CVS Health Corporation (CVS)

[FUNMAN]

CVS Health: Upside Remains
Dec. 15, 2021 9:14 AM ETCVS Health Corporation (CVS)WBA, AMZN36

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Summary

CVS Health Corporation has quickly evolved into more than just a convenient place to fill your prescriptions.

On Friday 12/10/21, CVS Health announced that they were raising their dividend, and with that, my conviction on CVS' stock grew even higher.
I believe the market is only just now beginning to appreciate the plan that management has laid out for the future.

I rate CVS a buy.


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Introduction

CVS Health Corporation (NYSE:CVS) has quickly evolved into more than just a convenient place to fill your prescriptions and pick up some toilet paper while you're there. Since 2017, when they announced what would become known as the largest healthcare merger in U.S. history with Aetna, CVS Health has transformed itself into a true giant in the healthcare industry. They now find themselves in the rather unique position of capturing profits through an interconnected array of services. The addition of "health hubs" in many of their stores is the final piece which will allow them to unlock their true earning power. I find the future being laid out for CVS to be quite attractive and believe now represents a great time to buy shares for the long term.

Company Overview
CVS derives revenue from three main segments. These include the company's newest addition Aetna, which provides health benefits and managed care to over 23 million members, making them the third-largest health insurer in the United States. Having such a large market share affords CVS the ability to offer lower cost, as well as a wider array of benefits, to current and would-be members. Their size also attracts more service providers, such as physicians and hospitals, willing to offer CVS lower prices in order to have access to their large customer base.

Then there is CVS' Caremark division, a pharmacy benefit manager (PBM) working behind the scenes for health insurers, Medicare, and large employers to negotiate with manufacturers and pharmacies for the best pricing on prescription drugs. Caremark essentially determines how much they are going to pay the pharmacies to fill prescriptions.

Which leads me to CVS' final segment, retail pharmacy. CVS currently owns and operates just shy of 10,000 stores. Building on what is referred to as "Minute Clinics", 1500 stores now have what is known as "Health Hubs". Health Hubs aim to be more staff intensive and focus on treating chronic diseases such as diabetes and sleep apnea, as well as behavioral and mental health conditions. These health hubs tend to lead to more foot traffic, front-of-store sales, and prescriptions dispensed.

I would also mention that Covid-19 has been somewhat of a tailwind for CVS Health through Covid-19 testing, of which CVS is America's largest private provider, as well as through the administration of over 43 million vaccines to date. This has led CVS to capture and retain many new customers, as 12.5% of new customers tested for Covid-19 have chosen to fill a prescription or receive vaccinations through CVS Health. Originally it was thought that the widespread use of vaccines would put a swift end to Covid-19, but new strains continue to evolve, such as that of Delta and Omicron. While I'm sure we would all like to see an end to this deadly disease as soon as possible, it appears that CVS will be administering testing and vaccinations longer than anticipated.

By the Numbers
Q3 2021 saw CVS Health beat top-line results by a healthy $3.27B, with total revenue of $73.8B, representing 10% YOY growth. While Non-GAAP EPS of $1.97, which equates to 18.6% YOY growth, beat analyst expectations by $0.18. Management is aiming for sustainable, low double-digit, bottom-line growth, starting in 2024.

Free cash flow (FCF) came in at $4.9B for the quarter. This compares quite favorably to FCF of $1.3B in Q3 2020. Over the trailing twelve-month period, CVS has had a massive free cash flow of $15.2B. CVS Health expects revenues of $286.5B to $290.3B for FY2021, representing growth of 6.2% to 7.5%. FY2021 adjusted earnings per share of $7.90B to $8.0B, if met, would equate to growth of 5.3% to 6.67%.

Since closing the Aetna merger in 2018, CVS took a major hit to their return on equity and return on invested capital, as their debt load skyrocketed. Yet both metrics have been trending up as they have consistently paid down debt.

CVS ROE and ROIC

Source: Simply Safe Dividends

Shareholder Returns
Now let's talk about the good stuff, shareholder returns. From 2003 to 2016 CVS raised their dividend every year at a rate of around 21.5% annually. Not too shabby. In 2017, when CVS merged with Aetna, they announced that they would be freezing the dividend at $2.00 per share and also stopping any share repurchases until they hit a more comfortable 3x leverage. This seemed to turn many investors off, and CVS' stock price continued to trend lower from around the $70 level, down to around $55, and then languished there for a while.

CVC dividend cash flow

Source: FAST Graphs

Management's original estimation was for them to reach their 3x leverage goal in the year 2022. Yet management did not disappoint, hitting their goal ahead of schedule, and on Friday 12/10/21, CVS Health announced a dividend raise, and with that my conviction on CVS' stock grew even higher. The raise came in at a fair 10%, bringing their quarterly dividend to $.55 cents a share, which equates to a current yield of 2.23%, with the first dividend payment due on February 1, 2022. They also announced a $10 billion buyback plan, which equates to just shy of 8% of their entire market cap. Wowzers! I have no doubt that this has kicked off what is the start of a decade(s) long run of dividend raises which could easily average double digits for the foreseeable future.

At its height in 2017, CVS Health sported an earnings payout ratio of 34%, yet since keeping their dividend frozen over the past few years, we have watched that ratio drift down to the 26% range. Now let's imagine that CVS is only able to grow their earnings per share at a 3% clip over the next 5 years. With an adjusted EPS of $7.95, which is the expected mid-point of FY2021, this would result in an EPS of 9.2x at the end of 5 years. At their current $2.20 dividend, CVS could realistically support raises of 10% a year till 2026 and would still have a healthy payout ratio of only 38%. This is an extremely conservative scenario and if CVS manages to get anywhere close to expectations we should easily see growth much faster than 3%, but this just goes to show the power of having a low payout ratio with a growing company.

CVC earnings payout ratio

Source: Simply Safe Dividends

Valuation
With a closing price on Friday 12/10/2021 of $98.86, CVS has a blended P/E of 12.39x. On a valuation basis, this compares favorably to their ten-year average of 13.77x, and 20-year of 15.66x. Analysts expect EPS growth of 3% in 2022 while ramping up to 8% in 2023. If CVS were to trade up to their 10-year average blended P/E, we could expect to see annualized returns just short of 13%. At their 20-year blended P/E, we are talking about 20% annualized returns! It is likely that CVS could realistically trade within the 13x to 15x range. At the mid-range of management's FY2021 EPS guidance of $7.95, this would give us a price range of $103.35-$119.25, which from current prices gives us an upside of 4.5%-20.6%.

CVC stock valuation

Source: FAST Graphs

Competitive Advantage
CVS Health has taken their business to another level with their blockbuster acquisitions of Caremark and Aetna. No longer are they dependent strictly on the retail side of things, as their revenues are split almost evenly between their retail business, Caremark's PBM division, and Aetna's health insurance. Each segment is surrounded by their own moats, giving them a durable, competitive advantage over their competition. These moats mainly take the form of cost advantages and network effects which essentially go hand in hand. The larger their network becomes, the more negotiating power they have, which in turn allows them to offer lower prices and better benefits. This creates a virtuous cycle that sees CVS continue to expand and grow their business.

While the Amazon effect has many companies backfilling their moats, CVS may prove immune. While CVS offers free prescription delivery, the majority of customers still prefer to pick up prescriptions in-store. Also, the implementation of health hubs will keep customers more reliant on in-store visits to receive care in the form of check-ups, vaccinations, and maintenance of chronic diseases. Most of these services would be very difficult to replicate any way other than in-person visits.

Peer Comparison
Walgreens Boots Alliance (NASDAQ:WBA) is CVS Health's largest competitor in their retail and pharmacy divisions. CVS and Walgreens both operate over 9,000 stores in the U.S. and are numbers 1 and 2 respectively as far as market share goes, based on prescription drug revenue. Both businesses will look to combat e-commerce with the implementation of care clinics in their store which should keep more customers reliant on in-store visits. Where CVS holds the advantage is that each of their three segments only accounts for roughly one-third of revenue, while Walgreens relies heavily on their retail stores, with around three-fourths of their revenue coming from their pharmacy segment. While CVS has seen their earnings per share and free cash flow per share consistently rise higher over the years, Walgreens has found itself on a downward trend in these categories, which has resulted in lower ROE and ROIC than CVS at 9% and 6% respectively.

Walgreens ROE and ROIC

Source: Simply Safe Dividends

This may have played a part in their most recent dividend raise in July of only 2.1% as compared to CVS' 10% raise this month. Overall, the future just looks much brighter for CVS, which is backed up by their outperformance over Walgreens over the past year.

Management
CVS recently saw the passing of the torch with the replacement of long-time CEO Larry Merlo with the former president of Aetna, Karen Lynch. Shareholders are hoping she is able to reverse the stalled growth that we have seen over the past few years, as she is already talking about achieving double-digit EPS growth long-term. Only time will tell if she is capable of delivering, but so far things have gone relatively smooth, and I'd say she will be much better received after the recent dividend hike.

Key Decisions
After the merger with Aetna, CVS' management made the decision to freeze their dividend and buybacks, and instead focus on paying down the large debt taken on in this merger. Not only did this show that management wasn't focusing on short-term share movements, or the typical pay bonus that comes with this, but instead they were determined to act in a manner that was best for the long-term viability of CVS Health by making smart, responsible decisions.

It was also announced recently that CVS has plans to close 900 stores, at a rate of 300 a year for the next 3 years. This works out to right around 9% of their total store count and is aimed at reducing store density. Many of the remaining stores will be updated to reflect their new strategy, which includes offering more health services through the addition of "health hubs". If these hubs are as effective as management seems to believe, and as many stores are beginning to show, then that could be a major boon for the company as a whole. The benefits to these health hubs are glaringly obvious, as they could effectively benefit each segment of CVS Health. Not only will they drive more foot traffic to their stores for doctor visits, which in turn will lead to more prescriptions being filled as well as more front-of-store purchases, but they can also use these formats to offer more benefits aimed at attracting a higher number of Aetna members to frequent CVS stores, while incentivizing non-members to sign up for their health insurance.

Another change you may have noticed in stores is the addition of self-checkout machines. Since CVS recently raised their minimum wage to $15, this would seem to be an obvious next step to keeping only their best workers and using technology to replace the rest. This is just one of the ways recently that CVS has shown their willingness to use technology in order to advance their business. Last year CVS announced they were teaming up with UPS in using drones to deliver prescriptions directly to homes, and more recently they have announced intentions to begin working with Microsoft, using their cloud service Azure in order to enhance capabilities of machine learning and customized health. Over time this should lead to higher margins, and in turn greater profits.

Risks
All equities involve risk, and while I believe the risk associated with an investment in CVS is rather low, I would be remiss if I didn't at least briefly cover the two main ones I see. First, there is the one where CVS ultimately fails at successfully integrating the Aetna merger, and the synergies they expected never fully materialize. This would make paying down the heavy debt taken on in the merger all the more difficult, but the fact that they were able to pay off $18.7 billion in debt since closing on the deal in 2018, makes clear that this has not yet been a problem. Management clearly believes things are going well, as the fact that they were able to reach their leverage goal ahead of schedule while resuming dividend raises and share repurchases, would point to the fact that they are confident in the direction things are heading.

The larger risk would appear to be the risk associated with all healthcare stocks at the moment, and that would be the sweeping change that democrats have been pushing at for quite some time. Universal health coverage could constitute a serious change for a large part of CVS' business, although it is difficult to envision a future where the larger insurers are not given a significant role to play in this scenario. If we have learned anything from politics over the years, it is that passing healthcare reform is extremely difficult with large companies like CVS wielding enormous power and influence.

Conclusion and Final Thoughts
The bull run of the last decade has pushed the overall market into highly overvalued territory. Yet there remain many great businesses trading at fair value or better if you know where to look. My favorite sector at the moment would have to be that of healthcare, as the perceived headwinds have unfairly kept many names in this sector from fully participating in the current bull market.

Ever since the announcement of the Aetna acquisition, I have had my eye on CVS and watched as the price flatlined and then eventually began to trend lower. The game plan that we see management implementing will make CVS a long-term winner. While many may point to the near 40% rise over the last year as a reason to avoid investing in CVS at this time, I believe the market is only just now beginning to appreciate the plan that management has laid out for the future and feel that the health hubs are the final piece needed to unlock the full value of their most recent mergers and acquisitions.

As CVS continues to use their large cash flows to rapidly pay down the debt acquired from their Aetna merger, this in turn will lower their annual interest payments and free up more capital to fuel the double-digit EPS growth management is guiding for. Now that CVS has reached that magical 3x leverage, the currently low earnings payout ratio allows for what should be some truly impressive shareholder returns through dividends and buybacks. This is the moment that many shareholders have been waiting for, which should allow us to see a mean reversion back to a more deserved 13-15 P/E ratio as those seeking income move back into this stock. With the market trading at such a lofty valuation, I would be more than happy to lock in double-digit returns for at least the next few years. I rate CVS a buy below $110 and will continue to add to my own position.