CVS Health: A Bargain Long-Term Opportunity (NYSE:CVS)

Investment Thesis

Over the past five years, the shares of CVS Health Corporation (NYSE:CVS) have not changed much. I believe this is not likely to last long as valuation suggests that the shares are considerably undervalued amid present risks and offer a great upside and seemingly limited downside potential.

Corporate profile

CVS Health is a leading American healthcare company with a diverse range of services encompassing pharmacy, healthcare benefits management, retail pharmacies, and healthcare clinics. With its headquarters in Woonsocket, Rhode Island, CVS Health has established a prominent presence in the healthcare industry, serving millions of customers across the United States. The company operates one of the largest pharmacy retail chains, providing prescription drugs, over-the-counter medications, and various health and wellness products. The company differentiates two major product groups as follows:

Relative healthcare sector undervaluation

In the broader market context, healthcare stocks seem inexpensive compared to other sectors. Over the last 30 years, the healthcare sector has been in an upward channel with peaks and bottoms in certain years. And 2023 appears to be the year when healthcare stocks are historically cheap relative to the S&P 500. Moreover, some subindices within the healthcare sector are trading at even more suppressed levels. For example, the Nasdaq Biotechnology index, which includes larger and established businesses, currently has a price-to-sales multiple of approximately 5.5 times, down from nearly 13 times at the last peak in 2015. Sentiment and cyclicality can be seen as factors behind this undervaluation as investors have favored predominantly tech stocks in recent years and there have not been many new developments driving the healthcare sector to the forefront. One can notice that healthcare got pricier, especially during post-correction, recessionary, environments which have not occurred frequently in the recent past.

Financial analysis

From the financial statements’ perspective, the company has a sustainable level of debt but quite low profitability, which has deteriorated over the past couple of years. I believe this could be the key concern why the share price is now historically at relatively low levels. Borderline liquidity (current ratio below 1) could be another reason. New drug and treatment discoveries could help to reverse these trends as medicaments are generally more expensive during their patent period and after some time become widely available.

As you can see in the following chart, CVS Health’s profitability currently belongs to the bottom of its peer group, yet in positive territory:

Key insights from the latest quarterly earnings call

During the latest quarterly earnings call, the company management sounded optimistic about the company’s future prospects but highlighted some headwinds to remain in 2024.

As we look forward into 2024, we obviously have the headwinds of the partial termination of Centene, and obviously we’re working close with the orderly transition of both the Medicare and Medicaid lines of business. As a result of Centene, our health plan business will be down year-over-year as we continue to focus on pricing discipline for both prospective customers and renewing our in-force customers. – David Joyner – President, Pharmacy Services

I’d really like to point out, Oak Street has been very successful across programs with different risk-adjusted methodologies. We were part of the Medicare shared savings program and we were a top 1% performer in that. We are the top performer in the ACO REACH program. We’re pretty confident in our ability to keep generating great results going forward. – Mike Pykosz – Chief Executive Officer, Oak Street Health

Valuation

Through the lenses of F.A.S.T. Graphs forecasting calculator, the company’s growth outlook appears very bullish. Should the company’s shares trade at more or less the same price-earnings multiple (7.5x) five years from now and CVS Health’s operating earnings expand at an annualized growth rate of around 7 percent, the shares’ fair price implies 9 percent annualized upside potential. And this is likely to be the worst-case scenario as the price-earnings ratio could expand and shares have more than 30 percent annualized upside potential (PE 22x).

DCF analysis

Plugging in CVS Health’s financial statement figures into my DCF template, the company’s shares show to be significantly undervalued. Under the perpetuity growth method with a terminal growth rate of 2 percent, 10 percent annual revenue growth over the next five years, and a stable operating income margin of 5 percent assumption, the model’s estimate of the intrinsic value of the stock comes at 286 USD. Under the EBITDA multiple approach of a discounted cash flow model, the intrinsic value per share of the company stands roughly at 276 USD if we assume that the appropriate exit EV/EBITDA multiple in five years’ time is around 10x.

Key risks

Investing in CVS Health shares carries several key risks that investors should be aware of. One significant risk is the company’s exposure to regulatory changes in the healthcare industry. As a major player in the healthcare sector, CVS Health is heavily influenced by government policies, reimbursement rates, and healthcare legislation. Any adverse changes in these areas could further impact the company’s profitability and growth prospects. Additionally, the retail pharmacy industry is highly competitive, with CVS Health facing competition from both traditional pharmacies and online retailers. This could put the company’s profit margins under pressure. The ongoing trend of consumers seeking convenience through online prescription services poses a threat to CVS Health’s retail business. Lastly, the company’s debt resulting primarily from acquiring Aetna in 2018 could increase its vulnerability to rising interest rates.

The bottom line

To sum up, CVS Health Corp has a very healthy revenue growth for a mature company and despite little struggles with business efficiency, the company’s concept seems to remain robust going forward. The company’s shares currently trade at an extraordinarily low price-earnings multiple, making it a bargain. Overall, I believe CVS Health’s strategic positioning, topline growth prospects, and commitment to healthcare innovation make it an intriguing long-term opportunity that should belong to every long-run equity portfolio.