Spencer Platt
Comments on our last coverage of the stock
In our last coverage of CVS Health (NYSE:CVS) on February 3, 2020, we emphasized the economic moat of the company with a special focus on its acquisitions, brick-and-mortar store improvements, and its e-commerce offering. Back then the company had acquired Omnicare, Target Pharmacy, and Aetna. The company had also started adding HealthHubs to their brick-and-mortar stores. CVS Health now has 968 HealthHubs across the U.S. providing care for chronic conditions and mental care among others. We also lifted upcoming cost savings for CVS Health from Aetna, enterprise modernization involving technological enhancements, and productivity improvement with target cost savings of $1.5-2 billion in 2022 and beyond.
CVS Health, a health-centric empire
CVS Health has helped America surpass the COVID-19 pandemic by ramping up vaccinations and anti-viral treatments for the population. The company now stands even stronger with ample cash reserves to finance future growth and secure continued dividend payouts in our view. There hasn’t been one dividend cut in the past 30 years and the dividend yield is now near all-time highs posing a significant opportunity to buy in.
CVS Health offers so much more than just a retail pharmacy. CVS Health has successfully built what we would like to call a health-centric empire with operations spanning from retail to insurance, to health care, making it a well-diversified business. For each strategic acquisition the company completes it builds on its economic moat, with a more holistic offering where consumers can find it all under one umbrella. And we believe that CVS Health will continue on this path.
“As one of the most trusted brands in the nation, our deep relationships with more than 100 million members give us a distinct advantage. Centering our work around consumers at an unequaled scale enables us to drive deeper penetration of our health products and services and meet their everyday health needs. We are dramatically reshaping how they experience care, with a unique blend of consumer, health care, and risk management expertise all within one company.”
The above statement from CVS Health reiterates our view that the company can, should, and will continue to use its size, resources, and reputation to expand by acquisitions because it has the prerequisites to scale any health-related business it acquires.
CVS continues to catch the opportunity
For instance, did you know that about 85% of Americans have to travel less than 10 miles to their nearest CVS Pharmacy and that nearly five million daily customers visit their retail pharmacies? It’s then easy to understand that there are major synergies to be gained by expanding their business. We believe CVS Health to be the best pharmacy stock out there, much because they were so early to act on those synergies by combining retail pharmacy with health services.
Back in 2006, CVS Health acquired MinuteClinic, which was the start of CVS Health’s in-store healthcare concept. The company now offers retail healthcare services with both in-store MinuteClinics and Health Hubs. Apart from apparent synergies, this step significantly helped CVS Health to differentiate its retail business from online competitors such as Amazon (AMZN) and allowed the company to strengthen its economic moat.
Most recently CVS Health acquired Signify Health, Inc. for $8 billion. Signify Health offers house call visits by doctors and other clinicians to their patients and currently has a network of more than 10,000 clinicians to provide house call visits. The acquisition will strengthen CVS Health’s ability to connect with individuals in the home substantially, improving patient engagement, outcomes, and care coordination. And once again, it’s clear that synergies are a driving force here with CVS officials saying that CVS is hoping to incorporate CVS’ clinics, pharmacies, and other assets for these patients.
We expect Signify to bring in close to $1 billion in revenues to CVS Health in 2023 but that’s not what’s important here. CVS Health has nearly $350 billion in revenues TTM and as such Signify revenues represent not even one-half of a percent of total revenues. What’s more interesting is the 2.5 million patients using the platform. Signify may generate major spillovers to CVS’s retail business while gaining a strong prospect for future growth as we believe house call visits by clinicians have the future in hand.
Our take on Cordavis
And finally, with Cordavis CVS Health takes the step into true vertical diversification, which is an important milestone for the company, having in mind those tight profit margins retail pharmacies are working with. Cordavis is a wholly-owned subsidiary that will collaborate with pharmaceutical manufacturers in the development, production, and commercialization of FDA-approved biosimilars. Although further acquisitions may be coming, we shouldn’t underestimate Cordavis. It has the opportunity to grow organically as it partners with leading manufacturers. We expect this initiative to prove very helpful for CVS Health’s retail business.
Digital Innovation to push back rivals like Amazon Pharmacy
CVS Health also remains at the forefront of digital innovation, adding digital tools to brick-and-mortar shopping, expanding their e-commerce offering (for instance with a buy-online, pickup in-store fulfillment option), and improving access to health care with their digital-first health care offering, CVS Health Virtual Care. We believe that the company’s digital innovation is key to pushing back competition from upcoming online rivals like Amazon Pharmacy. Apart from pure e-commerce, CVS Health has the opportunity to link online shopping to both its brick-and-mortar shops and its health care offering, delivering a more holistic and value-added customer experience. That’s what we call an economic moat.
Financials
Furthermore, CVS Health is a financially sound company with little to wish for. They continue to deliver strong operating cash flows and have ample cash reserves of $13 billion as of Q3 2023 to finance future growth. Furthermore, their long-term debt ratio is relatively low, at 78%, especially considering the Aetna acquisition in 2018 which cost the company roughly $70 billion, and the company has repaid more than $10 billion in long-term debt since the close of the Aetna acquisition. Indeed, we expect the company to continue to invest in future growth, most likely by acquisitions in the healthcare sphere, but also by expanding the reach of their recent acquisitions. Both Signify Health and the Oak Street Health subsidiaries are highly scalable businesses for the right owner, and the healthcare segment offers good margins as well. Hence, we expect CVS Health to utilize its resources and influence to scale the businesses of these two subsidiaries significantly.
Risk
Lately, operating margins has decreased for CVS Health, from 5.10% in 2020 to 4.05% TTM. This is likely due to lower margins from the retail business, with a pressure on pharmacy reimbursement from prescription drugs. Tight competition, not the least from e-commerce, including giants like Amazon Pharmacy, continues to pose a threat to CVS Health’s retail business and margins in retail may remain low in the future. But as long as revenues continues to grow it should be all fine. CVS Health’s most recent acquisitions in the health care segment offer a great growth opportunity in our view.
Valuation
For valuation purposes, we will use a slightly modified Ben Graham Formula. The original formula did not adjust the intrinsic value to the alternative cost of not holding “risk-free” bonds, but we do that by using the current yield of a 10-year treasury bond.
Our view on CVS Health’s EPS Growth
On the cost side of the retail business, CVS Health does struggle with pharmacy reimbursement pressure, which is the dollar amount that pharmacies ultimately get paid by the insurance companies for prescription drugs. Due to tight competition in retail, this issue remains but will most likely have a lesser impact on earnings as we move forward, as indicated by the company’s Q3 2023 results. Based on strong revenue growth we do expect earnings for this segment to experience positive growth in 2024.
Furthermore, increased utilization of Medicare is putting pressure on earnings for the Health Care Benefits segment, but again, the segment experienced strong revenue growth and should be able to turn earnings growth positive in 2024 as Medicare utilization levels mature.
Earnings from the Health Services Segment (Signify included) came out strong for Q3 2023, up by 10.8% YoY, and we expect this segment to remain a high growth area with a strong positive momentum in the future as CVS Health starts scaling the businesses of both Signify Health and Oak Street Health.
Based on the above premises and taking into account that the Health Services Segment of CVS Health already represents roughly 50% of total revenues and total operating income as of Q3 2023 YoY we find it highly plausible that earnings will be growing by at least 5% per year in the next few years.
Formula
Intrinsic Value = (EPS × (8.5 + (2 x long-term growth rate of the company)) × 10-yearTreasury Yield)/ BBB Corporate Yield.
EPS for CVS Health (Adjusted Net Income per share, 2023 FY Mid Guidance as provided by CVS Health): $8.60.
Long-term growth for CVS Health (HedgeMix estimate): 5%
U.S. Corporate BBB Effective Yield as of November 23, 2023: 6.06%
U.S. 10-year Treasury Yield as of November 24, 2023: 4.47%
Valuation Result
Populating the above formula with our input data gives us an intrinsic value of $117 for the CVS Health shares, equivalent to a 70% upside.
CVS Health offers a safe dividend
The company also pays a 3.5% dividend, and there hasn’t been one dividend cut in over 30 years. Furthermore, the dividend yield is now at all-time highs. This really poses a unique opportunity to buy in on this fantastic company.
MacroTrends
If we make the modest assumption that CVS Health reach its fair value 5 years from now, then that would translate into an annual growth of 11%. Adding the dividend yield on top of that gives us a total return of 14.5% per year.
Take-away message
Throughout the years CVS has gone from being a pure retail business to a health conglomerate with the advantage of being at the forefront of this transition. Because they are not alone. Both Walgreens (WBA) and Amazon have started to make similar moves. However, we argue that CVS Health has executed timely and impeccably on its acquisition strategy to drive deeper penetration of its health products and services, and consequently has a significant lead against its competitors. Furthermore, by embracing digital innovation across both retail and health care the company stands strong against its online rivals. As such, we believe you can expect strong performance from CVS Health ahead.
Also, please note that while CVS Health’s retail business may be suffering from margin contraction the opposite is true for health care. Healthcare is a lucrative business with solid margins that we believe will provide strong earnings growth for CVS Health for years to come. Finally, you’ll hardly find a more diversified pharmacy stock out there, and if a potential recession hits the economy, health-related services and products are among the last to be cut back on. All in all, this is a great stock to own and we highly recommend investors to include CVS Health in their portfolio.
