Remaining consistent with the theme of my previous articles, it is arguably more important now than it has been the past several years to focus on companies with strong brands that provide indispensable goods and services to its customers.
One example of a company that fits the above profile, is that of CVS Health (CVS).
I will be revisiting CVS Health’s dividend safety and growth potential for the first time since I initiated coverage in the stock in February 2019, reexamining recent operating results and the company’s risk profile, and using a couple of valuation metrics and a valuation model to arrive at a fair value for shares of the stock, which I believe collectively justifies my continued buy rating for CVS Health.
Already Strong Dividend Coverage Is Rapidly Improving
While CVS Health’s yield of 3.16% is reasonable given the S&P 500’s yield is 1.70% at the time of writing, I have made a habit of examining a stock’s payout ratios regardless of yield.
This represents a significant YoY improvement from the 28.5% adjusted EPS payout ratio through the first half of FY 2019 (according to data sourced from page 2 of CVS Health’s Q2 2020 earnings press release indicating $3.51 adjusted EPS against $1.00 of dividends/share paid during that time).
Moving to FCF, CVS Health generated $10.424 billion of operating cash flow against $1.190 billion in capital expenditures through the first half of FY 2020, for total FCF of $9.234 billion (as per data sourced from page 5 of CVS Health’s most recent 10-Q).
Against the $1.315 billion in dividends paid during this time, CVS Health’s FCF payout ratio equates to a mere 14.2%.
When this FCF payout ratio is compared to the 21.8% payout ratio through the first half of FY 2019 ($5.997 billion in FCF against $1.306 billion of dividends paid), the progress that CVS Health has made in the past year to transform itself into an absolute FCF beast is undeniable.
Given the sustainability of CVS Health’s payout ratios at this time and the tremendous progress that is being made on its deleveraging objective (more on that later), I believe that CVS Health’s long-term dividend growth is primed to slightly exceed whatever long-term earnings growth the company is able to deliver.
When factoring in that Yahoo Finance analysts are forecasting 6.3% annual earnings growth over the next 5 years, I believe that CVS Health is poised to deliver annual dividend growth of 7.5% over the long term.
CVS Health Has Thrived During A Time When Many Businesses Have Struggled
In a time when many businesses spanning most sectors of the economy have struggled to produce even decent operating results, CVS Health has generated tremendous operating results.
Starting with revenue, CVS Health managed to advance its consolidated revenues 3.0% YoY from $63.431 billion in Q2 2019 to $65.341 billion in Q2 2020, according to CFO Eva Boratto’s opening remarks during CVS Health’s Q2 2020 earnings call.
CVS Health’s solid top-line growth during COVID-19 was as a result of revenue growth in all 3 of the company’s segments, although the Health Care Benefits and Retail/LTC segments especially led the way.
Starting with the Health Care Benefits segment, the segment reported a 6.1% YoY increase in its revenue from $17.403 billion in Q2 2019 to $18.468 billion in Q2 2020 (slide 11 of CVS Health’s Second Quarter 2020 Earnings Call Presentation).
The strong top-line growth in this segment was due to the membership growth in its government products and the segment’s bottom line benefited from a 1,370 basis point expansion in its medical benefit ratio or MBR from 84.0% in Q2 2019 to 70.3% in Q2 2020 due to the deferral of elective procedures during the quarter (helping the segment to post 140.9% YoY growth in adjusted operating income from $1.438 billion in Q2 2019 to $3.464 billion in Q2 2020), as indicated by CFO Eva Boratto’s opening remarks in CVS Health’s Q2 2020 earnings call.
Moving to the Pharmacy Services segment, total revenues were essentially flat as Q2 2020 revenues of $34.889 billion represented 0.1% YoY growth to the $34.842 billion generated in Q2 2019 (15% YoY growth in Specialty Pharmacy was mostly offset by continued price compression in the segment according to slide 12 of CVS Health’s Second Quarter 2020 Earnings Call Presentation) as CFO Eva Boratto noted in her opening remarks during CVS Health’s Q2 2020 earnings call.
As a result of the slight advance in revenue and an improvement in gross margins compared to last year alluded to by CFO Eva Boratto’s opening remarks in CVS Health’s Q2 2020 earnings call, Pharmacy Services posted 2.4% YoY growth in adjusted operating income from $1.296 billion in Q2 2019 to $1.327 billion in Q2 2020.
Rounding out the segments, Retail/LTC reported a 1.0% YoY increase in revenue from $21.447 billion in Q2 2019 to $21.662 billion in Q2 2020, which was driven primarily by pharmacy drug mix and growth in retail pharmacy prescription volume, and mostly offset by reimbursement pressure and recent generic introductions (slide 14 of CVS Health’s Second Quarter 2020 Earnings Call Presentation).
Adjusted operating income was materially impacted by COVID-19-related investments to the tune of $240 million of colleague benefits, free home delivery to keep patients on their medications, and PPE/enhanced cleaning to keep colleagues and consumers safe as mentioned by CFO Eva Boratto in her opening remarks during CVS Health’s Q2 2020 earnings call, which resulted in a 36.7% YoY decline in adjusted operating income from the $1.669 billion generated in Q2 2019 to $1.057 billion in Q2 2020.
Overall, CVS Health generated 39.7% YoY growth in adjusted EPS from $1.89 in Q2 2019 to $2.64 in Q2 2020 as demonstrated above in slide 10 of CVS Health’s Second Quarter 2020 Earnings Call Presentation.
Year-to-date, CVS Health has generated 5.6% YoY growth in consolidated revenues from $125.077 billion in H1 2019 to $132.096 billion in H1 2020, which was again as a result of across the board growth in the 3 segments (as indicated by data sourced from page 2 of CVS Health’s Q2 2020 earnings press release).
Moreover, CVS Health generated strong growth in adjusted operating income, which trickled down to adjusted EPS as CVS Health’s adjusted EPS surged 29.6% YoY from $3.51 in H1 2019 to $4.55 in H1 2020.
Moving to CVS Health’s balance sheet, the company managed to repay $2.75 billion of scheduled debt principal in July 2020 as noted by CFO Eva Boratto’s opening remarks in CVS Health’s Q2 2020 earnings call.
CVS Health continued to demonstrate its commitment to deleveraging to its target leverage ratio of the low 3s in 2022 by indicating that it isn’t planning share repurchases until its target leverage ratio is met, which bodes well for the future sustainability of the company’s balance sheet.
While CVS Health is expecting a reversal of fortunes in the second half of this year as far as operating cash flow is concerned (due to COVID-19 related investments during the year, a normalization of utilization within the HCB segment, and estimated income tax payments normally due in Q2 as per slide 20 of CVS Health’s Second Quarter 2020 Earnings Call Presentation), CVS Health maintains access to $13 billion in liquidity through a combination of $7 billion in cash and cash equivalents and $6 billion available through commercial paper or borrowing capacity under credit facilities as illustrated above.
Finally, CVS Health is continuing to make significant progress in strengthening its balance sheet from the perspective of the interest coverage ratio.
As indicated on page 2 of CVS Health’s most recent 10-Q, the company generated $6.739 billion in income before income tax against $1.498 billion in interest expense through H1 2020, which represents a ~4.5 interest coverage ratio.
While further deleveraging needs to be done to transform CVS Health’s balance sheet into a fortress of financial strength, this represents significant progress over the $4.530 billion in income before income tax/$1.554 billion in interest expense and the interest coverage ratio of ~2.9 through H1 2019.
When I take into consideration that CVS Health has demonstrated its resiliency in its operating results through the first half of this fiscal year, CVS Health maintains a strong liquidity position, and that CVS Health’s interest coverage ratio is continuing to improve, I believe shares of CVS Health could represent a great buying opportunity for the long-term if acquired at or below fair value.
Risks To Consider
While CVS Health is a solid company, it still faces its fair share of risks that investors would be well-served to keep in mind.
Because CVS Health’s overall risk profile as outlined in pages 29-51 of its most recent 10-K has changed very little in the past year and a half since I initiated coverage, I will be focusing on the COVID-19-related risks facing CVS Health as noted in pages 67-71 of CVS Health’s most recent 10-Q.
The first COVID-19-related risk facing CVS Health, is that during the first half of this year, CVS Health “began to offer our medical members expanded benefit coverage and became obligated by governmental action to provide other additional coverage… without a corresponding increase in the premiums we receive in our Insured Health Care Benefits products” (page 68 of CVS Health’s most recent 10-Q).
The above actions taken by CVS Health could result in negative consequences for the company’s medical benefit ratio and financial results, given the uncertainty around the ultimate severity and duration of COVID-19 at this time.
Another COVID-19 related risk associated with CVS Health, is that the actions taken to curb the spread of the virus could prove to be detrimental on the company’s ability to operate, with partial or complete closures of its facilities, labor shortages, supply chain disruptions, and the possibility of cyber security breaches leading to the vulnerability of sensitive information given the remote work environment of many of CVS Health’s employees (page 68 of CVS Health’s most recent 10-Q).
If CVS Health were to experience an outbreak at one or more of its locations among employees, customers, or other stakeholders, this would likely prompt the company to shut down those locations for the foreseeable future, which would have a detrimental impact on the company’s financial results.
Disruptions to CVS Health’s supply chain due to any number of reasons, including outbreaks at a supplier’s facilities or financial difficulties on the part of the supplier, could also result in a detrimental impact to the company’s financial results as the company may not be able to sell goods or services to its customers due to supply shortages or the company may be forced to procure supplies at a higher cost from a different supplier, which it may not be able to pass onto consumers.
The final risk within the above subset of risks, is that CVS Health experiences a cyber security breach that exposes sensitive information of its customers, suppliers, or other third parties.
If this were to occur, CVS Health’s reputation could be adversely impacted, which could impair the company’s market share and financial results over the long term in a worst-case scenario.
The final key risk facing CVS Health overall, is that adverse economic conditions in the U.S. and abroad are likely to unfavorably impact the company in the near term (pages 70-71 of CVS Health’s most recent 10-Q).
Whether it’s reduced demand in the Pharmacy Services segment for PBM services, reduced consumer demand in the Retail/LTC segment, or increased costs within the Health Care Benefits segment due to increased medical unit costs as hospitals adapt to lower revenue as a result of COVID-19 disruptions, the impact of COVID-19 in the near term to CVS Health across its segments will likely be material, which could result in headwinds as long as the COVID-19 pandemic persists.
Although I have discussed several COVID-19-related risks facing CVS Health, the above certainly doesn’t entail a complete discussion of the risks facing CVS Health. For a more comprehensive discussion of CVS Health’s risk profile, I would refer interested readers to pages 29-51 of CVS Health’s most recent 10-K, pages 67-71 of CVS Health’s most recent 10-Q, and my previous article on the stock.
An Above-Average Quality Company Trading At A Deep Discount
Even though CVS Health is a great company, it remains paramount that investors avoid overpaying for shares of the stock to minimize the risks of lower starting yield, valuation multiple contraction, and total return potential.
With this in mind, I will be using a couple of valuation metrics and a valuation model to arrive at a fair value for shares of CVS Health.
The first valuation metric that I’ll utilize to determine the fair value of CVS Health’s shares is the current yield to 13-year median yield.
According to Gurufocus, CVS Health’s yield of 3.16% is well above its 13-year median yield of 1.33%.
Factoring in a reversion to a fair value yield of 2.50% and $80.00 a share (which I believe appropriately accounts for CVS Health’s risk profile), CVS Health is trading at a 21.0% discount to fair value and offers 26.6% upside from the current price of $63.21 a share (as of August 30, 2020).
The next valuation metric that I will use to arrive at a fair value for shares of CVS Health is the TTM price to FCF ratio to 13-year median TTM price to FCF ratio.
As per Gurufocus, CVS Health’s TTM price to FCF ratio of 6.08 is significantly below its 13-year median TTM price to FCF ratio of 14.76.
Assuming a reversion to a TTM price to FCF ratio of 8.00 and a fair value of $83.17 a share, CVS Health is priced at a 24.0% discount to fair value and offers 31.6% capital appreciation from the current share price.
Image Source: Investopedia
The valuation model that I’ll utilize to assign a fair value to shares of CVS Health is the dividend discount model or DDM.
The first input into the DDM is the expected dividend/share, which is the annualized dividend/share. In the case of CVS Health, that amount is currently $2.00.
The next input into the DDM is the cost of capital equity, which is the annual total return that an investor requires on their investments. While this often varies from one investor to the next, I require a 10% annual total return on my investments because I am of the opinion that this is ample reward for the time and effort that I allocate to researching investment opportunities and periodically monitoring my investments.
The third input into the DDM is the long-term dividend growth rate or DGR.
Unlike the first two inputs into the DDM that only require data retrieval to find a stock’s annualized dividend/share and subjectivity to set a required annual total return rate, accurately projecting a stock’s long-term DGR requires an investor to consider numerous variables, including a stock’s payout ratios (and whether those payout ratios are positioned to expand, contract, or remain the same), annual earnings growth potential, industry fundamentals, and the strength of a stock’s balance sheet.
When I factor in CVS Health’s sustainable payout ratios, improving balance sheet, and 6-7% annual earnings growth potential over the long term, I conclude that I am justified to reiterate my previous expectation of 7.5% annual dividend growth over the long-term.
Upon plugging the above inputs into the DDM, I again arrive at a fair value of $80.00 a share, which indicates that shares of CVS Health are trading at a 21.0% discount to fair value and offer 26.6% upside from the current share price.
When I average the three fair values above, I compute a fair value of $81.06 a share, which means that CVS Health’s shares are priced at a 22.0% discount to fair value and offer 28.2% capital appreciation from the current share price.
Summary: CVS Health Offers Yield, Growth, And Total Return Potential In Return For Patience
While CVS Health hasn’t announced a dividend increase since December 2016, the company has significantly improved its adjusted EPS payout ratio from 28.5% through the first half of FY 2019 to 22.0% through the first half of FY 2020, and the FCF payout ratio has also markedly improved from 21.8% through the first half of FY 2019 to 14.2% through the first half of FY 2020.
CVS Health has managed to produce mid-single-digit top-line growth from the first half of FY 2019 to the first half of FY 2020, which helped the company’s adjusted EPS to surge 29.6% from $3.51 through the first half of FY 2019 to $4.55 through the first half of FY 2020.
CVS Health’s interest coverage ratio has accordingly surged from 2.9 through H1 2019 to 4.5 through H1 2020, which represents significant progress for the company in deleveraging to a more sustainable debt load going forward.
Adding to the case for an investment in CVS Health, is the fact that shares are trading at what I estimate is a 22% discount to fair value.
Between its 3.2% yield, 6-7% annual earnings growth, and 2.5% annual valuation multiple expansion, shares of CVS Health are positioned to exceed my 10% annual total return requirement over the next decade.
Given CVS Health’s trifecta of yield, growth, and total return potential, I am reiterating my buy rating for shares of the stock.
Disclosure: I am/we are long CVS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.