MagicDiligence

About the Author MagicDiligence

MagicDiligence provides useful, simple, and effective stock screening tools inspired by Joel Greenblatt's Magic Formula® Investing methodology. Our Spells give value and growth investors a list of great stock candidates every day, and our advanced Spell Caster lets you create the Magic-style stock screen you've always wanted! Learn more about our exclusive set of investing tools today!

December Stock of the Month: CVS Health Corp (CVS)

For our final “stock of the month” for 2016, we are taking a look at a company virtually everyone in the U.S. should recognize.

A popular stock that has done quite well over the last 5 years, appreciating over 112%, vs. the S&P 500’s 81% rise.

A company with substantial competitive advantages, massive scale, #1 or #2 market position in several huge verticals, and a recession-proof business with large and reliable free cash flows.

However, conversely, also a stock that has badly underperformed the market in 2016 (down almost 16%, vs. an 8.6% rise in the S&P) and now trades near the low end of its 52 week range.

We recently added this December pick to the Magic Recipe Spell.

Could it be an intriguing time to look into healthcare giant CVS Health Corp (NYSE:CVS)? Let’s explore:

The Corner Drug Store

CVS is a familiar name best known for its ubiquitous retail pharmacy stores, with nearly 10,000 locations in practically every U.S. state. It is the second largest national chain (behind Walgreens (WBA)), and holds a #1 or #2 market position in most of the country’s largest drugstore markets. The “bread-and-butter” sales for these stores are filling prescriptions, which accounts for almost 75% of retail sales. Non-pharmacy sales are largely over-the-counter health items, but the stores also sell some food, beauty, and household items as well. In 2015, CVS spent $1.9 billion to acquire all 1,672 of Target’s (TGT) in-store pharmacies, nicely growing its footprint.

Lumped in with the retail segment are both CVS’s in-store clinics (MinuteClinic), which provide treatment for minor health conditions (strep, pink eye, etc.), vaccinations, health screenings, and so forth. There are roughly 1,350 MinuteClinics in operation, with CVS shooting for 1,500 by the end of next year.

Also a part of retail is CVS’s long-term care unit (LTC), which was bolstered by the 2015 acquisition of Omnicare. LTC includes several services for chronic care, assisted living, and other care facilities, such as: prescription drug distribution, pharmacy consulting, and ancillary services.

Altogether, CVS’s Retail/LTC segment accounts for 47% of total company revenue, but with its nearly 10% operating margin, this segment produces 64% of the company’s overall profits.

The Mail Order Pharmacy

CVS’s other, less-known but no less important business is its Pharmacy Services segment. Primarily, this segment is the legacy “Caremark” unit, which is a traditional pharmacy benefits manager, or PBM. The largest part of a PBM is managing mail order prescriptions, usually for chronic or ongoing conditions. Pharmacy Services also provides several other services, including home infusion (e.g., IV medications at home), disease management programs, and Medicare Part D administration.

Pharmacy Services generates the bulk of CVS’s revenue (63%), but operates at a lower 4% operating margin, producing a smaller amount of total company profit. Still, PBMs are a good business. The prescriptions filled through it are long-term, and customer retention rates are very high (97%), ensuring very predictable and recession-proof cash flows. CVS also has massive scale in this business – it is the second largest PBM behind Express Scripts (ESRX).

Reasons To Like The Stock

Clearly, CVS is a solid business for the reasons we noted: recurring and recession-proof cash flows, huge scale, and even a reasonably Internet-proof retail business. We like the company, but what about the stock?

Let’s start with growth potential. CVS has been able to maintain a pretty impressive 10% annual revenue growth rate over the last 5 years, through both organic and acquisition channels. Operating margins have risen slightly, leading to 13% annual profit growth. Going forward, management is still targeting high single-digit revenue growth. The main organic driver is increased numbers of people insured through the Affordable Care Act (“Obamacare”), as well as an aging demographic and increased incidence of chronic disease. While I wouldn’t expect much over 5% sales growth, that’s still respectable growth for such a large firm.

CVS also has a good track record of returning cash to shareholders. Share buybacks have been quite generous, with an average 4.5% reduction in share count annually since 2012. The dividend currently yields an above-market 2.1%, but more impressive is the 26.6% average annual INCREASE in the dividend since 2012, with another 18% raise slated for 2017. Even then, the payout ratio will only sit at around 30% – plenty of room for further dividend growth. These are impressive figures, some of the strongest cash returns you will find out there today.

Finally, the valuation looks attractive as well. Both its 9.4% earnings yield and 8.2% free cash yield rank in the top 15% of the market. When you compare these metrics against Walgreen’s at 6.3% and 6.7% respectively, that is a pretty remarkable valuation gap. Even Express Scripts, at 8.6%/8.7%, is valued cheaper, despite the lack of a retail business! A quick discounted free cash flow model, using a 9.5% discount rate and about 4% growth, gives me a fair value exceeding $100. That’s a lot of room to grow from the current stock price around $79.

The Risks and Why It’s Down

To be clear, compared to a lot of stocks screened by our Spells, CVS is squarely in the more conservative, lower-risk bucket. Conservative investors can have a fair amount of confidence that this isn’t a stock that will crater 50% or more, barring some serious problems.

That said, there are risks. In the macro picture, Donald Trump’s election could spell trouble for Obamacare. The promise (and reality) of a larger pool of insured Americans has helped CVS’s growth rates since 2014. A slowing down or even retraction of those trends would be a negative for CVS and its competitors.

Recent weakness in the stock is more of competitive nature. For a few years, disputes between Walgreens and Express Scripts drove a lot of PBM business towards CVS, but that has reversed over the past 18 months or so. CVS’s double-digit percentage drop after Q3 earnings were driven largely by Walgreens winning business from Prime Therapeutics (owned by the Blue Cross/Blue Shield plans), as well as from Tricare, the U.S. military’s health insurance provider, both away from CVS. In the PBM business, stealing customers is the main way to grow, and we should expect further ebb and flow of business, as well as likely pricing pressure, to continue.

Conclusion

CVS is a great business with a great record of returning cash to shareholders. The stock right now is at one of its more attractive valuations, historically, and far cheaper than its primary competitors. The stock’s weakness is due to what looks like short-term competitive pressures inherent to the PBM business, which we expect will ebb and flow over time. A reasonably conservative valuation puts the stock’s fair value above $100, creating a nice margin of safety from current prices. CVS looks like a solid option from the Magic Recipe Spell.