks to the business, mainly regulatory risks on the healthcare side of the business. But in the short run, the only real risks are whether the valuation is low enough to justify the frustration you're likely to incur. And at roughly 10x earnings, the answer is a resounding yes. CVS's problems are temporary and fixable and do not come close to justifying the valuation being as low as it is. CVS used to be a growth stock, and now it's a value stock, having reached the point of maximum pessimism last year. Despite this, CVS is expected to earn $7.78 in 2021, $8.23 in 2022, and $8.93 in December 2023. I would expect the increased dividend and buyback next year to lead to a slightly higher P/E ratio for CVS.

With this in mind, I expect CVS to trade for 12x forward earnings next year when the temporary issues around debt, labor, and integration costs subside. This should see CVS cross the $100 mark based on business fundamentals about 12 months from now. My earnings estimate and base-case valuation assumptions with the dividend and buyback give me a $99 price target on the stock. $100 could come sooner or later, but given the business performance, I view it as a "when", not as an "if".