CVS Deep Dive: A Case To Buy Shares Now (NYSE:CVS)


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Investment Thesis

With dependable growth, consistent profits, and strong cash generation, CVS Health Corp. (CVS) CVS is an appealing core holding. Its current valuation provides an attractive entry point. With organic growth in the low to mid-single digits, CVS is not likely to offer fast, high-beta returns; investors seeking this type of holding should look elsewhere.

In this article, we examine CVS through our Five-Factor Framework. The framework provides a consistent methodology to review stock opportunities and compare different stocks.

Factor 1: Financial Performance

Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion, and so forth. – Peter Lynch

Revenue

CVS has robust revenue growth and consistent performance from its three segments and expects the growth to continue for the next three years. CVS routinely makes acquisitions, including the significant acquisition of Aetna in November 2018, so it is essential to analyze the company’s organic growth in addition to total revenue growth. CVS has generated consistent historical organic revenue growth in the range of 3-5% annually.

CVS is not expecting a material impact from COVID-19 in 2020. The company disclosed on June 10th that its anticipated earnings for 2020 “remain unchanged.” Additionally, in earnings call on August 5, 2020, CFO Eva Boratto affirmed earlier guidance by saying:

While acknowledging the inherent and unprecedented uncertainty surrounding COVID-19 and its impact on us, we are raising our full year adjusted EPS guidance to $7.14 to $7.27 to reflect the favorability in the tax rate we experienced in the quarter. In addition, we are increasing our full year 2020 cash flow guidance to $11 billion to $11.5 billion, reflecting the timing of the payments of certain liabilities. (emphasis added)

Analyst consensus forecasts are for revenue growth to remain in the 3-5% range for the next three years.

CVS Total Revenue Growth

Chart & Organic Growth Calculations: Simplivest; Source Data: S&P Global Market Intelligence

Notes: (1) 2020, 2021, and 2022 are analyst consensus estimates; (2) LTM is for the last twelve months ending June 30, 2020

Segment Revenue

CVS is one of the largest integrated health care services companies in the US. It operates with three primary business units (1) Pharmacy Services Segment, (2) Retail / Long Term Care (LTC) Segment, and (3) Health Care Benefits Segment.

CVS Revenue by Segment

LTM as of June 30, 2020

CVS Revenue by Segment

Chart: Simplivest; Source Data: S&P Global Market Intelligence

The only blemish on the company’s growth record is in 2017 when the Retail / LTC Segment posted a modest decline due to health insurers making an adjustment to narrow the network of pharmacies in which their customers can fill prescriptions. The impact on the segment’s revenue was muted (a 2% decline), and revenue rebounded quickly after that. We want to point out how incredibly resilient and consistent CVS’s revenue is, which is not a surprise given the overall strength of the healthcare industry and CVS’s leading position in the industry.

CVS Revenue Growth – Pharmacy Services Segment

CVS Revenue Growth - Pharmacy Services Segment

CVS Revenue Growth – Retail / LTC Segment

CVS Revenue Growth - Retail & LTC Segment

CVS Revenue Growth – Health Care Benefits Segment

Shown Proforma with Aetna

CVS Revenue Growth - Health Care Benefits Segment

Charts: Simplivest; Source Data: S&P Global Market Intelligence

Notes: (1) Revenue is shown gross of intercompany eliminations; (2) Prior to 2018, revenue shown for the Health Care Benefits segment is that of Aetna; (3) LTM is for the last twelve months ending June 30, 2020

Profitability

CVS has a steady improvement in profit dollars and a slight decline in profit margins due to revenue mix shift. There is noise in the 2018 figures due to the Aetna acquisition. The Company is expecting steady profit margins and growth in profit dollars over the next three years.

Gross Profit

CVS’s gross profit dollars increased slightly from 2015 to 2018 (from $26.5 billion to $30.9 billion – a CAGR of 5.2%) and significantly increased from 2018 to 2019 (from $30.9 billion to $44.5 billion – a growth rate of 44.2%). Gross margins declined from 2015 to 2018 (from 17.3% to 15.9%) and increased dramatically from 2018 to 2019 (from 15.7% to 17.4%). The decline in gross margins from 2015 to 2018 was driven primarily by a revenue mix shift. As shown in the segment revenue growth charts above, the Pharmacy Services Segment (9.9% CAGR) grew 2x faster than the Retail / LTC Segment (5.0% CAGR).

The dramatic increase in gross profit dollars and gross margin from 2018 to 2019 resulted from the Aetna acquisition. Due to the transformative nature of the acquisition, reported results for 2018-and-after compared to 2017-and-before are an apples-and-oranges comparison. It is better to review results on a segment-level basis (see EBITDA discussion). Analyst consensus estimates call for steady growth in gross profit dollars and relatively steady gross margins over the next three years.

CVS Gross Profit

CVS Gross Profit

Chart: Simplivest; Source Data: S&P Global Market Intelligence

Notes: (1) LTM is for the last twelve months ending June 30, 2020; (2) 2020, 2021, and 2022 are analyst consensus estimates

EBITDA

CVS’s EBITDA dollars increased slightly from 2015 to 2018 (from $11.8 billion to $12.8 billion – a CAGR of 2.7%) and then increased dramatically from 2018 to 2019 (from $12.8 billion to $16.2 billion – a growth rate of 26.8%). EBITDA margins declined from 2015 to 2018 (from 7.7% to 6.6%) and then decreased slightly from 2018 to 2019 (from 6.6% to 6.3%). The decrease in margin from 2015 to 2018 is driven by the revenue mix shift mentioned above and pricing pressure in the Pharmacy Services and Retail / LTC segments. The dramatic growth in 2019 is due to the Aetna acquisition mentioned earlier. Analyst consensus estimates call for steady growth in EBITDA dollars and stable EBITDA margins over the next three years.

CVS EBITDA

CVS EBITDA

Chart: Simplivest; Source Data: S&P Global Market Intelligence

Notes: (1) LTM is for the last twelve months ending June 30, 2020; (2) 2020, 2021, and 2022 are analyst consensus estimates

As shown in the table below, the Retail / LTC segment experienced a decline in EBITDA margins due to reimbursement pressure, which has been a trend in the sector for many years. A Forbes article does an excellent job of explaining the cause for reimbursement pressures. The Pharmacy Services and Heath Care Benefits segments both have stable EBITDA margins.

CVS Segment EBITDA

CVS Segment EBITDA

Chart: Simplivest; Source Data: S&P Global Market Intelligence

Notes: (1) Segment EBITDA is gross of intercompany eliminations; (2) LTM is for the last twelve months ending June 30, 2020

Net Income

CVS’s Net Income dollars increased moderately from 2015 to 2017 (from $5.2 billion to $6.6 billion – a CAGR of 12.4%). Net Income decreased dramatically in 2018 to a loss of $0.6 billion, primarily due to one-time transaction expenses related to the Aetna transaction completed in November 2018. In 2019 and the LTM period ending March 31, 2020, Net Income rebounded to $6.6 billion and $8.3 billion, respectively. These 2019 and 2020 levels are somewhat depressed by continuing integration expenses related to the Aetna acquisition. Excluding the Aetna transaction and related integration expenses, net margins are consistent around 3.0% to 3.5%. For 2020 and beyond, analyst consensus estimates are for Net Income to continue to grow and net margins to remain around 3.5%.

CVS Net Income

CVS Net Income

Chart: Simplivest; Source Data: S&P Global Market Intelligence

Notes: (1) LTM is for the last twelve months ending June 30, 2020; (2) 2020, 2021, and 2022 are analyst consensus estimates

Free Cash Flow

CVS has a healthy cash flow profile, delivering excellent Unlevered Free Cash Flow (UFCF) and Levered Free Cash Flow (LFCF). The cash flow profile results from the company’s strong economic engine, which generates consistent revenue growth, profit margins, and returns on capital.

The company’s capital expenditures have averaged 1.1% of revenue over the last five years, and are mostly in support of the Retail / LTC segment. Capital expenditures are used for (1) new store construction, (2) retrofitting and updating existing stores, and (3) technology upgrades and other corporate initiatives. With the expected growth in revenue and stable profit margins over the next three years, we expect both UFCF and LFCF to exhibit growth.

CVS Free Cash Flow

CVS Free Cash Flow

Table & Calculations: Simplivest; Source Data: S&P Global Market Intelligence

Notes: (1) We calculate taxes on unlevered earnings and the tax shield assuming a tax rate of 37.5%; (2) LTM is for the last twelve months ending June 30, 2020

Factor 2: Return on Investment

We constantly seek to buy new businesses that meet three criteria. First, they must earn good returns on the net tangible capital (emphasis added) required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price. – Warren Buffett

CVS has some noise in its metrics, driven by a goodwill impairment charge and the Aetna acquisition (both in 2018). Still, we are satisfied with the overall capital efficiency of CVS’s business.

ROIC & ROE

CVS generates attractive returns on invested capital (ROIC) and returns on equity (ROE). Before 2017, the company posted ROIC’s of around 10% and ROEs that increased from 12.1% in 2013 to a peak of 17.7%. Both metrics were materially negatively impacted in 2018 by a $6.1 billion goodwill impairment charge tied to the LTC business.

In 2019 and the LTM period ending June 30, 2020, the metrics included the Aetna business’s full-year impact, which obfuscates the comparability to prior periods. Keep in mind that these calculations of ROIC and ROE include all intangible assets. To illustrate the true earning power of the underlying operating business, some investors, including Warren Buffett, like to review return on capital metrics using only tangible assets (excluding goodwill and other intangible assets created as a result of acquisitions). CVS’s ROIC and ROE would both be well north of 20% when excluding intangible assets.

CVS ROIC & ROE

CVS ROIC & ROE

Chart: Simplivest; Source Data: S&P Global Market Intelligence

Note: LTM is for the last twelve months ending March 31, 2020

Factor 3: Resilience

You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets. – Peter Lynch

CVS’s elevated debt levels put it in a slightly higher risk category related to the Company’s leverage and fixed charge coverage ratio. Its consistent performance through the last recession mitigates these risks.

Leverage

The GAAP rules for accounting for leases changed significantly in 2020. Companies must now account for their operating leases as if they were debt. This accounting change affects companies like CVS with retail stores. The change in accounting obscures comparability of leverage to traditional benchmarks, so we have removed capitalized leases from total debt in our calculations below.

CVS materially increased its debt load when it took on $53 billion of additional debt at the end of 2018 to facilitate the acquisition Aetna. The Company’s current leverage profile is somewhat high, with a total leverage ratio of 3.87x and a net leverage ratio of 2.91x. Management has stated that they target a total leverage ratio of around 3.0x and will use the company’s free cash flow to achieve this debt paydown. CVS’s relatively high leverage profile is a risk factor that investors should incorporate into their investment considerations.

CVS Leverage

As of June 30, 2020

CVS Leverage

Chart and Calculations: Simplivest; Source Data: S&P Global Market Intelligence

Note: LTM is for the last twelve months ending June 30, 2020

Fixed Charge Coverage Ratio

CVS’s FCCR is currently 1.31x, which is on the lower end of what we categorize as an acceptable FCCR. Please note, however, that this calculation uses the Company’s reported EBITDA, which is conservative. Debt credit agreements typically use an Adjusted EBITDA concept when calculating the FCCR, which includes additions to reported EBITDA for one-time expenses and the pro-forma effect for acquisitions.

CVS’s investor relations page identifies $667 million of adjustments to LTM EBITDA for acquisition expenses, store rationalizing charges, and a loss on a subsidiary’s divestiture. Adding these adjustments to EBITDA increases the FCCR to 1.37x, which more squarely in the range of an acceptable FCCR.

CVS Fixed Charge Coverage Ratio

LTM as of June 30, 2020

Chart and Calculations: Simplivest; Source Data: S&P Global Market Intelligence

Note: Current Portion of LT Debt Excludes Capitalized Lease Obligations

Performance Through the Downturn

As is typical for the healthcare industry, which is not as sensitive to economic cycles as other industries, CVS’s performance through the last economic downturn was outstanding. The company posted a modest decline in revenue in 2010 of 2.3%, but growth resumed quickly. This revenue performance illustrates the inelasticity of the products and services that CVS offers. It should give investors peace of mind for the current period of economic uncertainty and for when the next recession occurs.

CVS Revenue Through Last Recession

CVS Revenue Through Last Recession

Chart and Calculations: Simplivest; Source Data: S&P Global Market Intelligence

Factor 4: Alignment

Chief executives who themselves own few shares of their companies have no more feeling for the shareholders than they do for baboons in Africa. – T. Boone Pickens

Outside shareholders of a public company have little control over the management of a company. They want to have confidence that the management team is acting in the best interests of the shareholders. After all, it is the decisions that the management team will make that will drive investors’ returns. We are generally pleased with CVS’s shareholder-friendly behavior and the alignment with the management team.

Dividends

CVS pays a steady dividend and generates an attractive dividend yield. In 2019, the Company paid out $2.6 billion in dividends to shareholders or $2.00 per share. CVS’s current dividend yield is a highly attractive 3.1%.

Before the Aetna acquisition in November of 2018, CVS has a history of increasing its dividend each year. CVS took on substantial additional debt to facilitate the Aetna acquisition and is currently using excess cash to reduce the company’s debt burden.

Analyst consensus estimates are pointing towards only a modest future increase in dividend per share from the current amount of $2.00 to $2.06 in 2022. The lack of growth with the dividend is due to the company’s focus on paying down debt. Once the Company’s targeted debt level has been reached, we expect CVS to resume its past practice of increasing annual dividends.

CVS Dividends per Share and Dividend Yield

CVS Dividends Per Share and Dividend Yield

Chart: Simplivest; Source Data: S&P Global Market Intelligence

Notes: (1) 2020, 2021, and 2022 are analyst consensus estimates; (2) LTM is for the last twelve months ending June 30, 2020

Equity Repurchases & Shares Outstanding

We like to see a company repurchase its shares, which lowers the overall share count and – holding everything else equal – increases the share price. However, we believe it is vital for a company to repurchase its shares at attractive valuations. After all, equity repurchases are like any other investment. We want to see management being prudent about the timing in which it makes these investments with the Company’s (that is: the “shareholders'”) capital.

Equity Repurchases

Before acquiring Aetna, CVS regularly repurchased its common stock, spending between $4 billion – $5 billion each year. The Company’s repurchases were at valuation multiples that were roughly in-line with CVS’s long-term averages.

During 2018, the company curtailed its repurchasing activity to conserve cash for the Aetna transaction. Looking forward, we expect CVS to maintain its low levels of equity repurchases until it achieves its targeted debt level.

CVS Share Repurchases and Multiple Paid

CVS Share Repurchases and Multiple Paid

Chart & Wtg. Avg Multiple Paid Calculations: Simplivest; Source Data: S&P Global Market Intelligence

Note: LTM is for the last twelve months ending June 30, 2020

Insider Ownership

The ultimate alignment between company insiders and outside shareholders is significant ownership by members of the company’s management team. CVS insiders own 2.1 million shares, which represents 0.16% of the Company’s shares outstanding and is worth $132 million at the current stock price.

CVS Summary Ownership

As of June 30, 2020

CVS Summary Ownership

Chart: Simplivest; Source Data: S&P Global Market Intelligence

On a percentage basis, CVS’s insider ownership is low; however, this is not surprising for a large capitalization company with a market capitalization of $84.0 billion. Therefore, it is necessary to look at the dollar value of the ownership stake. On a dollar value basis, CVS’s insider ownership is decent with insiders owning a cumulative $132 million.

CVS Detailed Insider Ownership

As of August 5, 2020

CVS Detailed Insider Ownership

Table: Simplivest; Source Data: S&P Global Market Intelligence

Factor 5: Valuation

A ridiculously high purchase price for a given stock will cause a splendid business to become a poor investment. – Warren Buffett

Pulling a page out of the Buffett investing playbook, we prefer to make investments in companies at fair or discounted valuations. We believe it is critical only to buy companies at appropriate valuations. If we like a company, but the valuation is not attractive, we put it on our watchlist.

Stock Price History

CVS’s stock price declined from a high of $113.45 on July 29, 2015, to a low of $52.13 on April 2, 2019 (in the middle of the COVID-19 bear market). The stock currently trades at $64.40 (as of August 5, 2020).

CVS Share Price and EV/EBITDA Valuation

Data for the Last Seven Years

CVS Share Price and EV / EBITDA Valuation

Chart & Calculations: Simplivest; Source Data: S&P Global Market Intelligence

Valuation Multiples

CVS is trading in line or at a discount to its seven-year average valuations across all of the major valuation metrics, which provides an attractive point to purchase shares of the Company.

CVS Valuation Comparison

As of August 5, 2020

CVS Valuation Comparison

Chart & Calculations: Simplivest; Source Data: S&P Global Market Intelligence

Note: UFCF Yield is calculated as [5-Year Avg UFCF] / [Current Enterprise Value]

Risks

Investments are never a “sure thing,” and CVS is no exception. Below we highlight some risks that could negatively impact an investment in CVS.

Difficult Acquisition Integration: CVS is early in its process of integrating the acquisition of Aetna, which has become the Company’s Health Care Benefits Segment, its third-largest operating division.

Mitigating Factors: CVS is not new to extensive acquisition integrations and the early signs are positive. According to the Company’s 2019 proxy report: “the Board received regular reports regarding the successful first full year of Aetna integration, which produced synergies of approximately $500 million, exceeding expectations” (emphasis added).

Highly Competitive Environment: CVS faces competitive pressure and client demands for lower drug prices that could negatively affect its profit margins.

Mitigating Factors: CVS is working to transform itself into a broader healthcare services company that would increase customer engagement and enhance revenue that would offset margin declines.

Low Insider Ownership: Management owns 0.16% of CVS’s outstanding shares, worth $132 million.

Mitigating factors: A large part of executive compensation is long-term and tied to CVS’s stock’s performance, which provides alignment with outside shareholders.

Additionally, the CVS has long had a practice of traditionally “shareholder-friendly” initiatives of making dividend payments and equity repurchases.

High Debt Level: The Company’s total leverage ratio and fixed charge coverage ratio are 3.89x and 1.31x, respectively. Both are on the low end of what we deem appropriate.

Mitigating factors: CVS generates strong free cash flows and management has stated its intention to direct this cash flow to pay down debt until leverage is ~3x.

Disclosure: I am/we are long CVS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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