CVS – Integrated and Cheap
Although we weren’t huge fans of the old CVS as a standalone pharmacy, the new CVS, as a PBM, pharmacy and health insurer is very attractive and cheap. The old CVS had to cope with many headwinds including potential disruption, reimbursement issues, and the slow growth nature of what is already a saturated market for pharmacies. The Aetna acquisition changes everything. Its a path to future growth, potential for margin expansion, a further diversified business, and a much larger moat to protect against the behemoth which is Amazon.
CVS is currently a very cheap name, trading at less than 10x forward earnings with a LT projected growth rate in the low double digits. The Aetna acquisition means that CVS should be valued, not necessarily as a slower growth pharmacy like a Walgreens, but more so as a managed care business such as a UNH or Humana. Many argue that since the business is less focused and combined with a slower growth segment that it should be trading at a discount. We agree at least in the short term. In the long term, should they execute well on the plan, the potential synergies and long term opportunities of having the 2 verticals should ultimately lead to a more inline valuation with managed care. The vision is that CVS will be able to further expand margins with the existing pharmacies acting as a staple for chronic health issues, which happen to be the majority of costly hospital and doctors visits. With CVS pharmacies staples in almost every community (over 80% of Americans are within a close drive or walk of one), the infrastructure is already in place to be leveraged to further expand the low margin nature of health insurance. Although we believe this shift to convince patients to turn to pharmacies for chronic issues rather than doctors or hospitals will take time to make a reality, we think it looks very practical and profitable for CVS.
Strong Cash Flows
Another aspect about the new company is its strong cash flows, especially FCF conversion with its existing infrastructure in place and limited capex requirements in the shorter term. Cash flow long term will benefit from synergies between the 2 businesses, with expected synergies of $750 million per year. We think this will lead to debt being paid down at an accelerated rate. Bringing their debt to a lower leverage rate that is more practical longer term. Once debt is reduced to a more manageable level (estimated around 2020), the company will be able to easily grow their dividend at an above market pace. This is in addition to the company being in a good spot to buy back their shares, should the share price still be undervalued.
Sector wide growth
The other aspect that has been less publicized is potential for growth of the existing pharmacy business. The potential for increased traffic longer term as a result of the use of pharmacies in assessing chronic health issues should help same store sales, especially on impulse consumer staples. The other aspect leading to potential SSSG is demographics. An older population will mean greater need for prescriptions, meaning the integrated PBM side should grow and help reign in costs for the managed care side.
Our valuation based off of comparables such as peer WBA, leaves CVS trading at closer to $80, 1 year out. Although it is understandable for the company to be trading at a discount to purer play health insurers like UNH and Humana, we think the valuation still isn’t reflecting the new Aetna division. Overtime we think the market will shift their valuation into a premium on WBA and a smaller discount to managed care companies. currently Compared to WBA, CVS is trading cheaper on an earnings basis, even though CVS has a higher growth division of insurance as a large amount of its revenues. On a valuation basis we think 13x is what CVS should be trading at, compared to 12x earnings for WBA, especially as CVS de-levers the balance sheet . Should the market, long term, reward this multiple, one can look for this valuation re-rating, as well as y/y 10%+ capital gains as earnings keep up with the share price, and 2.5%+ in a growing dividend.
Check out our first report of 2019 here