CVS Health Corp. (CVS, Financial) has been distributing health, beauty and pharmaceutical products for a long time, having opened its first retail store in 1963.
The CVS chain grew to 40 outlets by 1969, the year it sold the business to Melville Shoes. Melville then restructured in the early 1990s, spinning off CVS and other retail units into a handful of separate organizations. The spinoff of CVS proved to be a fantastic decision. It now represents the largest pharmacy health care provider in the U.S., an enormous accomplishment.
CVS recently changed its name from “CVS Caremark” to “CVS Health.” Its flagship Retail Pharmacy domestic drugstore chain now operates more than 9,000 retail and specialty pharmacy stores over 40 states, the District of Columbia and Brazil. The company holds the leading market share in 89 of the 100 largest U.S. drugstore markets, more than any other retail drugstore chain.
Over time, CVS has broadened its market exposure through organic growth as well as through a series of acquisitions, including the purchases of Osco, Sav-On, Eckerd and Longs Drugs. It is worth noting that it was CVS’ purchase of Longs Drugs in 2008 that boosted its total market share position above that of Walgreens (WBA, Financial), CVS’ leading competitor.
CVS’ operating network is broadly scattered through a series of strip shopping centers and free-standing locations, with typical store size ranging from 8,000 to 13,000 square feet. Most new units being built are “Mega-Stores” based on a 10,000- to 12,000-square-foot layout that typically includes a grocery section as well as capacity for drive-through pharmacies.
CVS now has a proprietary branded product portfolio consisting of over 5,300 products, which account for roughly 20% of company sales. CVS fills or manages 1.9 billion prescriptions each year and has captured 39% of prescription growth over the past five years. Approximately 40% of company sales are derived from retail pharmacy sales (prescription, general merchandise, over-the-counter personal care and beauty and cosmetic product sales). This is usually the company’s most profitable product line. CVS also operates five mail-order pharmacies.
CVS is also a manager of pharmacy benefits. Specifically, it acts as the middleman between pharmaceutical companies and individuals with drug benefit coverage. The core component of these operations include some 65,000 pharmacy outlets in hospitals and clinics as well as in retail stores. This is a lower-margin business line with gross profits of only about 5% of revenues versus 30% for the Retail Pharmacy business.
Part of the Retail Pharmacy segment, the company offers a “MinuteClinic” service. This is a service consisting of 1,100 locations where the company’s nurse practitioners and physician assistants diagnose and treat minor health conditions, perform health screenings, monitor chronic conditions, provide wellness services and deliver vaccinations. The company continues to open MinuteClinic locations, most of which are located in CVS stores, helping to drive foot traffic. Plans are to grow MinuteClinic into 1,500 locations in 35 states by 2017, and the service now has more than 50 major health affiliations – up from 30 just a few years ago. The concept is slowly gaining momentum.
CVS also offers its “Corarm” business, which is one of the country’s largest providers of comprehensive infusion services. It cares for 140,000 patients annually through a national network of more than 85 locations as well as the largest home infusion network in the U.S.
2016 financial highlights
In 2016, CVS benefited from ongoing efforts to increase shareholder value through increased productivity gains, strong sales growth, significant free cash flow generation and positive capital restructurings.
Net revenues for the year increased 16% to a record $177 billion while earnings per share (EPS) rose 6% to $4.90. The compound annual growth rate in operating profit and adjusted EPS puts it at the high end of management’s long-term earnings guidance.
CVS experienced strong organic prescription growth in 2016, boosted by its Omnicare (OMN, Financial) and Target (TGT, Financial) acquisitions. Moreover, the successful CVS Caremark selling season led to growth in its membership base and claims in 2016. That said, management does expect to experience some headwinds in the near term that will slow earnings growth in 2017, driven primarily by pharmacy network changes announced late in 2016 that are causing some retail prescriptions to migrate out of its pharmacies.
Additionally, there remains continued uncertainty regarding health care reform and what a Trump presidency means for the industry. It is for these reasons, combined with increased short selling and downward negative momentum, that CVS' stock price suffered a 20% decline in 2016. Management does not view the stock decline as being reflective of its strength in the industry and will continue to implement initiatives to grow its customer base and boost its earnings growth in the years ahead.
All considered, CVS maintains tremendous cash-generating ability with operating cash flows of $6.78 per share and free cash flow of $7.27 per share. Free cash flow totaled $7.8 billion in 2016, and it returned over $6 billion in cash to shareholders through dividends and share repurchases during the year. After increasing its quarterly dividend by 21% in 2016, its board of directors has approved an additional 18% increase for 2017. That marks its 14th consecutive year of increasing the dividend. CVS also plans to continue to repurchase shares, taking advantage of the recent decline in its stock price. Through dividends and share repurchases, CVS expects to allocate more than $7 billion in 2017 to enhancing total returns for shareholders.
Purchase considerations
One thing we really like about CVS is that it is the market leader and holds a huge share of a very large industry. A second thing we really like is that it is very well diversified across a variety of product/service lines. What’s more, the company seems well placed to benefit from its multiple positions across the value chain, from benefits management to pharmaceutical distribution to onsite, at home and after-care services.
This, of course, all comes on top of a very favorable demographic megatrend –Â the aging population. Combined with higher aggregate income levels among seniors, patients are becoming increasingly willing to pay more for convenience. This will bode very well for CVS. We expect that it will continue to produce stellar financials. Moderate and steady gains year over year have turned into plenty of returns for shareholders both in the form of cash dividends, steady and large share buybacks and share price appreciation.
Over the long term we think this trend will continue.
Estimating sales growth
When assessing the competitive strength and investment merit of any firm, the first thing we like to do is to look at what’s going on with sales – that’s really the first level of inquiry that any investor should undertake. Ideally, we are looking to invest in companies whose sales are strong, consistent and are generally growing faster than nominal gross domestic product (GDP) growth (that is, real GDP growth and inflation combined).
Based on CVS’ historical sales data, you can see that things have been quite impressive. The 10-year sales growth has been 15.0% per year. This compares to nominal GDP growth of 3.3% per year over the same period. In 2010, CVS' sales dropped minimally due to changing health care pricing regulations. Since this decline, and starting in 2011, sales have grown at a significant pace due primarily to the massive surge in demand for pharmaceuticals and health care services.
Overall the company is on solid ground and retains substanital pricing power. We feel comfortable saying you can invest in this company if you're looking for steady sales. CVS’ sales growth has been 10.6% per year over the last five years and 11.9% per year over the last three years. CVS' three-year revenue growth is actually ranked higher than 75.0% of the 20 companies in the Global Health Care Plans Industry. Sales will continue to grow at a steady pace of approximately 5% per year over the next few years; continue to expect good and predictable things from this company in the future.
Figure 1: Revenues ($ millions) and revenue growth (%)
The second thing we like to do when assessing sales is to look at consensus market estimates. As reported in Yahoo Finance, the market is projecting 3.8% annual growth for this year and 5.9% for next year. These estimates are drawn from the projections of 21 analysts. The sales estimate is $184 billion for 2017, which compares to the year-ago estimate of $178 billion. Note that the market is expecting 5.9% growth for next year, which would imply total sales of $195 billion.
A third thing we like to do when assessing sales is to compute the firm's sustainable growth rate. The sustainable growth rate reflects the rate of growth in sales that a firm can support given its existing earnings power, capital resources and dividend payout policy. In any given year, a firm's sustainable growth rate is calculated by multiplying its return on equity (ROE) by its retention rate. Rather than rely on data from only one year, we calculate sustainable growth by using the firm's three-year average ROE and three-year average retention rate. CVS' ROE averaged 13.5% over the last three years while its retention rate averaged 69.1%, giving the firm a sustainable growth rate of 9.3% per year.
Let's recap briefly what the sales data is showing us. From what we can tell, it is not unreasonable to estimate that sales over the next five years could grow at a rate of up to 15%.
Table 1: Choices for possible growth rates
We're going to select a rate of 5.3%. With $178 billion in sales generated last year, this means that sales will continue to grow in the future and will reach about $230 billion in five years. This estimate reflects our understanding of the firm's historical results, market demand, population growth, pricing trends, aging patterns and income levels.
Estimating earnings per share
Now that we have generated our sales estimates, we’re going to estimate growth in EPS. This method applied below takes the sales growth projection – in this case, 5.3% per year – and subtracts the expenses and taxes. What we're left with are the earnings. Then we divide by the projected number of diluted shares outstanding to determine the EPS (see table below).
A projected growth rate of 5.3% will result in almost $230 billion in sales five years out. Now we need to take a look at the firm's pretax profit margin (what’s left over after expenses but before taxes are subtracted). In Figure 2 below, we can see that CVS produces some pretty stable margins – 5.9% in 2013, 5.5% in 2014, 5.6% in 2015 and 4.9% in 2016. The average for the last five years has been 5.4% and the average for the last 10 years has been 5.6%. CVS' margins will normalize at its medium-term mean of 5.0%. At this rate, projected pretax profits on $230 billion in sales would be just over $11.5 billion. This means expenses would amount to $218 billion.
Figure 2: Pretax profit margins (%)
The next step in our estimation process is to establish what tax rate will be paid on the company's profits. The most recent year’s rate was 38.4%. Normally we wouldn't play with that number too significantly because in general, it shouldn't change very much from year to year. The only time we would make major changes to this number would be in instances where maybe the current rate differed significantly from that of the past or if we had some knowledge about what rate was likely going to persist in the future, perhaps because the company is going to get some preferential tax treatment on operations abroad.
For CVS over the last 10 years, the company's tax rate has been as low as 37.3% and as high as 39.6%. Tax rates for most U.S. companies will fluctuate between 35% and 40%. We're going to select a rate of 39.0%, representing the average rate of the last 10 years, excluding the influence of nonrepresentative years. This would result in a tax expense of $4.5 billion from pretax profits of $11.5 billion in five years, leaving us with $7 billion in projected earnings five years from now.
Our next main consideration is a matter of determining the number diluted shares that will be outstanding in five years. CVS has decreased the number of shares outstanding over the last decade. There were 1.4 billion shares outstanding in 2007, then the number of shares went down to 1.3 billion in 2011 and then fell to 1.1 billion in 2016. Currently there are 1.1 billion shares outstanding. This data suggests that the company has been redeeming about 29 million shares per year. We're going to rely on the company's historical share repurchase activities to guide our estimation process but will be more conservative as we think equity issuances might be required to continue to support acquisitions. As such, we project share repurchases of 10 million per year over the next five years.
With shares estimated at 1 billion in five years, EPS is expected to rise at a compound rate of 6.8% over the period. This is higher than our projected five-year revenue growth rate and reflects primarily its declining equity-base. Note that it doesn't always work out this way. Based on this EPS growth forecast, we are expecting EPS of $6.81 five years out. Results of our forecasting procedure are summarized in the table below.
Table 2: Path from projected sales to projected earnings
Forecasting a target P/E multiple
Now we need to take a look at the price history of the company's stock. From Figure 3, we can see that the spread between the high and low stock prices has increased significantly over the last 10 years. We have a current price of $82.17 with a high in the past 10 years of $113.45 and a low of about $41.46. We want to keep this variability in mind when establishing our upper and lower valuation range. Specifically, given the firm's historical stock price behavior, we should expect the stock to fluctuate by at least $21.78 over the course of a year.
Figure 3: Stock price history: close, high, low
CVS’ stock has traded at a moderately volatile price-earnings (P/E) multiple over the last decade, averaging 17.3 over the last 10 years, 19.3 over the last five years and 20.5 over the last three years. Currently the firm is trading at 16.7 times trailing 12-month earnings per share and 13.7 times expected future earnings.
For determining an estimated target P/E multiple, the first thing we like to do is eliminate any outliers from the historical data series. This includes abnormal P/Es that are not reflective of the normal operations of the firm, and this could be the result of abnormal growth or significant one-time nonrecurring charges/gains. In the case of CVS, we are going to leave the historical series intact.
The next thing we like to do is to run an optimization procedure that reveals which P/E multiple yielded the best forecasting accuracy over the evaluation period. If this multiple continues to accurately portray the earnings and cash-generating power of the company as well as the growth and risk characteristics of the firm, then we will use this multiple as our target multiple. If not, we will adjust the multiple upward or downward accordingly.
The figure below presents the historical P/E profile for CVS. We will utilize a target P/E multiple of 18.0x that reasonably characterizes the risk-return attributes of the stock. This multiple represents an expansion of 7.8% relative to the current multiple. It also represents a contraction of -12.3%, a contraction of -6.9% and an expansion of 4.0% relative to the three-year, five-year and 10-year average P/E multiples.
Figure 4: Historical P/E multiple and target point of reversion
Setting a target price and valuation range
We selected a target P/E multiple of 18.0x. To determine a price target five years out, we then multiply this by our EPS estimate. EPS are estimated to reach $6.81 in five years giving us a target price of $122.51. This price is higher than its current price and is more in line with where it traded in 2015. Nonetheless, to properly judge the extent to which the stock may be under or overvalued, we need to determine a fair-value range within which we expect the stock to trade.
To do this we rely on the trend-adjusted average annual trading range for the stock, which from the analysis above we know is $21.78. This means that, given our target price estimate, we expect the stock to trade naturally, and fairly, between $111.62 and $133.40. The result of this is that when the stock is trading below $111.62 it is in the Buy Zone and when the stock trades above $133.40 it is in the Sell Zone. Currently the stock is in the Buy Zone.
Conclusion
So what return can we expect for holding CVS' stock? Well, we now know we can expect stock price appreciation of 49.1%. We can also expect to earn dividend income of about $8.50 over the evaluation period. Added to our price estimate, this means we could earn a compound annual rate of return of 9.8%, provided our estimates prove accurate. All in all, we are happy with this company and think it offers acceptable return potential to qualify for investment. We recommend buying the stock at current valuation levels or following a further decline. The business' competitive advantage remains intact and is well positioned for future growth as demographics shift in CVS’ favor.
That said, investors must be aware that the company's prospects could change dramatically if political forces undermine industry pricing.
Disclosure: We recently entered into a long position in CVS.
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