CVS’s Guide May Have Reached ‘Kitchen Sink’ Point (NYSE:CVS)

Introduction:

An old saw for value investors is, ‘First they get cheap, then they go down.’ If you look at the previous articles on (NYSE:CVS) dating back over a year, that statement might keep coming to mind. This was a stock that kept coming up on value screens I’d run, but I never bit until now. The negatives that kept me out can also be seen in the more recent articles, where authors have downgraded their view or punted completely. Fundamentals were deteriorating as seen in the margins of the consolidated company. It’s a complicated story, as they have taken a somewhat unique strategy by expanding horizontally into three distinct segments that they hope/argue will provide synergistic opportunities. Executing that strategy has led to acquisitions which required the company to increase leverage. Declining margins, conglomerate company structures, and higher than peer leverage are all bad enough. The cherry on top is the government action on their PBM business and resulting bad press.

I’m not here to sugar coat this. Look at that chart. It’s been nothing but bad for almost three years now. Its pandemic lows level bad on that chart. Yet I’m also here to share that I’ve bought in a half sized position. The reasons stated without details are: 1.) the stock is absolutely, historically, and relative to peers cheap, 2.) the yield is attractive and sustainable, 3.) the primary issue is with the Healthcare Benefits segment, i.e. Aetna, which is severe, but I believe likely correctable, i.e. not emblematic of a systemic change to the business model, 4.) while the smoke around their PBM business continues to be a negative, it’s not nearly as big of an issue right now as their Healthcare Benefits segment decline is. In other words, there’s the perception of the company’s problems versus the reality. Despite the most recent attacks, plus the abysmal guidance for the second quarter in a row, the stock is starting to build a base and resisting a new leg down when the market was weak. Paying attention to how a stock trades in relation to significant news is important, particularly relative to the market, and it looks to me it’s beginning to form a base in this 50’s zone. Now to fill in the details on all of those points.

Valuation:

I’m a value investor, so yes, this is important: CVS’s stock looks really cheap, and I believe still discounts the risk of further deterioration which is absolutely understandable. That’s also something I like about this entry point. As a general rule of thumb, if the market believes an earnings profile is stable but only at best an in-line growth profile to Gross Domestic Product, then at worst the stock will receive a 10x Price-to-Earnings multiple. There are variations to this general rule depending on how cyclical the industry is, but as accurate as any generalization can be it’s an effective rule. Hence, a stock trading below 10x arguably is pricing in some risk for further deterioration in income.

We’re just under 9x on the forward guidance now which is to say I find this, on an absolute basis, fitting the valuation profile. You can also see on this chart the argument for historically cheap in the trailing PE Ratio. Zooming in on this period since 2018 shows the 10x trailing multiple has been the low end of the range. I admit the PE Ratio is not my favorite metric, but in this case, it may be the best fit for using as an historical review given the negative tangible book value due to those acquisitions I mentioned. Price-to-Sales also is hard due to the segments mix changing and the lack of their contribution in the past. It’s a challenge however we look at it, so I’d lean more heavily in recent trends than ones from thirty years ago for example.

I also mentioned it looks cheap relative to peers. Again this is challenging as there is no single perfect peer to CVS due to their horizontal expansion. However, there are certainly some similar companies. UnitedHealth Group (UNH), The Cigna Group (CI), and Humana (HUM), all share some exposure with CVS excluding the consumer pharmacy storefront business. Elevance Health, Inc. (ELV), and Centene Corporation (CNC), have healthcare benefits business. Walgreens Boots Alliance, Inc. (WBA), and the barely a pulse Rite Aid Corporation (OTC:RADCQ), are peers for the consumer segment, but let’s be honest and just admit those two are in terrible shape and not very good comparisons to any functioning business. Hence, I’m going to focus on the healthcare comparisons for this peer review.

The above is the forward PE Ratio for all six companies, but I want to highlight CVS with CI below, as those two probably show more clearly the change in the relative relationship.

I’m not trying to say CVS should be getting UNH’s multiple. The PE ratio has its limitations. In this case, I’d probably use Enterprise Value to Operating Income on a forward basis if I could get that chart, but it’s not an option, unfortunately. However, you can see the clear deterioration in CVS’s multiple versus CI. We can debate what multiple CVS could earn in the future, but I think we can agree it at least appears cheap on all three iterations: absolute, historical, and relative. Another valuation method we could employ is a Sum-Of-The-Parts for each segment with specific peers. I encourage the reader to try this as well, but when I did this the result looked so cheap for CVS that I didn’t think it was useful. Which leads to my next reason for owning some stock here: it’s yield.

Stock Yield:

CVS is paying a quarterly dividend of 0.665 which equals an annual $2.66 per share. That equates to a 4.6% yield on a forward basis, with the stock currently trading at $57.98 as I type. With the two and ten year treasury rates essentially at 3.65%, that makes CVS an attractive yielding security to my eyes. Here’s a snapshot of an income table I recently took from Fidelity’s Active Trader Pro.

These all depict the highest rate available across different security types, durations, and ratings grades. You can see how far either out in duration, or increase in risk via type of security or investment grade rating you have to go to get a comparable yield right now. It’s not high enough to make me worried the market is signaling something about its forward outlook, but it’s attractive enough that one can make the argument the stock could be viewed as if it were an income security with a perpetual call option attached.

Here’s how the trailing yield looks on CVS’s chart since it started paying a dividend. This is for a company with a different mix of businesses over time, and a very different interest rate curve, but still interesting to note. The key question of course though: is this dividend rate sustainable?

We can discuss payout ratios for determining sustainability of dividends, but I think it’s more useful to cut to the chase and see the dollars being used for that purpose relative to the free cash flow generated. A few items to explain on this chart above: the yellow for fiscal 2024 is based on their guidance, “FCF-power” is a metric I create that ignores changes in working capital by using net income plus depreciation and amortization as the effective cash flow from operations calculation. Over time, most business models should have their CFFO match that simple calculation unless there is something unique in their model that causes it to consistently deviate. That’s the case here as CFFO consistently outproduces my metric, but I still find the process a useful exercise when studying a company.

The key points to focus on though, is the percentage of cashflow used to pay dividends from the free cash flow generation of CFFO-Capital Expenditures. Yes, this year’s guide shows it’s up to just under 55%, but on the last call they said they wouldn’t repurchase any more stock, and they’ve consistently reiterated their commitment to maintaining an investment grade rating. The dividend is also only about 75% of their depreciation and amortization rate. Hence, there are a number of different ways they can cover this payout rate assuming this is the relative floor in fundamental deterioration.

Q1 2024 Conference Call: Tom Cowhey – Chief Financial Officer

Shifting to liquidity in our capital position, first quarter cash flow from operations was $4.9 billion. We ended the quarter with approximately $1.9 billion of cash of the parent and unrestricted subsidiaries. In the first quarter, we returned $840 million to shareholders through our quarterly dividend. We also completed our $3 billion accelerated share repurchase transaction, retiring approximately 40 million shares in the quarter. We do not expect to repurchase any additional shares for the remainder of 2024.

Our leverage ratio at the end of the quarter was approximately four times. This leverage ratio was higher than we expect to maintain on a normalized basis. We remain committed to maintaining our current investment grade ratings.

Q2 2024 Conference Call: Tom Cowhey – Chief Financial Officer

Shifting now to liquidity and our capital position, through the second quarter, we generated year-to-date cash flow from operations of approximately $8 billion. During the quarter, we returned $858 million to shareholders through our quarterly dividend and ended the quarter with approximately $2.9 billion of cash at the parent and unrestricted subsidiaries. We remain committed to maintaining our current investment-grade ratings.

Healthcare Benefits Segment:

I’m a generalist value investor, so when I enter an industry that I have not previously done significant in-depth analysis with before, I try to keep in mind the 30,000-foot view at all times. It’s very easy to let the details overwhelm the longer term fundamental outlook of a business model. I.e., another old saw, don’t miss the forest for the trees.

In terms of CVS’s Healthcare Benefits segment’s performance and the industry as a whole, I still haven’t found the reasons as to why this isn’t a company-specific issue that can be corrected over time, versus it being a greater systemic issue that will affect all providers eventually. To this point, the most plausible explanation for CVS’s deteriorating performance from this segment, is that they got way too aggressive last year on Medicare Advantage pricing. Management went for more medical membership growth primarily on the back of Medicare Advantage subscribers, and they got clipped by pricing too aggressively to get that growth at the same time medical utilization expenses spiked. While that’s bad and it has led to the loss of the job for the segment’s head, it does not suggest in itself a fundamental change to the future model’s earnings capabilities.

In the above chart, I’ve assembled a group of Healthcare Benefits adjusted operating income or EBIT margins to the best of my abilities. These are just the specific segments in some cases versus the entire company’s if they have other business lines like CVS. I’ve extended CVS’s line to include their guidance for 2024 in total. It’s even worse if you were to just look at their second half effective margins around 1.1%. Hence, why I do think they may have just given us the kitchen sink guide for this segment after the last report. The other peers on this list show variance, but nothing to the degree of the decline CVS finds itself. We could debate what the forward margin profile should be in the future for CVS. Perhaps it should be grouped more with Humana Inc. (HUM), and Centene Corporation (CNC), versus UnitedHealth Group Incorporated (UNH), Elevance Health, Inc. (ELV), or The Cigna Group (CI). Either way, I think it’s clear to see that Aetna is way under its normal margin profile and the rest of its peers, and that it should be able to return to something north of where they have guided to now over the next few years. How much it is able to regain will determine how far the stock can go, but at this stage of my investment, the thesis is hinged on the collapse in margins looks like it can be reversed since we’re not seeing peers showing anything similar to what CVS is suffering.

Perception Vs. Reality:

It’s not to say that bad press and government agency attacks don’t matter. Of course, they do, and if nothing more it at least effects sentiment which will dampen the multiple a stock receives. The degree of importance though in why this stock has declined also matters in assessing the risk/reward. It is my contention that these news items have been more about the last straw for investors than fundamentally additional negatives driving results down.

Hopefully, I showed in the last section the magnitude of the decline for the Healthcare Benefits segment. In terms of the importance of this segment to the entirety of CVS’s consolidated results, I’d point to that last line item in the chart above I’ve added that shows the percentage of the adjusted operating income from the Healthcare Benefits segment to the total gross adjusted operating income of the company. Normally, it’s about 1/3rd or more of the total, but this year it’s going to be a mere 17.2% based on guidance.

Now let’s look at the trailing twelve-month operating income line for the consolidated CVS. If you compare the above chart with the Healthcare Benefits spreadsheet above it as well, then you can see how the deterioration from the Healthcare Benefits segment explains most if not all of the fundamental decline for consolidated CVS. Yes, it also suggests that the remaining two segments aren’t exactly growing like gangbusters. Both are guided to be down this year (1%) to (4%) respectively between Healthcare Services and the retail Pharmacy Consumer. The former contains the PBM business that is receiving a lot of concern over what the government might do. CVS’s Caremark is the largest of the three that dominate the market, but the degree the negative press hurts CVS’s stock seems to outweigh in comparison to fellow competitors UNH and CI. The traditional retail business is down more, and also has a negative narrative for those bearish around struggling competitors and of course Amazon Inc. (AMZN) entering the pharmacy business. AMZN does have a knack for driving profitless growth in revenue and getting rewarded for it in stock price, but I would contend CVS’s current weakness in retail has more to do with the post-pandemic effect than AMZN at this point.

The above chart is the same trailing operating income chart from before, but zoomed in to start from 2009 and in a log scale. Hence, it better displays the rate of change of a series of numbers versus a traditional linear display. I think this shows the bump CVS saw from the pandemic as so many citizens in the U.S. went to their stores to either get treatment, vaccines, or test kits when needed. The key metric in my opinion for these stores has always been the Same-Store-Sales figure for the Front-Of-Store. That’s where they make a profit, and that’s why they put the pharmacy in the back of the store. If you enter to get some medication, then they hope you buy something else before you leave. The Front-Of-Store figures from FY’19-FY’22 were the following percentages: 1.1%, 0.9%, 7.6%, 7.8%. That slowed to 0.3% for all of FY’23, but the second half is when that figure turned negative. The last four quarters have been: (2.2%), (3.1%), (2.2%), (4.0%). Management has been highlighting the effect of just the test kits.

Tom Cowhey – Chief Financial Officer, Q2 ’24 Conference Call:

Same store front store sales were down by about 4% versus the same quarter last year. Excluding OTC test kits, same store front store sales were down about 2%, reflective of general softening of consumer demand. As a reminder, the public health emergency was active through mid-May last year.

Hence, there has been some weakness ignoring the post-pandemic effect. You can blame AMZN, or you can blame the economy, but either way I don’t think it’s as bad as the narrative makes it out to be, and they have at least fully lapped the pandemic boost now with the reports moving forward. Hence, I would expect to see some moderation in these Front-Of-Store trends even if we go into a recession.

Bottom line, I continue to believe the focus should be on Aetna and less on the headlines. I haven’t seen a convincing argument for why Aetna’s struggles can’t be reversed over time, and the market so far backs up that view with the way CVS’s peers trade. I don’t have a strong view either way about current management, but I do believe someone will find the right solution for turning Aetna around. It’s still the third-largest Healthcare Benefits provider in the country, which suggests they should receive some degree of positive network effects from their positioning relative to the smaller competitors.

Conclusion:

I’m not going to make a separate risk section as I’ve already been discussing the primary ones throughout this article, but I would like to try and tie it all together here in a more nuanced approach to assess the risk-reward equation for this buying suggestion. A large part of my thesis depends on my assumption that the risk is not in the FTC’s or Congress’s attacks on the PBM business, or AMZN’s entrance into mail-order pharmacy business, but the mis-step in the Healthcare Benefits segment around Medicare Advantage. If I’m wrong about any of these issues, then I get some cushion in that the stock valuation is low enough to already be discounting further deterioration. The yield is at an attractive level for an equity security, particularly relative to the current curve opportunity in treasury rates, and it looks very sustainable to me based off of their free cash flow generation even on this year’s depressed level of performance.

One risk I haven’t discussed in greater detail to this point is their leverage. It’s higher than their peers, which can be explained by their horizontal expansion via acquisitions over the years.

Here is the financial debt to equity ratio of the healthcare benefits peer group. The spikes from CVS in 2018 and 2023, are from the Aetna and Oak Street acquisitions, respectively. This is a big reason why I believe the stock is cheap, and to be honest is also one of the reasons why I never bit at this potential long earlier in its decline. Leverage is how cheap stock investments go horribly wrong. If it wasn’t for the free cash flow generation of the company, and it’s stated commitment to reducing its leverage to maintain investment grade ratings, I wouldn’t be touching this name. If you want to get this stock up and get a better multiple, all they have to do is pull this leverage back down to in-line with peers. I believe they would at least get a 10x type of stable multiple just on that basis alone.

An argument one could make against my thesis, is that I argue the market’s treatment of Healthcare Benefits peers doesn’t suggest there is a systemic problem in that business model, but one could retort that’s not the case for the Pharmacy/Consumer segment. Clearly, CVS looks like the only company left standing with a functional national pharmacy chain that’s profitable. This is true, and it’s important because a lot of that free cash flow generation comes from the Retail business. That FCF can allow them to de-lever, and pay a stock supporting dividend at the same time. A significant further deterioration quickly in that business would be a problem for my thesis and the stock.

However, I do wonder if this is a spot where their horizontal expansion could help. If we assume that AMZN really does eat into their market share so that foot traffic declines leading to further Front-Of-Store deterioration in sales, then I wonder if they can’t take a novel approach to utilizing those spaces with more Healthcare Services operations. I.e., instead of expanding those business lines with standalone new operations, they switch to incorporating them into their current storefront space. Now, you have potential customers going to CVS to get checked by a doctor, who can prescribe on the spot medicine if needed, that, (if done correctly), could be picked up at the pharmacy counter a few minutes later instead of making another trip. This might have already been discussed previously by management, as I’m sure I’m not hitting on a possible approach that hasn’t been seen by many others before, but the point is the horizontal expansion likely does offer some strategic initiatives they can take where their competitors in retail find it harder to implement to the degree CVS could.

To sum it up again, the key to me is their free cash flow generation is still significant. It keeps their dividend easily sustainable with the stock yielding an attractive 4.6%. That should also allow them to de-lever their balance sheet at the same time which would enhance their multiple in relation to their peers. The stock is absolutely, historically, and relative to peers cheap with a multiple that still implies risk to the downside in their earnings estimates. Yet, the key culprit in their fundamental decline is not in the headlines about their PBM business or retail competition, but the precipitous decline in their Medicare Advantage business in the Healthcare Benefits segment. While the magnitude is severe, I haven’t found a reason yet to believe that it can’t be turned around over time. While the eventual target for the stock will depend largely on what degree of margin this division can regain, the behavior of the stock suggests that it may be supporting the valuation as establishing a base zone until fundamentals improve. I like that setup when obtaining an attractive yield as one essentially would be getting paid to wait.

Above are the one-year charts for this year’s EPS estimate, and the actual bar chart of the stock with earnings reports indicators. Note how despite the last report leading to a further decline in the estimate, the stock did not begin a new leg lower on the chart. Instead, it’s beginning to form a base here in the $50’s. Time will tell how it manages to get through the tax loss season, which is why I haven’t taken a full position as of yet, but I am open to adding more if it gets down to an 8x PE handle in the low 50’s.

In terms of the long-term historical stock chart, I often like to use a log chart for as long of a period I can get. If the company has been a good return business over time, then you should see a defined rising channel. I’ve excluded the effect of the 1974 bear market for drawing the channel purposes. This is a subjective process, so feel free to make your own, but this is how I look at the stock of CVS long-term. Generally, when I’m long something like this and it breaks north of its uptrend line, then I begin to at least sell some of the position without a fundamental reason to argue for this cycle being different. Of course, the opposite is true as well as I like buying these when they break below their trends.

In the case of CVS’s long-term chart, we have to accept that the business mix is changing so the above channel may be changing as well. Technical analysis can only go so far. The slope of that channel also suggests that while it’s been a good stock, it looks about the same as long-term returns for the market as a whole.

Indeed, for the most part, since the mid-1990’s, the stock has traded in a relatively tight range to the equal weighted S&P 500 (RSP). It was right at the bottom of its range until the recent calamity. This could be viewed negatively, i.e., ‘It’s broken it’s low!’ However, for the time being I’m operating with the view that the long-term fundamentals of the businesses are still intact. Hence, this looks more like a value opportunity than a trap.

Continue to monitor how the stock trades relative to both its own negative headlines, and the overall market itself. I’ll continue to watch the volume as well to see if tax loss selling is picking up or abating. There very well may be better opportunities to purchase the stock between now and the end of the year depending upon those two factors, but the yield and absolute valuation coupled with the sentiment and severe reduction in the Healthcare Business guidance, has me comfortable enough to take on a half part of a total position here. Good luck investing out there to everyone. –NCSI