CVS Health – A Good Time To Buy This Undervalued Company (NYSE:CVS)

Investment Thesis

CVS Health (CVS) stock has been out of favour with the marketplace for some time, but perhaps that is all about to change.

Share price performance of CVS Health vs S&P, healthcare blue chips. Source: TradingView.

As we can see from the above chart, over the past five years CVS’ stock price has underperformed the S&P 500, losing 15% of its value versus the S&P 500’s 55% gain. In 2018, CVS failed to make a net profit despite increasing its overall sales by 5% to $194.5bn, perhaps suggesting that the company’s Pharmacy and Retail divisions – responsible for almost of all its sales at the time – needed reinvigorating, and another major complementary source of revenues needed to be found.

CVS’s $69bn acquisition of Aetna – America’s third largest health insurer – which finally overcame all obstacles and was approved in November 2018, therefore came at just the right time for CVS and has been a catalyst for growth. In 2019 CVS grew revenues by 32% as a result of the Aetna contribution to $257bn, made an adjusted operating profit (calculated by CVS) of $15.3bn, and posted a GAAP EPS of $5.08 per share and PE of ~12.2x.

Although the company’s net profit margin in 2019 was just 2.6% CVS’s free cash flow from operations amounted to >$12.8bn – up 44% year on year – enough for the company to pay down its near term debt position of ~$4.7bn (and $8bn of debt overall), dividend of $2.0 per annum to shareholders ($2.6bn) and still have sufficient funds to invest back into the company.

At the same time, CVS says that it is realising cost savings and synergies from the Aetna deal faster than forecast and expects to save between $800-900m in 2020, but despite all of this the market has continued to assign a surprisingly low price to the company’s share price relative to (what I would consider to be) their fair value.

This is probably down to three factors. Firstly, the huge amount of debt CVS had to take on in order to complete the Aetna deal. CVS’ debt currently stands at around $65bn giving the company a debt to equity ratio of 2.47x – the company now carries $112bn of goodwill on its balance sheet.

Secondly and thirdly, two perceived market headwinds: the challenges posed by the likes of Amazon and Walmart to CVS’ network of physical stores and how the lowering of drug prices will affect its pharmacy benefit management business – a long-term target for government criticism due to the murky nature of the work that goes into setting reimbursement rates, formularies and drug prices.

For me, however, the fundamentals behind CVS’ business model and the company’s growth projections – which do not have to be much more than modest in order to generate significant cash flows for investors to benefit from – suggest that CVS is a buy.

The market has undervalued the retail pharmacy sector for too long (not just CVS but also its biggest rival, Walgreens Boots Alliance – see the chart above), without the threat of a Democrat President implementing Medicare For All the attacks on the role on PBM’s have relaxed for now, and the Aetna acquisition gives CVS a share of a high growth industry – Medicare Advantage – which is both profitable and highly complementary to CVS’ existing products and services.

As such I do not think CVS will trade at such low multiples to earnings or cash flow for much longer. I don’t think it would be unreasonable for CVS’ share price to double in the next 18 months provided it can show progress within its core divisions as I will discuss below. I will also discuss how CVS’s investment profile is similar to that of UnitedHealth (UNH) – a company that trades at nearly 6x the price of CVS but offers a similar value proposition.

Despite its ongoing stock market woes I believe CVS is a great stock to hold long term that pays a handsome $2.0 per annum dividend and whose shares may one day earn the valuation they deserve.

Company Overview

70% of the US population lives within 3 miles of a CVS pharmacy, whilst CVS makes >700K home visits annually and has 72M people using its text messaging program, the company says, meaning CVS interacts with one in every three Americans at least once every year.

Following the Aetna acquisition CVS has an unmatched coverage of the healthcare industry with 9,900 retail locations, 1,100 walk-in medical clinics, 105m pharmacy plan plan members, a pharmacy care service serving >1m members, and 37m people receiving health insurance related services including Medicare Advantage (“MA”) and standalone Medicare Part D.

The Company has four reportable segments: Pharmacy Services, Retail/LTC, Health Care Benefits and Corporate/Other.

CVS total revenues and adjusted operating income by segment 2017-19 projected 2020. Source: my table using data from company 2019 10K Submission.

As we can see from the table above whilst Pharmacy Services drives the majority of CVS’ revenues – $141bn in 2019, a figure which the company forecasts will slip to ~$138bn in 2020 – it is actually the Retail segment – with sales of $87bn in 2019 – that makes the greater contribution to CVS’ bottom line thanks to its superior net profit margin of 7.7% which is nearly 2x greater than Pharmacy Services 3.62% margin.

Pharmacy Services

According to CVS’ 10K submission the company’s Pharmacy Services division covers a broad range of services which includes:

plan design offerings and administration, formulary management, retail pharmacy network management services, mail order pharmacy, specialty pharmacy and infusion services, clinical services, disease management services and medical spend management.

This segment includes most of CVS’ administrative divisions including its Pharmacy Benefit Manager (“PBM”) which came about via CVS’ acquisition of Caremark for $21bn in 2006, with the division still known as CVS Caremark.

The company’s integrated systems keep track of all customers prescriptions across a network of more than 68,000 chain and independent retail pharmacies and help customer’s choose and tailor the most appropriate plans to their personalised needs, whilst deciding which drugs make physicians formularies, what the list prices and reimbursements will be and making sure they are available either at a physical store or via mail order across all clinical needs including chronic managed care services.

In 2020 CVS forecasts that revenues within its Pharmacy Services segment will decline by ~2% to around $138bn with adjusted operating income likely to reach $5bn – a 3.5% year-on-year increase. This is important since it suggests that CVS is prioritising streamlining the costs of existing Pharmacy Services business lines rather than paying the price of chasing new business. With the Aetna deal ensuring CVS generates around one third more revenues each year the company need not be overly concerned about growth rates in its other lon-standing divisions and instead focus on creating cost and service efficiencies.

CVS says that the projected revenue decline is due to net selling season losses and continued price compression. The company expects to process more than 2bn claims in 2020 and says that it has already completed 65% of its 2021 Pharmacy Services selling season renewals. CVS anticipates tailwinds in 2020 to include a strong performance from its Specialty section and increased claims volumes driven by the addition of Aetna’s mail order business and Specialty division and the onboarding of Anthem’s PBM Ingenio RX during 2019.

CVS identifies competition within the Pharmacy Services space as provided by the Express Scripts business of Cigna Corporation, OptumRx, Prime Therapeutics, MedImpact, Humana and PillPack plus smaller, standalone PBMs.

Retail / LTC

CVS’s retail segment earns revenues from sales of prescription drugs and other general merchandise including over-the-counter drugs, beauty products, cosmetics and personal care products across its 9,900 retail and 1,100 Minute Clinic locations. In 2019, the company filed 1.4bn prescriptions on a 30-day equivalent basis, or approximately 26.6% of the total retail pharmacy prescriptions in the United States.

In 2019 Retail was responsible for $87bn – or ~34% – of CVS’ revenues and ~44% – or $6.7bn – of its net profits, achieving a net profit margin of 7.7%. CVS are forecasting total revenues from Retail of between $87,530 – $88,800 in 2020 – a modest 1% -2.5% increase with operating income growing by between 0.25% – 1.75% to ~$6,770 with between 1.48 – 1.51bn prescriptions filled. CVS puts the modest growth forecasts down to continued reimbursement pressures but is forecasting higher sales from the “Front Store” sector (worth around 23% of sector revenues with pharmacy products claiming the other 77%) owing to growth in health and beauty product sales.

Within the Retail division CVS’ major innovations are its Health Hubs and Minute Clinics. Although the company may face a threat from online pharmacy services such as PillPack (acquired by Amazon for $753m) CVS continues to believe its physical stores – complemented by the digital data the company gathers about every individual’s personalised health needs – are the most convenient and professional way to look after its customers healthcare needs.

CVS now has more than 1,100 Minute Clinics set up – mini-health clinics, staffed by professional nurses and physicians’ assistants which can provide 80% of the scope of typical primary care practices in a quick and efficient manner. 92% of Minute clinic revenues were earned from visits paid for by third party employers or health insurers in 2019. CVS’ Extra Care card scheme is one of the largest loyalty programs in the US and the company also provides a benefits based subscription program – Care Pass – offering a suite of benefits and rewards based around a 7,000-strong collection of proprietary branded products.

Health Care Benefits

As mentioned both CVS’ Pharmacy Benefits and Retail divisions are highly complementary to the health insurance business the company has taken on through its acquisition of Aetna.

In 2019 Health Care benefits accounted for 27% of all CVS revenues and 34% of its adjusted operating income with a net profit margin of 7.5%. The Aetna effect can be recognised by the fact that in 2018 Healthcare Benefits represented just 5% of total revenues – revenues grew by 677% between 2018 and 2019, or pre and post Aetna.

The full range of products now offered includes: medical, pharmacy, dental and behavioural health plans, medical management capabilities, Medicare Advantage and Medicare Supplement plans, PDPs, Medicaid health care management services, workers’ compensation administrative services and health information technology (“HIT”) products and services.

The most exciting element here is the Government Medical Service Medicare Advantage – HMO and PPO products for eligible individuals which provide additional benefits to a standard government plan such as disease management, dental, visual, and wellness, that are administered by CVS under contract to the Centers for Medicaid and Medicare (“CMS”).

CVS has acquired 1.75m MA members from Aetna with membership growing by 400,000 between mid-2018 and 2019 and CVS say they are able to provide coverage access to at least 80% of Medicare eligible lives. Research has shown that annual gross margins in the MA market are nearly twice that of individual and group markets per covered person – the market is proving popular with seniors and, with 10,000 Americans becoming eligible for MA every day in the US, it is projected to grow from a 37% penetration of the Medicare market, or 21m members, to 50% – or between 29m and 35m members – by 2025.

CVS’ share of the MA market is around 10% – a figure the company will hope to grow by incentivising customers with, for example, “zero” co-payments for treatments and services at its Minute Clinics and enhanced services at its Health Hub stores. Both United Healthcare and Humana have seen their share prices rocket in recent years thanks to their respective 18% and 26% shares of the MA market and in fact, Humana attempted to merge with Aetna itself in 2017 only to see the deal blocked on anti-competitive grounds.

To me this is a good sign since it suggests the long-term value of Aetna’s plans is well known within the industry and as such, to my mind the Aetna acquisition represents smart, empire-building business by CVS – there are few faster growing industries in healthcare than Medicare Advantage. The only question is whether CVS can handle the debt burden brought on by the deal.

Financials and forecasts

Certainly CVS is now highly leveraged – long term debt stood at $65bn at the end of 2019 – but I believe the company can ease this burden over the coming years without jeopardising shareholder value thanks to the large cash flows it can generate.

CVS has forecast revenue from Healthcare Benefits in 2020 to be $74bn – up 7% on 2019, with adjusted operating income of $5.5bn (35% of all company income) up 6% year-on-year. This seems somewhat conservative to me given the promise of MA but even so, it would not be unreasonable for CVS to target net income of >$10bn in 2020 from all its divisions given the integration synergies (estimated long-term to be worth $2.5bn) the company will realise as Aetna is fully bedded into the overall company structure.

Going forward, if CVS can generate annual growth of just 3% it would be enough for the company to exceed $300bn in revenues by 2025 and with only single-digit percentage increase in operating margins generate cash flows perhaps as high as >$20bn – giving CVS a surprisingly high fair value valuation compared to its current market price.

We can compare CVS for example with a company in the same sector, United Health (UNH), to illustrate why I believe CVS is undervalued. UnitedHealth stock trades at $285 at the time of writing and has ~950m issued shares giving the company a market cap of $270bn, whilst CVS trades at $61 and has ~1.3bn shares giving it a market cap of $78bn.

United earned revenues of $242bn in 2019 compared to CVS’ $256bn and earned a net income of $14.2bn compared to the $6.6bn earned by CVS. In terms of free cash flow United’s stood at ~$17bn compared to CVS $11bn. United has a long term debt position of $37bn compared to CVS’ $65bn. United’s ROIC in 2019 was 13.8% compared to CVS’ 6%. United pays a dividend of $4.3 per annum whilst CVS pays $2.0.

Although the comparison favours United I would argue that it doesn’t justify United stock being priced nearly 6x more than CVS stock which scores reasonably well across all ratios. As such I think we can conclude that the market is significantly undervaluing CVS stock rather than overvaluing United.

Conclusion – CVS is a great stock to own and to hold with 3 complementary and growing business lines

Even if CVS were reliant upon its retail and pharmacy divisions alone I believe the company would still represent a buy owing to its expertise, dominant market position and data capture capabilities, but the Aetna acquisition has added a new dimension and made CVS an attractive growth stock operating in a high growth, lucrative market that is perfectly complementary to the other markets it operates within.

CVS stock had started to climb in late 2019 and had it not been for the coronavirus crisis I believe the ascent would have continued since CVS has every chance of being profitable again in 2020 whilst significantly reducing its leverage and growing at least 2 out of its 3 business divisions. The company hopes to generate ~$10.75bn of cash flows from operations and make ~$4.4bn available for debt repayment.

CVS performance vs company scorecard. Source: Investor Day presentation 2019.

As we can see above CVS has mapped out a path to progress supported by a growth strategy based on 4 key pillars of growth and differentiation, transformational products and services, modernised enterprise functions and capabilities and a consumer-centric technology infrastructure. As healthcare and technology become increasingly intertwined CVS – with its portfolio of assets – is well placed to benefit from remarkable long-term cost synergies and reductions brought about by significantly enhanced patient tracking and monitoring, which ought to result in more targeted services and wider operating margins. Other long-term catalysts include the aging US population and increased incidences of chronic disease.

At current price I believe a reasonable forward PE for CVS (for 2025) would be <5x and as such I expect the share price to rise. Analysts’ consensus 1 year price target is $79 but I would go a little higher than this and target somewhere around the $100, underpinned by a superior technology-enhanced understanding of customer needs, better quality of store (everything the customer needs and nothing they don’t), the addition of a health insurance arm and the strong cash flow generation of each of the business divisions.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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