CVS Health: A Solid Place to Hide in the Coronavirus Selloff
At the most recent count as of the writing of this article on March 4, 2019, the novel coronavirus (Covid-19) has 93,000 confirmed cases in nearly 80 countries. Of these cases, there have been approimately 3,100 deaths worldwide, including nine in the Seattle, WA area of the U.S. The virus has also shown up in New York and North Carolina.
In an effort to prevent the further spread of the virus, some countries have closed factories, business and schools. Others have urged residents to stay indoors in order to avoid infection. There is even some discussion that the Tokyo Olympics scheduled to be held later this summer could wind up being canceled.
The markets, which has been on a sugar high due to tax cuts and low interest rates, finally took notice last week. All of the major averages suffered severe double-digit declines as investors rushed to the exits on fears of a slowdown in global economic growth due the coronavirus. The Dow Jones Industrial Average lost more than 3,500 points last week, while the S&P 500 lost 11% over five days. A large inflow of cash led to a new record low yield for the 10-year Treasury note. In short, last week was the worst week for markets since the global financial crisis in 2008. Markets did rebound on Monday, but were hit with another round of selling on Tuesday.
When events like this occur, many investors, as well as machines using trading algorithms, simply sell everything. There was no safe place to hide last week.
Until the virus is contained, markets are likely to remain volatile. In the meantime, there are companies that can still perform well in this environment that offer a good place for investors to hide out while the world deals with the new coronavirus. CVS Health Corp. (NYSE:CVS) is one such company.
Company background and recent results
CVS Health operates nearly 10,000 retail locations and 1,100 medical clinics and has more than 100 million plan members in the U.S. The company is the largest pharmacy chain in the country, controlling more than a quarter of the retail pharmacy market. CVS completed its $70 billion purchase of health insurer Aetna, and its 39 million customers, near the end of 2018. The company trades with a market capitalization of almost $82 billion.
On Feb. 12, 2020, CVS Health reported fourth quarter and full year results.
Source: CVS Health's Fourth-Quarter Earnings Presentation, slide 14.
Revenue for the quarter improved 23% to $66.9 billion, which topped estimates by $2.9 billion. Adjusted earnings per share decreased 19% from the fourth quarter of 2018. For 2019, revenue was higher by more than 32% to $256.8 billion, while adjusted EPS of $7.08 was flat from the prior year. Much of the growth in revenue for both the fourth quarter and 2019 was due to the addition of Aetna. The decline in adjusted EPS can be attributed to an increase in the average number of shares outstanding due to the purchase of Aetna. Factoring in the growth in share count, adjusted net income increased 36.3% to $15.3 billion.
Clearly, the addition of Aetna has had a dramatic impact on both the top and bottom-lines for CVS, but the rest of the business also performed well in the quarter.
The Pharmacy Services segment, the largest business within the company, grew 6.2% to $37.1 billion. This segment had a 10.2% increase in the number of pharmacy claims processed. CVS processed more than 533 million pharmacy claims during the quarter. This growth in volume was partially offset by price compression. Also impacting results for Pharmacy Services was an increase in the generic dispensing rate by 90 basis point to 87.8%.
Revenue for the Retail/Long-Term-Care segment increased 2.5%. Prescriptions filled improved 5.6% to 369 million, which helped offset lower reimbursement and a higher generic dispensing rate. Retail pharmacy same-store sales increased 3.2%, led by strength in pharmacy sales and pharmacy prescription volumes. CVS Health's pharmacy script market share increased 80 basis points to 26.8%. Front of stores sales were up less than 1%, but the company did see strength in health and beauty and cough and cold products during the quarter.
The Health Care Benefits segment, which is comparable to the former Aetna Health Care business, generated more than $17 billion in sales, and total memberships improved 3.6% to 22.9 million.
CVS Health expects adjusted earnings per share of $7.04 to $7.17 for 2020, with the midpoint representing a slight increase from last year's results.
The company has compounded earnings per share at a rate of 6.5% and 10.2% over the last five and 10-year periods, respectively. Given the additional revenue from Aetna and the improvements in pharmacy prescriptions market share, EPS growth estimates of at least 3% to 5% going forward seems a reasonable, conservative expectation, in my opinion. This level of EPS growth may not attract growth investors, but there are other components of total returns that investors should consider.
Dividend and valuation
Prior to 2018, CVS Health raised its dividend for 14 consecutive years. The company paused its dividend growth (and share repurchases) in 2018 as it attempted to pay down debt associated with the Aetna transaction. The company repaid $9.1 billion of debt last year, including a prepayment of $4.7 billion of long-term debt. Included in this total was ~$8 billion of debt reduction from the Aetna transaction, which was above the company's target of $7.5 billion.
The company expects to reduce its obligations by another $4.2-$4.6 billion in 2020. The majority of CVS Health's $65 billion of long-term debt is due to be repaid between 2020 and 2028, making it likely that dividend growth will not return for at least a few years.
So, why should CVS Health be an attractive stock for dividend growth investors? For starters, the company may have paused its dividend growth, but did not cut its dividend. CVS Health is expected to pay $2 in dividends per share in 2020. Using the midpoint for adjusted earnings per share for 2020 of $7.11, the payout ratio is just 28%. This is slightly lower than the five-year average payout ratio of 29%.
Just as important, free cash flow shows that the dividend should be on safe ground. The company generated $10.4 billion of free cash flow in 2019, a significant spike from the previous year's $6.8 billion. The company distributed $2.6 billion in dividends last year for a free cash flow payout ratio of 25%. CVS Health expects free cash flow of $10.5 bill to $11 billion for 2020, with the share count remaining fairly stable. This means that the free cash flow payout ratio will remain low, arming the company with additional capital to further reduce its debt obligations.
With a current dividend yield of 3.1%, shareholders of CVS Health are being rewarded with a yield that is 120 basis points above the average yield of 1.9% for the S&P 500. In addition, the stock's valuation is now in the single-digits. Using the most recent closing price of $62.54 and the midpoint for adjusted EPS for 2020, shares of CVS Health trade with an estimated price-earnings ratio of 8.8. Shares are currently undervalued compared to the 10-year average price-earnings ratio of 14.1. If the stock were to trade with a price-earnings ratio of 12 to 14, then shares would be worth $85 to $100. This would be a 36% to 60% improvement from the current share price due to multiple expansion alone.
Final thoughts
After a rough week for equity markets, investors could be worried about where they should put their money. Companies showing strong growth and offering an attractive yield that are trading with a low valuation appear to be a good place to park capital. CVS Health looks like just such a company.
CVS had a solid fourth quarter and full year 2019. Revenue and adjusted net income both increased by an impressive clip, mostly due to the purchase of Aetna.
The dividend may not grow over the next few years, but appears to be safe using either EPS or free cash flow payout ratios. CVS Health is using its additional free cash flow to pay down its debt. In the meantime, investors can enjoy a high, safe dividend yield.
Finally, shares trade with a low price-earnings ratio. Reaching even a modest valuation level would result in a high rate of return, and that is just from an improvement in the multiple alone. Factor in the dividend and earnings growth and suddenly CVS Health sets up nicely as an excellent total return investment.
Disclosure: Author is long CVS Health.
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This article first appeared on GuruFocus.
