CVS Health Stock – a poison pill?

The CVS stock has had its ups and downs in recent years. At its all-time high in mid-2015, the stock was worth USD 113.45 per share. Today, the stock is trading at only USD 75. Investors who bought at the top have been sitting on losses for several years now. Ever since the price drop in 2016, the stock has been trading sideways but has nevertheless been quite volatile. On several occasions, the price has broken out to the upside, only to completely give up those gains shortly after. As a result of this volatility, the individual return of a CVS investor has heavily depended on the timing of the investment. For example, those who bought at the bottom at the end of May 2019 achieved a total return of 50 percent to date. By contrast, those who bought just six months earlier at the end of November 2018 are sitting on a loss of 0.5 percent. Of course, these dates are arbitrarily chosen. Nevertheless, they illustrate the dilemma of selecting an unfavorable entry point in a volatile stock like CVS.

In this stock analysis, I will explain CVS’ business model and answer the question whether the CVS stock can be a lucrative investment despite the recent volatility.

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The business model: how CVS makes money

CVS Health stock
Logo
Country	USA
Industry	Healthcare
Isin	US1266501006
Market cap.	102.3 billion $
Stock Price	77.69 USD
Dividend yield	2.57%
Dividend stability	0.95 of max. 1.0
Earnings stability	0.72 of max. 1.0

CVS is a U.S. healthcare provider with a market capitalization of USD 97 billion and annual revenues of USD 269 billion. CVS operates more than 9,900 pharmacies (2020 Annual Report, page 2), as well as 1,100 outpatient clinics (2020 Annual Report, page 2). Furthermore, CVS is a so-called pharmacy benefits manager (PBM). A PBM negotiates drug prices with pharmaceutical companies to achieve lower prices for its customers. CVS divides its business into four segments: Pharmacy Services, Retail/LTC, Health Care Benefits, and Corporate/Other.

Pharmacy Services

This segment deals with the previously mentioned “Pharmacy Benefits Management”. In the US, many health insurance companies and employers use the services of a PBM. The customers of CVS include insurers and other private companies as well as government agencies. On behalf of its clients, CVS manages the administrative tasks that are associated with handling the prescription claims of customers. These include price negotiations with drug manufacturers, as well as the distribution of prescription drugs.

Retail/LTC

This segment includes CVS’ pharmacies and outpatient clinics. Revenue is generated from the sale of drugs and medical treatments. CVS also offers vaccinations against Covid-19 and other diseases.

Health Care Benefits

Although this segment existed prior to the acquisition, it now essentially consists of the acquired health insurance company Aetna. CVS offers health insurance with various benefits in this segment. An estimated 34 million people are the customers of this segment.

Corporate/Other

Under this segment, CVS groups all administrative activities, as well as existing contracts of old products which are now longer sold.

The Aetna acquisition

Aetna is a healthcare provider that sells health insurance and related products. In 2017, CVS announced its plans to acquire Aetna. The deal was ultimately closed in 2018. CVS paid about USD 70 billion for the company. About a third of the price was paid in stock, the remainder was paid in cash. In addition to the purchase price, CVS assumed USD 8 billion of Aetna’s debt, bringing the total purchase price to a total of USD 78 billion.

This acquisition was strategically important for CVS both as a way to achieve cost savings on synergies and as a way to grow revenues. At the time of the acquisition, Aetna had total revenues of USD 60.5 billion (page 88). Following the integration of Aetna, CVS now covers a wide range of the healthcare value chain.

How profitable is CVS?

For years, CVS has steadily grown its revenues until 2018 when the company had to report a loss as a result of a large impairment charge. In 2015, CVS acquired Omnicare, a pharmaceutical company specializing in nursing homes. In 2018, impairment tests came to the conclusion that the future prospects of the business were not as good as CVS had previously thought. This resulted in two impairment charges in the second and fourth quarter of USD 3.9 billion and USD 2.2 billion respectively (page 77f). This total charge of USD 6.1 billion ultimately resulted in a reported loss. However, since this was a one-time event, earnings recovered immediately in the following year. Furthermore, a write-down does not result in a cash outflow, which is why the operating cash flow was not affected in that year.

Earnings, cash flow, dividends and payout ratios of CVS

The integration of Aetna takes time and costs money, which is why profits have not yet recovered to their previous high in 2017. However, patient investors could be rewarded fairly soon, as analysts expect large increases in CVS’ earnings in the coming years. By 2024, earnings per share are expected to rise from the current USD 5.46 to USD 8.62 per share, which would represent a total earnings growth of 58 percent in just four years, or 12 percent per year.

Revenues increased sharply following the Aetna acquisition, from USD 195 billion in 2018 to USD 257 billion in 2019. Since the acquisition was not completed until late 2018, the additional revenue does not show up in the earnings of CVS until the following year. The operating margin, on the other hand, has trended downward over the years and currently sits at about 5 percent.

Revenues and operating margins of CVS

How safe is the dividend of CVS?

CVS pays its dividend in quarterly installments. For the entire year, shareholders currently receive a total of USD 2 per share, which translates into a yield of 2.6 percent. This is about half a percentage point below the 12-month average (3.1 percent) but half a percentage point higher than the 10-year average (2 percent).

Dividend History of CVS

A dividend yield of 2.6 percent is not extraordinarily high, but decent nonetheless. However, the dividend has not been increased for several years because the company is focusing on decreasing the debt it took on to finance the Aetna acquisition. Currently, CVS has USD 169 billion in debt, half of which is interest-bearing. CVS had to pay USD 2.9 billion in interest on this debt last year which is roughly 20 percent of the operating profit.

CVS’ debt has risen sharply following the Aetna acquisition in 2018.

Paying down the debt should not be a big issue. CVS generates large cash flow surpluses which have been rising in recent years. Last year, free cash flow came in at USD 13.4 billion, of which only USD 2.6 billion, or about 20 percent, was used for dividend payments. Furthermore, the payout ratio is very low at just 37 percent. With such a high surplus, paying down the debt and increasing the dividend further down the line seems easily possible.

Amortization power and cash reserves of CVS

The management has already stated that this year’s dividend will remain at USD 2 per share. I think the decision to keep the dividend flat until leverage has been reduced is the right choice. There is one silver lining: CVS has stated that it plans to meet its leverage target by the end of 2022 (page 8). I therefore expect dividend growth to resume in 2023 at the latest.

Outlook for 2021

For 2021, CVS expects revenues to increase between 3 and 4.5 percent. Earnings per share are expected to be in the range of USD 7.39 to USD 7.55 per share, which is a growth rate of 4 to 6 percent. On top of that, the company expects to realize an additional USD 1 billion in costs savings for the year.

Those earnings figures are based on the adjusted earnings, which you can also take a look at on Dividendstocks.cash.

Forecast for the adjusted earnings of CVS

As you can see, the analyst forecast on Dividendstocks.cash lies within the guidance of the company. The reason as to why the adjusted earnings are higher than the reported earnings is that the reported earnings are affected by one-time charges whereas the adjusted earnings are not.

At the current price of USD 75 per share, those earnings estimates translate into a forward P/E of 10, which is a very attractive valuation in my opinion.

Risks of the CVS stock

Just like any other stock, CVS is not risk-free. In my opinion, the two biggest risk factors are the debt as well as the political environment.

While the interest burden is fairly large, I don’t consider the debt to be a dangerous risk to CVS. The company has enough cash flow to easily service the debt. Nevertheless, an increase in borrowing costs (higher interest rates) would substantially increase the interest burden and therefore put pressure on the profit. Thankfully, a significant rise in interest rates seems unlikely at this point in time.

The other risk factor is the political climate in the US. Many people in the US are overburdened with the costs of healthcare. In a survey, 53 percent of participants stated that they had experienced financial hardship at least once due to high treatment costs, even though 90 percent of those people had health insurance. This issue is also talked about in politics. As a result, there is growing pressure on PBMs like CVS, as well as health insurers and drug manufacturers, to lower their prices. If legislation is passed to enforce this, it could negatively impact revenues of these companies.

Valuation

CVS currently trades at USD 75 per share and a P/E ratio of 14, slightly below its 10-year average of 15.

To value the stock, I used the dynamic stock valuation on Dividendstocks.cash and chose a 10-year timeframe. In my opinion, the fair values for the dividend yield, cash flow, and adjusted earnings are most suitable to value the CVS stock. I use the adjusted earnings to account for the large impairment charge in 2018. As a result, I get a fair value of USD 99, USD 110, and USD 96 for these ratios respectively. All of these metrics indicate that CVS is currently undervalued, trading at a discount of about 20 to 30 percent. This has not always been the case, as you can see in the chart below. From the early- to mid-2010s, the stock was trading well above its fair values.

The CVS stock in the dynamic stock valuation

The most likely reason as to why CVS currently trades at lower multiples than it did in the past, is that the company has a not kept up the growth rates it had in the early- to mid-2010s. As a result, the markets priced the stock at a lower valuation. This is short-sighted in my opinion. The Aetna integration is going well, cost savings are being realized and earnings are growing again. In my view, the current valuation does not fully reflect this changed outlook which gives investors the chance to acquire the stock at an attractive price.

Conclusion: CVS Health stock is being underestimated

Despite the price increase in recent months CVS is not overpriced. On the contrary, in my opinion, the growth potential from the Aetna acquisition has not yet been fully priced in. Fading Covid-19 costs, additional savings and synergies should ensure rising profits in the coming years. The stock has not yet reacted to this accordingly. In my view, a P/E of 14, and a forward P/E of 10, is very cheap for a company with a positive outlook and growth potential. I believe that the CVS stock currently offers a good entry opportunity for long-term investors. For this reason, CVS is the largest single position in my portfolio. For a long-term investment, the current volatility of the stock is less relevant. However, if you are unsure whether the rise of the last few months will be followed by another drop in the stock price, you can opt for a savings plan instead of a lump-sum investment. However, dividend investors should bring the necessary patience, as it will likely take a few years until the dividend of CVS returns to its growth rates of the past.