“Dangit!” I said to myself. “I was afraid that was going to happen.” Not that I could have done much about it or foreseen the major announcement by CVS Health Corp (CVS) back in late October. The price of CVS was already below where I had purchased it and I am loathe to sell stocks below my purchase price if I can help it. It does happen though.
A few months ago on October 6th I purchased 29 shares of CVS for $80.25 (about $2,300). A month later it bottomed out (hopefully) at $66.80. As I type this it sits right about the middle of that range, approximately at $73, and there is new information to digest for a dividend growth investor.
So what happened?
I wrote about this in an article here. But basically on October 26th it was reported that CVS was in talks to purchase Aetna Inc. (AET). And just like that the stock that opened at $75.79 on the 26th closed at $73.31. The market was apparently not enthralled with the acquisition.
Worse than that though, the next day, the 800 pound cyber gorilla named Amazon.com Inc. (AMZN) indicated they might be entering the pharmacy benefit management space. And the stock that closed at $73.31 dropped to close at $68.99 the very next day.
The CVS-AET Acquisition Aftermath
Earlier this month, CVS announced that they had reached an agreement with AET. And shortly after that they held a conference call and gave an investor presentation. In that presentation they said, essentially, that since they were going to be so highly leveraged now they were not going to be able to raise the dividend or repurchase stock for some time.
Source: CVS-Aetna Investor Presentation
Alright, well then how long do we think it will take before they reinstate the share repurchase program and begin raising their dividend again? Well luckily, they do tell us in that same presentation exactly how highly leveraged they expect to be after the merger:
New debt of $45 billion will result in pro forma leverage of approximately 4.6x; expect to deleverage rapidly
Great, so now we know what the new debt to EBITDA ratio is that they expect, and thanks to the same presentation we also know what they expect their new EBITDA to be.
Right. So the new EBITDA is 18.5 and they are adding new debt of $45 billion. This is like a puzzle, a very, very expensive puzzle.
So, with a pro forma leverage of “approximately 4.6″ and a pro forma EBITDA of $18.5 (billion), and new debt of $45 billion we can rough out what the approximate debt is and what it would have to be to get down to the “low 3x” range. (For you lucky souls that didn’t take Latin in high school, “pro forma” means “we’re totally guessing”. No, I’m kidding, it means “for the sake of form” but in financial circles it generally refers to a forecast of an expected number based on best known information at the moment.)
With an EBITDA of $18.5 billion and a debt to EBITDA ratio of 4.6, that gives us a debt of about $85 billion. That kind of checks out since the latest numbers we have (September 30) show total liabilities of $58 billion, the AET purchase price is about $65 billion, and the transaction is a mix of stock and cash. If anything, my back of the envelope calculations based on 326 million AET shares outstanding and AET shareholders receiving $145 per share, leads me to believe that $85 billion might be too low. Note that the statement in the presentation says they issued new debt of $45 billion, but they also “get” to assume AET’s debt (and get their cash). And we don’t know exactly how much cash they’ve accumulated since September 30th. But it is getting pretty complicated. Let’s assume their numbers are correct and roll with a total debt of $85 billion at the time the transaction closes (expected to be the second half of 2018).
What would it take to get down to a debt to EBITDA ratio in the “low 3x”. Well, I am going to assume that 3.25 is considered low.
So, of course CVS expects their EBITDA to rise as a result of this deal. How much and how soon is very unclear, and I would expect that the synergies realized as a result of this transaction will not be immediate and certainly will take at least a few years to be fully realized. By that time I will be getting quite impatient with the lack of dividend hikes, so we’ll pretend (pro forma) that the EBITDA remains flat for at least several quarters.
If we assume EBITDA remains flat, then a debt to EBITDA ratio of 3.25 would mean that debt would have to drop to roughly $60 billion, or by about $25 billion. That is a ton of debt to pay off.
OK, but EBITDA will almost certainly not remain flat. Over the past five years the CVS has grown EBITDA as follows:
Now let us also look at what a tremendous cash generating machine CVS is. Just last month CVS affirmed their guidance for free cash flow for FY17 at a range of $6.0-6.4 billion. This is completely realistic and in line with previous years. So as 2017 is almost over (CVS’s fiscal year ends December 31), let us assume a few things. Next year they generate free cash flow of $6.5 billion, which I don’t think is ridiculous, and they do not re-purchase any shares, which they said they would not do. However, they do have to issue new shares to existing AET shareholders as part of the deal. Based on what was reported in the presentation (” 0.8378 in CVS shares per AET share”) and the total AET share count reported as of September 30 of 329.7M shares, I calculate the total number of new CVS shares issued to be a little over 276 million. CVS, also as of September 30 reported 1.02 billion shares outstanding. So let’s call it 1.3 billion shares of CVS once the merger is complete.
CVS currently has a yearly dividend of $2.00 per share. So, in what is probably the easiest calculation so far, total dividends will be and should remain $2.6 billion for the next year or two.
Now let’s put it together and assume for the moment that the EBITDA will continue to grow nicely, let’s say at 4%, and free cash flow is about $9-10 billion ($6.0-6.5 from CVS and $3.0-3.5 from AET). Share buy backs will be $0 per year going forward, $2.6 billion per year in dividend payments, which gives CVS maybe very roughly $6.5-7.5 billion of debt reduction for the year.
- Initial Debt: $85 billion
- Initial EBITDA: $18.5 billion
- EBITDA growth: 4%
- Debt Reduction: $6.5 billion in 2019, $7 billion in 2020, $7.5 billion in 2021
Put those assumptions together and the Debt/EBITDA looks like this going forward:
So it looks like by late 2020 or thereabouts we’ll see Debt to EBITDA in the “low 3x” range.
And what to do next?
Well, after reading several articles I thought it would be instructive to run through my eight guidelines, which I used as reasons to purchase the stock in the first place, and find out what has changed.
Guideline #1 – Revenue Per Share Increasing
CVS is issuing more shares, but their revenues will also be increasing by the amount of revenue that the AET businesses generate. So the revenue per share number is almost certainly increasing. If it was an all-stock transaction, this number would be more dubious.
Guideline #2 – Book Value Per Share Increasing
Long term, I have to believe that the book value per share will be going up.
The liabilities number is obviously growing, the total assets will be the sum total of the assets of the two companies. This leads me to believe that the shareholders equity number will be going down. Total shares outstanding will be slightly below the combination of the total of the shares outstanding of CVS and AET shares since each share of AET will receive less than one share of CVS. That makes it very difficult to determine if the book value per share is going to go up from where it is or down to begin with. If they plan on paying down the debt aggressively, however, the total liabilities number should shrink rapidly and the book value should increase quickly the first few years after the deal.
Guideline #3 – Quality Rating
Unknown. They had, when I wrote my first CVS article, the highest safety and financial strength rating from ValueLine. I haven’t seen anything that indicates any of the rating agencies have lowered their credit rating for CVS yet.
Guideline #4 – Debt
We’ve talked about this at length, obviously. Debt is going way up which is the entire reason they have frozen their dividend. I wrote about this in my first article: “I don’t generally like seeing a balance sheet with this much debt ($58B) or the fact that it is growing…”.
I didn’t like the debt then and it is going to be much higher now. This situation has definitely worsened in my opinion.
Guideline #5 – FCF and Payout Ratio
Well, their free cash flow is only going to increase, and their payout ratio should remain below 30% of free cash flow, which is excellent. They will have to pay approximately $2.6 billion per year in dividends and they will have approximately $9-10 billion in free cash flow (pro forma – and yes, I’m totally guessing). I will say this metric remains fairly positive.
Guideline #6 – Common Shares Outstanding
In this metric, I like to see the number of shares outstanding coming down slowly and steadily. We know by the company’s own word that they won’t be buying any shares back until they have deleveraged. That turns this to a negative for me.
Guideline #7 – Show Me the Money!
CVS had previously raised their dividend, aggressively, for 14 consecutive years (5 year dividend growth rate of 27.7%). They mentioned on their website that they had every intention of raising it again. Now, and the main reason I’m writing this article, we know they have frozen the dividend at $2/share.
That is a fairly decent dividend at 2.7%. However, the reason I prefer dividend growth companies is because in 10 years my dividend will be so much higher than it is today. I expect that if I have invested $10,000 and it is paying me $200 per year, that in 10 years that annual dividend will be $500 or higher given a 10% annual dividend increase. If they had kept raising it at 27.7% per year (unlikely) my annual dividend on a $10,000 investment would have been over $2,300 per year.
But despite all that math, a frozen dividend is obviously negative for a dividend growth investor.
Guideline #8 – P/E Ratio
No idea. The P/E ratio once the deal has closed is nearly impossible to predict and I like to compare that ratio vs. the ratio of the industry they are a part of. What industry will an AET CVS combination be a part of? They’ll kind of be their own industry.
Right now the P/E ratio (ttm) of CVS is 15.1. When I wrote my first article it was 15.4 while the P/E ratio of their industry was 19.9. That was the primary reason I bought the stock in the first place. I have to give them a neutral rating though because I’m just not sure how they will stack up going forward to whatever industry they will be a member of according to Morningstar.
Final Results
So based on my initial reasons for my CVS purchase, let’s see how many of the eight boxes are still sitting with check marks in them. The only one of the eight of these that I might have checked as neutral back in early October would have been #4 (Debt). Here’s how it would look if I were writing that article today:
Three good ratings, three bad ratings and two neutral.
So now what?
Well, I would not buy CVS today, but I also am not inclined to sell at these levels. Most of the analysts actually have very high price targets and out of the 23 that follow the stock, I don’t see a single sell rating. I expect the “fair price” for CVS is quite a bit higher than the $73 it is selling at today.
So, for now I hold the stock. If they cut the dividend, we’ll have problems. But for now I don’t think that is in the cards and I believe with their debt repayment plans they will be a very financially strong company again in a few years and will at some point once again start to aggressively raise their dividend. But I will not be adding here unless I feel the dividend raises are imminent.
Thanks for reading, and good luck!
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/4133713-sand-shoes-frozen-dividends