CVS Health Corporation (CVS)

[FUNMAN]

CVS Health Drops The Dividend Bombshell
Dec. 10, 2021 7:15 AM ETCVS Health Corporation (CVS)

Summary

CVS cut its shareholder returns a couple of years ago in order to pay for its acquisition of Aetna.

Deleveraging efforts have been successful, and CVS is now in a position where it can ramp up shareholder returns thanks to strong free cash flow.

Shares are inexpensive, offer a reasonable dividend yield, and the growth outlook for both the dividend and CVS' earnings per share is compelling.

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Article Thesis

CVS Health Corporation (CVS) has focused on deleveraging for the last couple of years in order to clean up its balance sheet following the $69 billion takeover of Aetna. CVS has, thanks to strong cash flows, reduced its debt levels successfully in that time frame and is now in a position where it can start to reward its shareholders more aggressively. CVS announced an attractive 10% dividend increase, and also started a new buyback program worth $10 billion. Combined with solid business growth opportunities, this makes CVS an attractive investment.

Why CVS Had To End Its Dividend Growth Streak
CVS Health Corporation has had a solid dividend growth track record between 2000 and 2017:

CVS dividend
The company raised its dividend regularly, and at an attractive pace, on the back of solid business growth. Since 2017, however, the dividend has been held flat at a level of $0.50 per share per quarter, providing a dividend yield of around 2.2% at current prices -- this is still more than what one can get from the broad market, but without any dividend growth, CVS was not too attractive for dividend growth investors.

The reason for the halt of CVS' dividend growth path was its high debt load following the closing of the acquisition of Aetna in 2018. Management rightfully prioritized debt reduction over dividend increases and buybacks over the last couple of years in order to bring its leverage ratio back down to earth:

CVS liabilities

Source: CVS 10-Q

With $58 billion in short- and long-term debt, offset by $10 billion of cash, CVS had a net debt position of $48 billion at the end of the third quarter. This amount has declined by about $20 billion over the last couple of years. Debt levels still are higher than they were prior to the Aetna takeover, but that is not a disaster -- the company is now generating significantly higher profits and larger cash flows, which makes higher debt levels more sustainable. On a net debt to EBITDA basis, CVS is employing a reasonable amount of leverage:

CVS EBITDA estimates
Based on 2021 EBITDA estimates, current net debt to EBITDA stands at 2.5, while current net debt to EBITDA estimates for next year stands at 2.4. This does not yet account for the debt reduction, in absolute terms, that will likely take place during the current quarter and during next year, as CVS will still use at least some of its cash flows to bring down debt levels further, despite the recent dividend increase. With $3 billion in additional debt reduction in those five quarters, CVS' net debt to EBITDA ratio would drop to 2.3 by the end of 2022, whereas $5 billion in additional debt reduction over those five quarters would result in a 2022 net debt to EBITDA ratio of 2.2. Either way, it seems pretty clear that CVS is now at a point where its debt usage is not overly high, and where its balance sheet looks pretty reasonable.

In retrospect, I believe that CVS would actually have been able to keep its dividend growth track record intact -- with minimal raises of $0.01 per year in 2018-2021, CVS would still be a Dividend Contender, and deleveraging efforts would not have been hampered a lot, as the total dividend payout over those years would have been almost the same compared to what CVS had to pay out in reality. With several years of no dividend increases, the dividend growth track record was broken, of course, and CVS is no longer a Dividend Contender -- which means that becoming a Dividend Aristocrat is not possible in the foreseeable future.

Ramped Up Shareholder Returns
With its deleveraging efforts mostly completed, CVS Health is now in a position where it can finally increase cash returns to equity owners. CVS has announced to do this in two ways. First, the company will increase its dividend by 10% to $2.20 annually in early 2022, and on top of that, the company has announced a new $10 billion share repurchase program.

Looking at the dividend raise, it seems quite attractive to me -- if CVS Health were to keep that dividend growth rate in place, investors would get a combination of a yield slightly north of 2% and 10% annual dividend growth, which could position the company for 10%+ annual returns for as long as CVS is able to keep that growth rate in place.

Calculating a forward yield for when the new dividend is in place, we get to a yield of 2.4%, which is pretty attractive relative to the 1.3% dividend yield we can get from the S&P 500 right now -- CVS will be offering a yield that is almost twice as high as that of the broad market.

With dividends of $2.20 annually, CVS will still have a pretty conservative dividend payout ratio. Based on expected earnings per share of $8.10 next year, the midpoint of management's guidance of $8.00 to $8.20, CVS will pay out 27% of its profits in the form of dividends, which equates to a very strong dividend coverage ratio of 3.7.

Looking at CVS' dividend coverage on a cash flow basis, we again see that there is negligible risk of a dividend cut. Management is guiding for operating cash flows of $12.5 billion to $13.0 billion next year, which should translate into free cash flows of around $10 billion to $10.5 billion once we account for capital expenditures of around $2.5 billion (see CVS' latest 10-K filing). CVS will pay out around $3 billion in dividends next year, which makes for a dividend payout ratio of 30% or a little less than that. When we also account for the fact that CVS' management has a history of being conservative with guidance initially and raising it as the year passes, then actual dividend coverage could be even stronger in 2022 compared to what we can calculate based on current guidance metrics.

When it comes to CVS' buyback program, the wording in the announcement was a little confusing:

CVS capital deployment

Source: CVS announcement, linked above

The "used to at least offset share count dilution" part made some investors worry that CVS would use its shares to pay for an acquisition in 2022, but I don't believe that will be the case. It would, after all, not make a lot of sense to issue new shares just to buy them back, possibly at a higher price, during the same year. Also, CVS' hunger for acquisition doesn't seem to be too large right now from what I can see. Instead, I believe that the offsetting dilution phrase refers to shares being issued to employees and management -- those will be bought back in any case, and CVS might buy back additional shares under its new program. Management likely wants to be flexible with the pace of share repurchases and might deploy a larger amount to them if valuations remain attractive. Management might, however, also prefer to put more money towards further debt reduction instead of pushing all surplus free cash flow towards buybacks. I believe that this approach is reasonable, as the usefulness of buybacks does depend on valuations shares will trade at throughout 2022, of course.

Growth Opportunities And An Inexpensive Valuation
CVS Health has been able to grow its business reliably in the past, and the same should hold true for the future. There are several avenues for that. First, CVS has invested in integrating its businesses and in locking new customers into its ecosystem:

CVS new customers

Source: 2020 Annual Report

This was, for example, done through a massive COVID testing push that has resulted in millions of new customers that have now had their first contacts with CVS and that can now be turned into repeat customers. CVS' subscription program has a similar goal of increasing the loyalty of customers and of generating higher revenue from the existing customer base.

CVS is also increasing its capabilities in the chronic illnesses space, with focus areas being kidney diseases and diabetes:

CVS clinical programs

Source: 2020 Annual Report

CVS has millions of active customers already and is pushing to bring this service to additional customers in the coming years. Since those that require support in these areas do so for their entire lives, locking in one customer generates high lifetime revenue opportunities for CVS.

Digitalization is another focus area of CVS, with improved outreach, virtual care options (that can be less costly than in-house visits), and more consistent health monitoring being some of the measures CVS has been pushing.

Through these growth venues, combined with overall industry growth, CVS Health is expected to grow its revenue at a mid-single-digit rate over the coming years. With debt reduction leading to lower interest expenses, and with buybacks in future years leading to a declining share count, CVS should be able to grow its earnings per share at a higher rate, however. Analysts are forecasting growth of 8%-9% in 2023 to 2025, although I believe that actual growth might be higher, depending on how aggressive CVS will pursue buybacks once debt is at target levels -- with free cash flow of $10+ billion a year, CVS Health could buy back around 5%-7% of the float a year without too much hassle even after paying its dividend.

CVS Health does, despite this solid earnings per share growth outlook, only trade at 11.7x forward earnings, which does not seem expensive at all for a company that grows at a high-single-digit rate and that will offer reliable dividend growth in the coming years. I thus believe that CVS could be a solid longer-term dividend growth investment at current prices, especially since CVS is also suitable for risk-averse investors thanks to its recession-resilient business model.

Takeaway
CVS is a resilient company generating solid business growth, and its shareholder returns will likely rise considerably in the coming years. With the announced dividend increase possibly attracting new investors, I could see CVS Health rise in the coming months, as dividend growth investors might push into the stock that is still trading at pretty inexpensive valuations.

This article was written by

Jonathan Weber profile picture
Jonathan Weber
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I work together with Darren McCammon on his Marketplace Service Cash Flow Kingdown.

Disclosure: I/we have a beneficial long position in the shares of CVS either through stock ownership, options, or other derivatives. 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.