New Position – CVS

On Friday, I bought 50 shares of CVS at $82.225/ share for a total purchase price of $4,119.20.

This was a timely buy, as a day earlier I had a bad thumb infection, and had to pickup the antibiotic at a CVS.

Divine providence perhaps?

In this post I’d like to explore why I think CVS is a compelling investment here, despite some political uncertainty and competitive concerns.

About CVS

CVS owns over 9,600 retail pharmacies, 1,100 medical centers and is a leading pharmacy benefits manager (PBM) with over 80 million plan members.

CVS is comprised of two segments – Retail/ LTC (Long term care) and the pharmacy services segment.

Retail/ LTC

Retail makes it’s money by selling all the things you see when you walk in a CVS store, like OTC drugs, convenience foods, greeting cards, and overpriced toys. The majority of the revenues in this segment are earned through the sale of prescription drugs, which are dispensed by their more than 30,000 pharmacists.

They have stores located in 49 states, the District of Columbia, Puerto Rico and Brazil operating primarily under the CVS Pharmacy, CVS, Longs Drugs, Navarro Discount Pharmacy, and Drogaria Onofre names, 32 onsite pharmacies primarily operating under the CarePlus CVS Pharmacy, CarePlus and CVS Pharmacy names, and 1,136 retail health care clinics operating under the MinuteClinic name (of which 1,129 were located in CVS Pharmacy stores, as well as clinics located within Target stores), and online retail websites, CVS.com, Navarro.com and Onofre.com.br.

LTC operates under the Omnicare and Neighborcare names. While most people are familiar with the retail side of CVS, most don’t know that in fact there are pharmacies that distribute medications primarily to SNFs (Skilled Nursing Facilities) and ALFs (Assisted living facilities). Needless to say, with the aging of the population, this is a meaningful trend that should benefit LTC providers. CVS bought Omnicare in 2015 for $12.7 Bn which it funded primarily through cash payments and assuming $2.3 billion in debt. In exchange they received additional market share to dispense prescription in assisted living and LTC facilities.

CVS’s retail/LTC segment accounts for 47% of total company revenue, but with its nearly 10% operating margin, this segment produces 64% of the company’s overall profits.

PBM

What is a PBM?

PBMs handle payment of pharmacy benefits at point of sale, a sort of middleman between manufacturers and end users. They manage costs through a formulary, which is the exclusive list of products that they sell.

PBMs lower the overall cost of healthcare for consumers, and benefit from doing so. By way of example Express Scripts negotiated a deal with Abbvie to sell exclusively their inferior but cheaper Vikera Pak for Hep C, which led to a domino effect of causing Gilead to lower the cost of their Hep C drug for access,

Drug industry price rivalries remain fierce, and PBMs serve to pit companies against each others, which helps to lower prices, which is a benefit to the end consumer, and as a benefit to CVS, PBM’s keep about 10% of the profit they negotiate down for themselves.

The Investment Thesis

While CVS is generally categorized in the consumer staples sector (XLF), 85% of their revenue is healthcare related.

Aside from the loss of contracts to Walgreens,  companies and consumer staples performed rather poorly in 2016. The lack of momentum in these sectors simply becomes the contrarian’s opportunity.

Now CVS’ share price – while a nice outperformer to the S&P for the past 5 years – has lost 25% of its value since May, in large part to news of loss of major contracts to Walgreen Boots Alliance. This period of underperformance has pulled its valuation down significantly, and currently trades at a 30% discount to Walgreens.

So is this an opportunity, or a continuing sign of things to come?

Part of the problem with the healthcare sector and why it’s underperformed for the past year has been political uncertainty.  If there’s one thing we can see investors don’t like it’s uncertainty, and so this has led to a lot of opportunities across the board in the healthcare space. Still it appears that the loss of Obamacare and impact on the insured base is somewhat overblown, and any losses should be mitigated somewhat by a more favorable tax treatment by the new Trump administration.

With regards to Walgreens eating their lunch, the loss of contracts would appear to be a short term miss, which may have taken them unawares at first, but should be rectified by management in 2017.

In other words, it appears that the winds are shifting in a favorable direction for them. As CVS itself says when talking about their growth drivers:

Industry tailwinds that will increase demand for prescriptions include the aging population, healthcare reform and rising specialty drug introductions and utilization. We are uniquely positioned to capture an outsized share of this growth through our various enterprise channels and competitive advantages,

Let’s talk dividends and capital allocation strategy.

From the dividend investor’s point of view, it’s important to look at the company’s plans on how they plan to allocate capital, how much they will pay out to shareholders, and how sustainable the dividend will be, as a function of the organic cash flow they generate..

Currently free cash flow yield is over 7% on the basis of its current market capitalization. Based on it’s ample cash flow, CVS’ current dividend accounts for less than 1/3rd of cash flow generated. This will ensure the opportunity for growth in the dividend for years to come.

CVS plans to allocate capital as follows:

  1. Investing in high return, value enhancing projects (ie. company growth)
  2. Increasing the dividend to reach a payout goal of 35% in 2018
  3. Share repurchases that will total $4-$5 Bn annually

This sound capital allocation strategy and secular industry tailwinds should lead to outsized returns over the coming years.

Finally, management is projecting the following targets through 2018:

  • Net revenue growth = 8-13%
  • Operating profit growth = 7-9%
  • EPS growth = 10-14%
  • Average annual cash for shareholder value = $8Bn

The Risks

Any investment has risks. The primary risks to look out for here include the retail store expense base, political developments, and competitive threats from the larger Walgreens Boots Alliance (WBA).

One main problem plaguing CVS is their retail expense base, just meaning the expenses that it costs to run each store. In order to be profitable, CVS has to run a lot of prescriptions through their stores, and every prescription filled above the amount that it costs to run the store is just pure profit. Thus prescription volume has a large impact of their overall profitability. Efforts that reduce prescription drug costs and pharmacy reimbursement rates could impact long term profitability.

Secondly, Trump has promised to repeal Obamacare in the first day of office, with Republicans saying they’ll figure out what it will be replaced with in the first year, with a phase out by 2018. The promise (and reality) of a larger pool of insured Americans has helped CVS’s growth rates since 2014. A slowing down or even retraction of those trends would be a negative for CVS and its competitors.

We also see competitive pressures from Walgreens. in Oct 2016 it was announced that CVS had been pushed out of the Tricare pharmacy network by Walgreen Boots Alliance, which was a major blow to the firm, given that it was a benefits program with over 9.4 million beneficiaries. However, the way in which the PBM business grows is by stealing market share, so while still a large loss, is rather immaterial based on the size of their overall business, and one should expect to see some ebb and flow with this type of competitive activity in the future in any case.

Valuation

CVS sports a below market multiple of 14x this year’s earnings which is attractive given the frothy level of the market.

Based on a DCF analysis, CVS is worth approximately $103 per share with a fair value range of $82.00 – $124. This model reflects a compound annual revenue growth rate of 7.9% during the next five years, a pace that is higher than the firm’s 3- year historical compound annual growth rate of 7.6%. The model reflects a 5-year projected average operating margin of 6.9%, which is above CVS trailing 3-year average. Beyond year 5, it is assumed free cash flow will grow at an annual rate of 3.3% for the next 15 years and 3% in perpetuity. For CVS, a 9.3% weighted average cost of capital is used to discount future free cash flows. (Valuentum)

Conclusion

I think that CVS has all the makings of a value in a market where value is hard to come by. A dominant #1 or #2 position in almost every area in which they compete, massive scale, and gobs of free cash flow in a recession proof market, that trades at a discount to the market. While anything can happen in the short term, it would seem that at today’s valuation now would be a compelling time to start building a position, if you haven’t already started doing so.

Based on a dividend yield of 2.43%, this purchase will add an additional $100 to my forward annual income.

So what say you? Do you like CVS or not? 

Thanks for stopping by.

4 Comments

  1. Dividend Producer January 8, 2017
    • Greg Gee January 8, 2017
  2. Jay January 8, 2017
    • Greg Gee January 8, 2017

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