I’ve been a fan of late of CVS Health (CVS) as I find the company’s tremendously successful pharmacy business to be an increasingly interesting asset to own. The stock, however, has moved against me after I thought a breakout was occurring back in the low-$80s, and after the Q3 report, is right back at its lows again. However, I see reasons to own the stock long term, not the least of which is a very attractive combination of yield and valuation.
The stock has plummeted in the past few weeks and has actually made new lows just under $67. Obviously, that’s not a great situation for the bulls as the bears have been fully in control since the breakout failed back in September. The stock, however, should find some buyers here as not only is it at the spike low of last November, but the yield is nearing 3%. Finally, the RSI is showing the stock is back in oversold territory and for these reasons, I’m hopeful buyers will step in here.
However, the more compelling story is that of CVS’ fundamentals, and despite the reaction from investors, I still think Q3 has something to offer the bulls. Revenue was up almost 4% on continued strength of the Pharmacy business, which saw revenue rise better than 8%. CVS saw strength from specialty pharma volume, brand inflation and greater network claim volume. Volume was up more than 8% but was partially offset by greater generic dispensing. Still, the pharmacy business continues to produce very strong growth and is carrying the weaker retail unit.
The Retail/LTC segment saw revenue fall almost three percent on a same store sales decline of roughly the same amount in Q3. Front-of-the-store sales have been tough for a while for CVS and competitors while the rest of the business is booming in a relative sense. To be honest, the retail business has been pretty weak for some time and it doesn’t seem to be improving as traffic – which is the lifeblood of any retailer – continues to fall. The pharmacy business is driving growth but is being held back by the retail business and unfortunately, there don’t appear to be any catalysts to change that around anytime soon. It seems to be an industry problem and CVS is struggling with it just like everyone else.
Operating profit was down almost 12% in Q3 due to some already-known pressures on the pharmacy business, including the shifting of Medicare Part D profits as well as price compression. However, CVS reaffirmed guidance for this year and that should tell you that the pressure on margins is transitory. After all, CVS did allow for its weak operating profit performance in Q3 in its guidance, meaning the stock should not have reacted the way that it did. Given that it was already near the lows, I found the reaction of the stock on Monday to be overly pessimistic. Keep in mind that CVS warned us about Q3 margins in advance and there were two massive hurricanes that took place; this was not a normal quarter.
To that end, CVS still thinks it will hit nearly $6 in adjusted EPS this year and $6B to $6.4B in FCF. Given the relevance of capital returns to the CVS story, that’s very important. The dividend is just over $2B per year and CVS is buying back $5B in stock according to guidance; that is cumulatively slightly more than FCF guidance but the excess is easily covered with other sources of cash. That means that barring some disaster down the road, we’ll continue to see strong dividend growth as well as share buybacks that will boost EPS growth. And given the current valuation, CVS should be buying all the stock it can handle.
Shares are going for just 10.5 times next year’s earnings, representing a PEG of just over 1, provided it hits its 8% EPS growth estimate. With the pharmacy business producing growth quarter after quarter and the much-welcomed tailwind of buybacks helping EPS along, that seems like a reasonable assumption to make. But even if CVS doesn’t hit 8% EPS growth, it is still cheap unless it totally whiffs and hits the low single digits instead. Obviously, that’s not my base case but stranger things have happened.
On the whole, while I found the operating profit reduction to be unpleasant, the long term pharmacy growth story is still very well intact. The pressures on Q3 were already known and although I’d like to see the front of the store contribute to sales growth, that doesn’t seem a realistic objective at this point. I do find the stock exceedingly cheap here and with a nice yield to boot so if it is value and yield you’re after, you can do much worse. CVS continues to produce strong FCF and that will allow it to spoil us with its extra cash year after year; that’s not a bad place to be.
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.
Article source: https://seekingalpha.com/article/4121945-cvs-health-approaching-3-percent-yield