CVS Health Corporation (CVS) has declined approximately 10% since my original Buy recommendation in May 2020 to $57/share today. Following the company’s Q2 earnings report and this further valuation discount, I’m reiterating my Buy rating but have slightly adjusted my expectations given the recent margin deleveraging within retail. That being said, existing growth drivers such as mail orders, health insurance, and Minute Clinics will sustain operating performance and should reignite long-term earnings growth.

Two Headwinds

Normally, I like to address risks near the end, but given some negative factors have already materialized, they deserve to be discussed upfront.

1) Even though Retail/LTC revenue growth continued in the low single digits as anticipated, margins significantly deleveraged and operating income declined from $1.67 billion to only $1.06 billion, or a decrease of approximately $600 million. While that may not seem significant for a company that generates $14 billion in annual EBIT, it stalls earnings growth and delays the long-term growth that institutional investors have modeled out over a 5-10 time horizon. Nearly all of the cost increases were related to COVID-19, some of which are permanent and others temporary, according to the latest Q2 filing:

In accordance with governmental directions to shelter-in-place, eliminate large gatherings and practice social distancing, the Company has transitioned many office-based colleagues to a remote work environment. The various initiatives we have implemented to slow and/or reduce the impact of COVID-19, such as colleagues working remotely and installing protective equipment in our retail pharmacies, and the COVID-19-related support programs we have put in place for our customers, medical members and colleagues have increased our operating expenses and reduced the efficiency of our operations.”

Some of the expenses related to remote working is transitory, e.g. purchases of computer hardware, but others such as video conferencing are more structural. The in-store cost increases are significant, but temporary for when the pandemic subsides (e.g. “deep cleaning” staff, sanitation stations, etc.).

Despite that most retail SKUs have taken off during the pandemic, consumer health and beauty (which tend to carry higher margins) were highlighted in the latest Q2 2020 conference call as being disproportionately lower relative to other categories. For context, makeup, hair care, perfume, and other beauty products carry gross margins that are 2x-2.5x higher than CVS’ other categories. With net-net consumers looking to avoid in-store shopping whenever possible, it’s fair to say that certain stores have been impacted from a sales per square footage standpoint. So, while same-store sales are holding up quite well for the store as a whole, storefront sales declined by 4.5% but should reverse and improve over time.

2) The other factor has been a slowdown in healthcare insurance growth, specifically in terms of membership and written premiums. Aetna remains the third-largest healthcare provider in the U.S., has made considerable membership gains over the last decade, and will continue doing so for years to come. Although membership growth was essentially flat quarter over quarter (only growing 50bps) due to Medicare Supplement, while its commercial membership detracted from membership with a 50bps sequential decline primarily due to higher unemployment. The most concerning factor that wasn’t disclosed on the conference call, however, was the fact that insurance premiums sequentially declined by 4%. It’s important to recognize that the decline is only partially related to the slight decline in commercial membership, but more so due to employers and employees choosing cheaper healthcare plans for rationalizing benefit costs, particularly at a time when the economy remains weak and unemployment is still trending within the mid-to-high single digits depending on the state. Clearly, Aetna has excellent scale and is deeply entrenched within the healthcare system, but elevated unemployment has negatively affected all healthcare insurers, and Aetna is no exception. Once unemployment eventually turns to a lower level, then membership trends will likely revert back to their historical low-single digit growth rate and the healthcare plan mix should normalize again.

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Three Growth Drivers

While retail pharmacy has performed decently throughout the pandemic, online delivery has done exceptionally well. Mail choice has been growing by low single digits annually and sustained its trend headed into the second quarter at more than 3% QoQ. Mail choice now represents more than 40% of total pharmacy sales, compared to about 60% in-store. Undisclosed within the footnotes, management mentioned that prescription home delivery volume was up 500% in Q2, which compares favorably against the underwhelming 22.7% growth from Walgreens (WBA). From a revenue segmentation perspective, CVS is mostly likely the market leader at $56.4 billion online deliveries annually, given that Walgreens and Rite Aid do less in total pharmacy sales and have reported weaker same-store sales. Amazon (AMZN) does not provide any material revenue disclosures related to PillPack, and Walmart (WMT) provides revenue segmentation related to health, but these include other non-pharmacy product sales and its disclosures do not breakout in-store versus ecommerce. All in, it appears that competitors remain behind the curve. With CVS being the market leader and plugging away 3%+ growth annually, albeit partially cannibalizing in-store pharmacy sales, it shows that the company will not allow its pharmacy sales to be taken by competitors, as it seeks to be the best in terms of convenience and service quality.

Speaking of health services, management believes that this arena is their next growth driver and will soon provide accretion to operating margins. Currently, there are more than 9,000 urgent care facilities in the United States with a total market share size of $28.4 billion, meaning that these facilities average about $3 million in annual revenue, certainly distinguished by population density and the types of services provided (some provide basic services, while others offer more detailed diagnostics and scanning, surgery, etc.). Urgent care’s total addressable market has also been expanding rapidly between growth rates of 5-9% annually. So, there appears to be a meaningful opportunity that CVS will capture over time, particularly given approximately 1,100 physical stores (or 12% of total retail locations) already have Minute Clinics. COVID-19 testing has also created a natural gateway to Minute Clinics, as nearly 1 million individuals that were screened for COVID-19 were determined to be first-time customers. Heading into the flu season, CVS could pull in additional new customers as well.

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In order to improve customer retention, the company has rolled out options to set up appointments for in-store and web conferences comparable to what would be provided through an urgent care facility. These Minute Clinics appear relatively affordable at $59/per visit, with payment options available for individuals with and without insurance. Of course, this strategy is a marathon, but with existing retail assets and customer cross-compatibility with its pharmacy and insurance operations, the vertical integration strategy reinforces the potential for revenue synergies. On balance, there’s potential for Minute Clinics to falter in areas of intense competition, but it’s not hard to imagine that the vast majority of these locations should do quite well, particularly given management has confirmed profitability related to these operations.

Circling back to health insurance, that segment has been a headache with lower written premiums, however, the industry remains a secular growth business. In the last three years, revenue among its most comparable public company peers have grown by a high-single to double-digit range:

ChartData by YCharts

Furthermore, EBIT margins are within the 6-8% range, which compares favorably against CVS’ other businesses that have low-single digit EBIT margins. It’s fair to say that total memberships will likely be higher by the end of 2020 and premiums will continue their historical growth as they always have, despite all of the political chatter and regulatory concerns. There’s risk that things change, but for now, history favors its wholly owned subsidiary Aetna and the industry overall.

Reducing Debt and Valuation

Previously, it was discussed that CVS carries a healthy balance sheet:

…with its very large cash cushion and access to liquidity. It’s debt load is moderate from both a capital structure and performance perspective.

Running additional calculations shows how much the company has improved its credit profile. Directly after CVS acquired Aetna in Q1 2019, net debt was approximately $87 billion, while TTM EBITDA was approximately $14.2 billion and somewhat higher at run rate with Aetna included. However, turning to Q2 2020, net debt has fallen to $74 billion, as cash has been stockpiling, and all the while TTM EBITDA has increased to $18.8 billion. Therefore, within the span of five quarters, net debt-to-TTM EBITDA has improved from 6.1x to only 3.9x. Moody’s Investors Service recently updated their research note to say that once leverage falls beneath 3.25x and times interest earned exceeds 6x, the company would be considered for an upgrade back to Baa1.

Given that CVS beat Q2 earnings and management raised guidance, the company is expected to generate more than $11 billion in annual operating cash flow. As store remodeling spend rolls off, capital expenditures should revert towards their 5-year average, which will result in a couple hundred million in capital budget cash savings.

ChartData by YCharts

For context, CVS has invested 221K per store over the last five years versus Walgreens at only 153K, which funnels down into maintenance/store remodels that will effectively lead to better sales performance for CVS. With a $11.25 billion and $2,25 billion in capex assumptions, together that would conservatively put the company at $9 billion in free cash flow. When factoring in annual dividends of $2.6 billion, total retained free cash flow lands at $6.4 billion. If all discretionary cash flow over the next two years of $12.8 billion is applied to debt reduction, the company would fall within the 3.25x leverage target and 6x interest coverage. Net tendered debt, in combination with lower interest cost issuance, should effectively reduce its total interest burden heading into 2021 and going forward.

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Quite frankly, issuing record-low interest debt to finance the Aetna acquisition (generating annual sales of ~$69 billion) and being able to return to pre-acquisition leverage over a roughly three-year time horizon, if executed as expected, is absolutely incredible. While institutional capital and Wall Street analysts continue to worry about current growth headwinds, this transition period gives value investors an opportunity to purchase shares at a good price. There’s no reason to put together a complex DCF when back-of-the-envelope math shows the stock is priced for unwavering, gradual declines in operating performance. Yet, that doesn’t seem to be a likely case, as CVS is an essential business and society is slowly returning to normal.

When comparing its free cash flow to enterprise value and market capitalization, the company is selling for a reasonable 9.5x and 5.6x, respectively, as well as 9.1x EV/EBIT.

ChartData by YCharts

These valuations are among its cheapest relative to historical levels. When comparing price to free cash flow against its primary industry peers, CVS also holds the lowest valuation multiple in the group.

ChartData by YCharts

Additionally, both Walgreens and Rite Aid (RAD) have reported impairment charges during the last two quarters, while CVS has not. So, despite the headwinds for the pharmacy chain industry, CVS continues to perform quite well and appears to be the most inexpensive in the pack.

Bottom Line

CVS stock price has returned to levels not seen since the March 2020 stock market sell-off over concerns related to the pandemic. Management continues to execute its multi-pronged strategy of growing pharmacy online, leveraging stores with Minute Clinics, and maintaining business as usual with Aetna, which has allowed the consolidated company to generate $9+ billion in FCF annually. Seasoned management, adaptive operations, and reasonable valuation multiples make the stock a buy at $57/share. This sturdy business remains in my forever investment portfolio, and I plan to accumulate additional shares. If you have any thoughts or questions, please comment below.

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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.

Additional disclosure: I plan to accumulate additional shares of CVS at $57/share or less over the next 72 hours.