CVS Pharmacy Is Nearing Its 1-Year Low

(CVS Pharmacy, Image Source)

CVS (CVS, Financial) Pharmacy delivered its second quarter and first half fiscal year 2016 earnings results on Aug. 2.

For second-quarter earnings, the company delivered 17.6% sales growth to $43.7 billion and -27.4% profit growth to $924 million. For first-half earnings, CVS delivered 18.3% sales growth to $86.9 billion and -17% profit growth to $2 billion. CVS explained that it had lowered profits secondary to a loss on early extinguishment of debt and the company’s acquisition-related integration costs.

"I'm very pleased with our solid second quarter results across the enterprise. Operating profit in the Retail/LTC segment was in line with expectations while operating profit in the Pharmacy Services segment exceeded expectations. At the same time, we have generated substantial free cash flow year to date and continued to return significant value to our shareholders through dividends and share repurchases.

"With our differentiated value proposition, we see 2017 shaping up to be another very successful PBM selling season with substantial gross and net new business to date. Given our outperformance in the second quarter and confidence in our expectations for the back half of this year, we are raising and narrowing our adjusted EPS guidance and also raising our free cash flow guidance for 2016." –Â President and Chief Executive Officer Larry Merlo

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Notably, CVS paid more in the second quarter for its $15 billion debt-issuance related to the acquisitions of Omnicare and Target’s (TGT, Financial) pharmacies and clinics.

(Target Pharmacy Store, Image Source)

In May 2015, CVS acquired Omnicare for $10.4 billion. According to the Wall Street Journal, Omnicare operates in two business segments. First, Omnicare is the largest (at the time of acquisition) U.S. provider of prescription drugs to nursing homes and other housing facilities for elderly and disabled people. Second, the latter also handles and fulfills prescription orders for specialty drugs, such as cancer and multiple sclerosis.

In June 2015, CVS acquired Target’s pharmacy business for $1.9 billion. The acquisition involved 1,660 Target pharmacy stores. As of June 30, CVS grew its store count by 23% to 9,652 retail drugstores in 49 states, the District of Columbia, Puerto Rico and Brazil.

Despite the heavy reduction in profits CVS' shares closed just -0.64% to $97.43 per share that day.

(CVS Health, Google Finance)

In addition to the earnings release, the company also updated its fiscal year guidance. The company reduced its GAAP (generally accepted accounting principles) earnings per share by 6.7% to about $4.96 per share. CVS also increased its free cash flow estimates by 13% to $8.95 billion compared to fiscal year 2015.

Market performance

Year to date, CVS' total returns were inverse the returns of the broader Standard & Poor's 500. The pharmacy company provided a total return of -5.09% while the broader S&P 500 had given 5.71%. For the past five years, however, CVS outperformed the S&P 500 with 21.58% total return and 15.48% for the latter.

CVS Pharmacy

CVS, formerly called Consumer Value Stores, Pharmacy was founded 53 years ago in Lowell, Massachusetts. In its filing, CVS claimed to be the largest integrated pharmacy health care provider in the U.S. based on revenue and prescriptions filled. In addition to its retail drugstores, CVS had 1,100 walk-in medical clinics. The company also is a pharmacy benefit manager (1).

CVS Pharmacy operates three business segments: Pharmacy Services, Retail/LTC and Corporate.

Pharmacy Services segment

CVS’ Pharmacy Services segment (PSS) provides a full range of pharmacy benefit management services including mail-order pharmacy services, specialty pharmacy and infusion services, plan design and administration, formulary management and claims processing. In addition, through the company’s SilverScript Insurance Company (“SilverScript”) subsidiary, the PSS is a national provider of drug benefits to eligible beneficiaries under the federal government’s Medicare Part D program (2).

According to CVS, the PSS generates net revenue primarily by contracting with clients to provide prescription drugs to plan members. Prescription drugs are dispensed by mail-order pharmacies, specialty pharmacies and a national network of retail pharmacies.

Net revenue is also generated by providing additional services to clients, including administrative services such as claims processing and formulary management as well as health care-related services such as disease management.

CVS further dissects its Pharmacy Services segment into mail choice and pharmacy network segments (3)(4). In the past three years (fiscal 2013 to fiscal 2015), the pharmacy network segment contributed 74.6% to CVS’ Pharmacy Services segment. Observably, the segment has been growing steadily in recent years.

(CVS’ mail choice and pharmacy network sales, Tabulated Data from Annual and Quarterly Filings)

CVS went into further detail in its filings and reported its generic dispensing rate (5). Basically, as the pharmacy’s gross pharmacy expenditures decline, its dispensing rate improves.

(Generic Dispensing Rate, Tabulated Data from Annual and Quarterly Filings)

In contrast to the positive findings above, mail choice penetration rate (6) has been on a decline for the pharmacy giant.

(CVS’ mail choice penetration rate, Tabulated Data from Annual and Quarterly Filings)

Overall, the Pharmacy Services segment grew 13.5% in fiscal 2015 to $100.4 billion. In the first half of the year, the Pharmacy Services segment grew 20.6% to $58.3 billion. The segment also carried a three-year (fiscal 2013 to fiscal 2015) operating margin average of 4%.

Retail/LTC segment

In its filing, CVS’ Retail/LTC segment sells prescription drugs and a wide assortment of general merchandise, including over-the-counter drugs, beauty products and cosmetics, photo finishing, seasonal merchandise, greeting cards and convenience foods, through the company’s CVS Pharmacy ®, CVS ®, Longs Drugs ®, Navarro Discount Pharmacy ® and Drogaria Onofre TM retail stores and online through CVS.com®, Navarro.comTM and Onofre.com.br TM

In its filing, CVS further divided its Retail/LTC segment into prescription drugs (72.9% of fiscal 2015's total segment sales), over-the-counter and personal care (10.9%), beauty and cosmetics (4.5%) and general merchandise and other (11.7%).

(CVS’ Retail/LTC Same Store Sales, Tabulated Data from Annual and Quarterly Filings)

As can be observed in the graph above, CVS’ same-store sales demonstrated some form of growth consistency, hovering between 0.5% and 3%. According to CVS, its same-store sales and prescriptions exclude revenue from MinuteClinic®, and revenue and prescriptions from stores in Brazil, long-term care operations and commercialization services.

Overall, Retail/LTC grew 6.2% in fiscal 2015 to $72 billion. In the first half of 2016, the segment grew 17.3% to $40.1 billion. The segment also demonstrated an average three-year operating margin of 9.8%.

Sales and profits average

CVS had five-year average sales and profits of 9.7% and 8.85%.

Cash, debt and book value

As of June 30, CVS had total cash of $1.1 billion. The company also had $28.6 billion in debt with a debt-equity ratio of 0.82 times. CVS took in a good amount, $15 billion, in debt to finance its 2015 acquisitions.

Cash flow

(CVS’s Cash Flow, Annual Filing)

CVS has been able to grow its cash flow from operations in the past three years. From its cash flow of $8.4 billion, CVS allocated $2.4 billion in capital expenditures leaving it with $6 billion in free cash flow. CVS also allocated $11.5 billion in acquisition expenditures and $6.6 billion in net payouts (7). In the past three years, CVS allocated 110.2% of its free cash flow to shareholder net payouts on average.

CVS also took in $14.8 billion in debt while reducing it by $3.6 billion.

Valuations

According to GuruFocus data, CVS had a price-earnings (P/E) ratio of 21 times (industry median of 21), price-book (P/B) value of 2.8 times (industry median of 2.5) and price-sales ratio of 0.61 (industry median of 0.48). The company also has a trailing 12-month dividend yield of 1.78% with a payout ratio of 36%. CVS also had a share buyback ratio of 3.7%.

Conclusion

Overall, CVS Pharmacy has been a consistently growing pharmacy company giant. More importantly, the company is growing in terms of sales, profits and free cash flow. Accompanied by well-qualified management, this would mean the company would definitely be able to support its net payouts in the coming years.

Here is the tough question: Should investors begin buying CVS shares now?

Recently, I have been including two types of investors in my discussions: conservative and aggressive. I usually do not write about a company in which on face value I would not even consider investing. In CVS’ case and in my upcoming articles, it’s automatically a buy for aggressive investors unless otherwise stated.

I would basically define an aggressive investor as someone who would be willing to buy a company’s shares and lose 50% of it and still be willing to buy more shares until it reaches a target price. A conservative investor, on the other hand, would be someone who is afraid to see his/her portfolio in the red and would not be able to sleep at night due to this. Also, a conservative investor would be someone who would only invest in companies that would have ongoing dividend payouts and trades at below industry median average (using GuruFocus data).

In my first discussion about CVS Pharmacy in February, I arrived at a discounted cash flow (DCF) value of $68 per share. This would mean that CVS’ shares, despite their recent slump, are still trading at a good premium. The market is giving a good premium to CVS’ shares secondary to its wide moat in the pharmacy business. I also do not find any compelling reason to update this target despite its recent acquisitions. Also, CVS traded just at par compared to its industry.

(Read: Is CVS Pharmacy Undervalued?)

In the meantime, I would advise conservative investors to hold some cash until CVS’ shares go down further to $80 to $85 per share before accumulating. I know this would disregard my initial DCF calculation, but I do not really see CVS shares collapsing to under $68 per share unless there is a recession. That would be a good time to buy up some of the pharmacy company’s shares.

Using a simple earnings multiple with CVS’ five-year historical average of 19 times accompanied by its diluted earnings-per-share guidance, I arrived at a price target of $96 per share. Asking a 20% margin of safety would provide a $77 per share value.

In summary, I would mark CVS shares as a hold.

Notes

1. Wikipedia: A pharmacy benefit manager (PBM) is a third-party administrator (TPA) of prescription drug programs for commercial health plans, self-insured employer plans, Medicare Part D plans, the Federal Employees Health Benefits Program and state government employee plans. A PBM is primarily responsible for processing and paying prescription drug claims.
2. Wikipedia: Medicare Part D, also called the Medicare prescription drug benefit, is a U.S. federal program to subsidize the costs of prescription drugs and prescription drug insurance premiums for Medicare beneficiaries.
3. CVS filing: Mail choice is defined as claims filled at a Pharmacy Services mail facility, which includes specialty mail claims inclusive of Specialty Connect claims filled at retail as well as prescriptions filled at retail under the Maintenance Choice program.
4. CVS filing: Pharmacy network net revenues, claims processed and generic dispensing rates do not include Maintenance Choice, which are included within the mail choice category. Pharmacy network is defined as claims filled at retail and specialty pharmacies including our retail drugstores and long-term care pharmacies but excluding Maintenance Choice activity.
5. Journal of Managed Care Pharmacy: The generic dispensing ratio (GDR) – the number of generic fills divided by the total number of prescriptions – is a standard performance metric on which pharmacy benefit designs and their managers are routinely evaluated. Higher GDRs are considered important because they consistently produce lower prescription drug costs.
6. Drug Channel:Â Discussed by Dr. Adam J. Fein in 2012, he observed that there was an ongoing overall decline in the mail penetration rate across different PBMs. He stated four factors that may have contributed to the decline in the rates: 1. Mail's economic advantage is diminishing; 2. The generic price war is heating up; 3. Part D is about 20% of the market; and 4. Maintenance Choice is booming.
7. Own: sum of shareholder buyback amount and dividend payout.

Disclosure: I am long CVS.

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