CVS Health Corporation (CVS)

[FUNMAN]

CVS Is Still A Bargain

Sep. 16, 2021 3:15 AM ET
CVS Health Corporation (CVS)

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Summary

CVS Health improved its balance sheet and continues to improve its business.

CVS is still deeply undervalued and trading at least 30% below its intrinsic value.

And from a technical point of view, CVS is also bullish.


CVS Health Corporation (NYSE:CVS) is a diversified business with almost 10,000 local touchpoints (pharmacies) and 85% of the U.S. population living within 10 miles of one location. CVS also has 1,100 walk-in-medical clinics and about 900 Health Hubs. Additionally, CVS has about 108 million PBM plan members and about 2.9 billion prescriptions filled or managed as well as 34 million health insurance members.



(Source: CVS Investor Fact Sheet)

Knowing very well that we should restraint from using such phrases, CVS is without any doubt a great business. And it is one of the companies I covered several times in the last few years (my last update was published in May 2021), but as long as I see great value in a stock, I intend to cover the company and stock regularly. Despite the increasing stock price, CVS is still one of the best picks in the current market and a great long-term investment in my opinion. In the following article I will explain my reasoning again why I think CVS is a great pick and we will start by looking at the last quarterly results.

Quarterly Results
In the second quarter of fiscal 2021, CVS Health Corp increased revenue from $65,341 million in the same quarter last year to $72,616 million, reflecting an increase of 11.1% YoY. While revenue increased with a solid pace, operating income declined from $4,680 million in Q2/20 to $4,326 million in Q2/21, a decline of 7.6%. And diluted earnings per share also declined from $2.26 in the same quarter last year to $2.10, a decline of 7.1%. Adjusted earnings per share were higher ($2.42), but also declined year-over-year ($2.64 in Q2/20).



(Source: CVS Q2/21 Investor Presentation)

When looking at the different business segments, all three contributed to growth in the second quarter:

Pharmacy Services: This segment generated $38,314 million in revenue in the second quarter - an increase of 9.8% YoY. Adjusted operating income increased even 32.3% YoY from $1,327 million to $1,755 million. And total pharmacy claims processed increased from 505.4 million to 562.2 million.
Retail/LTC: Revenue from this segment increased from $21,662 million in Q2/20 to $24,728 million in Q2/21 - an increase of 14.2% YoY. Adjusted operating income almost doubled (93.4% YoY) from $1,057 million to $2,049 million and prescriptions filled increased from 345.4 million in Q2/20 to 394.4 million in Q2/21.
Health Care Benefits: Revenue from this segment was $20,525 million, an increase of 11.1% compared to $18,468 million in the same quarter last year. While the other two segments not only increased revenue, but also increased their adjusted operating income, this segment reported a steep drop from $3,464 million to $1,614 million.


(Source: CVS Q2/21 Investor Presentation)

While CVS could not report bottom-line growth this quarter, the company increased the guidance. Total revenue is now expected to be between $280 billion and $285 billion and GAAP earnings per share are expected in a range of $6.35 to $6.45 - reflecting 16% to 18% year-over-year growth. And adjusted EPS is now expected to be between $7.70 and $7.80.

Improved Balance Sheet
In case of CVS Health, we also must pay close attention to the company's balance sheet as it is one of the major reasons for concern. As consequence of the Aetna acquisition, CVS not only took on a lot of debt to finance the acquisition, but goodwill also increased. Since the acquisition, CVS is doing a pretty good job to reduce the outstanding debt and to improve the balance sheet. In the last quarter, it repaid $2.4 billion in debt and year-to-date debt was even reduced by $5.4 billion. In total, CVS repaid $17.6 billion of long-term debt since the close of the Aetna transaction.

And the balance sheet improved once again. On June 30, 2021, long-term debt was stable ($59,294 million compared to $59,207 million on December 31,2020), but short-term debt declined from $5,440 million to $60 million. CVS had to use some of the cash and cash equivalents and this amount declined from $7,854 million to $7,119 million. While short-term investments stayed stable ($3,006 million vs. $3,000 million), long-term investments increased from $20,812 million to $22,136 million. Goodwill remained at a high level ($79,552 million), but total shareholders' equity increased from $69,701 million to $73,565 million.

Chart
Data by YCharts
The improved balance sheet is also reflected in improved metrics. The debt-equity ratio of CVS is only 0.81 and any number below 1 can be seen as acceptable. But while the D/E ratio is acceptable, we must also compare the total debt to the operating income and that ratio is still a bit too high. When subtracting cash and cash equivalents from the total debt and using the operating income of the last four quarters ($13,676 million), it would take about 3.8 times the operating income to repay the outstanding debt. This ratio is not really a reason to worry, but it is still a bit higher than I would like to see.

Intrinsic Value Calculation
I have argued several times in the past, that CVS is extremely cheap and one of the best bargains in this market. And CVS increasing more than 60% since the previous lows does not change the fact, that the stock is still a bargain.

Chart
Data by YCharts
When looking at the price-earnings ratio, CVS is trading for 15.5 times earnings right now (using GAAP numbers). This is not extremely cheap, but also not a high valuation multiple - considering that CVS is a high-quality business that can grow with a solid pace and especially considering for which multiples other stocks are trading. When using management's guidance for fiscal 2021 ($7.75 in adjusted earnings per share), CVS is trading for only 11 times earnings. And as I have often argued in the past, the best simple valuation metric to use is the price-free-cash-flow ratio. Right now, CVS is trading for a P/FCF ratio slightly below 10 - a number that is cheap for almost any stock.

Aside from these simple valuation metrics, I will also offer a discount cash flow calculation. For such a calculation, we must make several assumptions what free cash flow to expect in the years to come. As basis we can take the free cash flow according to CVS's own guidance. Management is expecting cash flow from operations to be between $12.5 billion and $13 billion and capital expenditures to be between $2.7 billion and $3 billion. Hence, we can expect a free cash flow of $10 billion for fiscal 2021 and we take that as basis in our calculation.

For the next ten years, analysts are estimating earnings per share to grow with a CAGR of 4.35%. And although I think these numbers are too low - I will later argue why - let's assume these growth rates in our calculation. When assuming 4.35% growth from now till perpetuity, using a 10% discount rate and considering 1,327 million outstanding shares, the intrinsic value for CVS would be $133.38. The stock would therefore be trading 36% below the calculated intrinsic value and is clearly a bargain.

And although CVS seems already undervalued with the assumptions used above, I consider even higher growth rates being realistic for several reasons. First, in the last four decades, CVS could grow its earnings per share with a CAGR of 7.71% and I consider similar growth rates likely for the years to come. We also must consider that CVS Health Corporation transformed its business with the acquisition of Aetna (after it already transformed the business by also becoming a pharmacy benefit manager). And I consider CVS to be a much more stable business today making consistent growth rates more likely.



(Source: Author's work)

Second, the company will not only reinstate the dividend in 2022 again but will also start to repurchase shares again. According to a company presentation, the company is expecting to have $10 billion to $12 billion annually available for dividends and share buybacks. I already calculated in a past article that CVS could repurchase about 6% of its shares annually. Of course, we must take into consideration a higher stock price, but 2-3% growth due to share buybacks seems realistic.



(Source: CVS Investor Day 2019 Presentation)

Third, CVS could also improve its margins in the years to come. It can especially improve its net income margin due to lower net interest expenses. In the last four quarters, the company had to spend $1,664 million on interest expenses. If the interest expenses would go to zero, this would increase the bottom line about 20%. And although it seems unlikely, that CVS won't have any debt on the balance sheet in the next few years, even a reduction of the interest expenses of $100 million in any given year will add at least 1% growth to the bottom line.

Adding all these aspects together should rather lead to growth rates in the mid-to-high single digits in the years to come. And these growth rates would still be below management's long-term growth targets (presented during the last Investor Day).



(Source: CVS Investor Day 2019 Presentation)

Technical Picture
Aside from analyzing the business and calculating an intrinsic value, we can also look at the chart - and the picture is also looking bullish in my opinion. The correction, which we saw since 2015 is over (of course, one can argue when a correction is over, and it also seems legit to argue that a correction is not over before the stock reaches the former highs again). CVS could not only overcome several resistance levels, but the trend of lower lows and lower highs - which is characteristic of a bearish correction - was also broken.



(Source: TradingView)

I am quite confident that the double bottom around $50 (lows of 2019 and 2020) was the low point of that correction. And since then, the stock could not only climb above the 200-week simple moving average again, but also break the declining trendline (black line), which was in place since 2015. Additionally, the stock could overcome several resistance levels in form of previous highs (marked in orange and red). These previous resistance levels can now be seen as support levels, and I don't expect the stock to drop lower than $75 before it will continue its bullish path to the previous all-time high and beyond.

Preparing For The Inevitable
I know it is annoying when I repeat again and again that current stock prices are not sustainable and when we (as I am not the only one) are warning about a bear market that will come. And we are not talking about a 20% correction or about a short 5-week crash with stocks rallying afterwards. We are talking about a severe correction that will not only be extremely steep (in order to be fairly valued again, the major U.S. Indices have to correct 70% and more) but will probably last for several years. We are talking about a bear market that will find its place in the history books next to the Great Recession and Great Depression.

And while the party is still going on and you are allowed to dance, it does not hurt to think about what will happen when the music stops. There are clearly several strategies to deal with extreme bear markets and one strategy might be to invest in companies like CVS Health - recession-proof, defensive companies that are undervalued right now and therefore have limited downside potential. Granted, CVS has higher debt levels than I would like to see, which is not great in time of distress and turmoil, but aside from the higher debt levels on the balance sheet, CVS is a good pick for the coming years. Of course, this does not rule out declines for CVS in the years to come. But one of my fundamental beliefs is that a stock will move towards its fundamental value - even if this will take some time.

Conclusion
CVS is recession-proof and can be described as a defensive play (and the stock might therefore be suited for the years to come). CVS is also trading for very low valuation multiples, which is limiting the downside and is trading below its intrinsic value. The company is also continuing to perform and improving its business from quarter to quarter. Revenue and earnings per share are constantly improving and the company is a cash cow. And in 2022, we can expect the company to start repurchasing shares again and increasing the dividend. Only the high debt levels are not great, but CVS is reducing debt levels from quarter to quarter.