Thesis

CVS Health (CVS) is a diversified healthcare company that has a strong track record and that should be able to capitalize on growing healthcare spending over the coming years as well. Right now shares are very inexpensive. As debt gets paid down over the coming years, while profits and cash flows continue to climb, a re-rating in CVS’ valuation is not unlikely. A return to a higher (historically justified) valuation, and a resumption of dividend growth, could allow for meaningful returns over the coming years.

Buffett says to buy low, CVS HealthSource: imgflip.com

CVS Health Is An Underestimated Growth Company

According to some investors, CVS is not a growth company, is “dead money”, etc. But the facts say that CVS is, quite contrary to public opinion, indeed a growth company:

ChartData by YCharts

Over the last 20 years, CVS Health has grown its revenues by 800%, its profits by 670%, and its cash flows by 1260%, all on a per-share basis. It should be noted that earnings per share, which have underperformed revenue per share, are artificially deflated by high non-cash amortization charges over the last couple of years. Adjusted for that, i.e. when we look at non-GAAP numbers, EPS growth would have been significantly higher. Even an EPS increase of 670% over 20 years is quite a feat, however, as this equates to an annual growth rate of 11%.

Looking at the cash flow per share growth rate, which may be more important, as cash flow is what the company uses to pay down debt, to pay dividends, build out assets, etc., the annual growth rate over the last 20 years is 14% a year. A company that is able to grow its revenues, earnings, and cash flow at a double digit pace for the last 20 years has showcased quite compelling growth in the past for sure, but CVS does not get a lot of respect for that. Quite the contrary, the company oftentimes is deemed as a low-growth, or even no-growth stock.

Past returns, of course, do not equate to future returns of a similar magnitude, but CVS Health still has a solid growth outlook. This is showcased by the fact that analysts are modeling a meaningful EPS improvement in both 2021 and 2022, versus the base year of 2020:

ChartData by YCharts

This meaningful EPS growth of around 15% between 2020 and 2022 is forecasted to occur despite the fact that CVS Health is not spending meaningful amounts on share repurchases right now. Instead, the company is focused on deleveraging. Once its deleveraging goal has been met and the company can shift cash flows to buybacks again, EPS growth could easily accelerate. This is due to the fact that the EPS accretion of buying back shares at a sub-10 earnings multiple is much higher compared to paying down debt.

The company should, in the long run, also benefit from the megatrend of growing healthcare spending. Politicians sometimes argue that healthcare is too expensive, that costs should be lower, but it is a fact that healthcare spending has been rising across the globe for decades, and there isn’t really any good reason why this trend should suddenly reverse. Aging populations mean that more people require treatment for a rising number of ailments, while new high-tech medication and treatment options come with higher costs. Forecasts see US healthcare spending grow by 5.5% a year through the 2020s, which could be enough to fuel mid-single digit revenue growth for CVS all by itself, assuming that its share of total US healthcare spending remains unchanged. Adding in some additional EPS growth from margin increases, buybacks, etc., and earnings per share could easily grow at a high single digit rate over the coming decade. So why aren’t investors more into CVS? I believe that one factor could be that CVS has a meaningful debt load, which the market does not like right now, despite record-low interest rates. Debt, however, is not a major problem for the company when we take a closer look.

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Debt Is Very Manageable

Looking at CVS’ debt load, we see that the standing for total long term debt is $72 billion as of the end of the second quarter. This is down just 4% from the high, which was hit in early 2019.

ChartData by YCharts

At the same time, however, CVS has reduced its net debt by a more meaningful pace by building up cash on its balance sheet. This cash position can be used to either pay down debt once it matures, or to buy back bonds on the open market. Not counting restricted cash, CVS’ cash totaled $7 billion at the end of the second quarter, for a net debt position of $65 billion. If restricted cash is included, the net debt position is way lower, at ~$54 billion.

The net debt position is still not small at all, however, at $65 billion (we will exclude restricted cash for now in order to be conservative). CVS is targeting a leverage ratio (net debt to EBITDA) in the low 3s in 2022. With EBITDA of $18.5 billion during the last four quarters, and conservatively assuming that EBITDA will not grow through the next couple of years, CVS would have to reduce its net debt to $59 billion in order to hit a 3.2 times leverage ratio. When we assume that management decides to be even more conservative and go for a 3.0 times leverage ratio, net debt would have to drop to $56 billion. Compared to the current level, this means that debt would have to decline by ~$9 billion. Since management plans to hit its deleveraging target by the end of 2022, the company has about 2.5 years to get there. This seems like a very achievable goal: The company guides for operating cash flows of $11.3 billion during 2020, which would be down slightly versus 2019. According to the 10-K, CVS has spent $2.5 billion on capital expenditures in 2019. Assuming that capital spending will remain unchanged from 2019, the company would generate free cash flows of $8.8 billion during the current year.

Considering that the dividend costs the company about $2.6 billion, after-dividend free cash flows total about $6.2 billion a year. In order to be extra conservative we can round this down to $6 billion per year which would be available for debt reduction, acquisitions, or share repurchases. Since the company has vowed to forego share repurchases until its leverage goal has been hit, the company will likely concentrate the majority of these funds towards debt reduction. Over the next 2.5 years, CVS could thus theoretically reduce its net debt by $15 billion, which would be more than the $9 billion necessary to hit their leverage goal. In fact, the goal could be hit as early as the beginning of 2022 were the company to concentrate on it instead of also simultaneously funding additional acquisitions ($400 million was spent on acquisitions in 2019).

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When we factor in that cash flows may be higher in 2021, which would allow for increased debt reduction, and that EBITDA will likely rise over the coming years, which means that hitting a debt level of 3 times EBITDA becomes easier, it looks like management’s guidance is quite conservative. It does not seem overly optimistic at all to assume that CVS will have reduced its net debt to around 3 times EBITDA by the end of 2022. In fact, it seems like this goal could be achieved earlier than that without too much hassle.

All in all, the debt position looks thus quite large at first sight, but the company will be able to reduce its net debt meaningfully over the coming years, while its high EBITDA means that its debt load is not really threatening.

A Low Valuation And Rising Shareholder Returns

Once the target leverage ratio has been met, CVS will most likely divert more cash towards shareholder returns once again (as it did before the Aetna takeover). This will likely mean that the dividend will start to grow again, but CVS will, we believe, also get back to repurchasing shares. Between 2011 and 2018, CVS has bought back roughly one-third of its shares, which shows that management has been a big fan of buybacks in the past. Once leverage is in the target range, which should occur in 2022, investors can thus count on an increase in payouts via both rising dividends and buybacks.

If CVS, which has a market capitalization of $76 billion right now, were to pay out its free cash flows of $8.8 billion (2020 estimate) completely, that would equate to a shareholder yield of 12%. This shows the strong potential for shareholder returns once the debt reduction goal has been hit.

This brings up the question of how CVS should be valued. Is a 8.0 times earnings multiple a fair valuation for a company with a strong growth track record, a solid long-term outlook, and the potential for rapidly increasing shareholder returns 2 years from now? I believe that the market will re-rate CVS once the debt reduction goal has been met and dividend growth and stock buybacks resume.

ChartData by YCharts

For a company with CVS’ track record and favorable long-term megatrends, a 12 times earnings multiple in 2023, following the completion of the debt reduction efforts, would not be too high at all, I believe. In fact, a 12 times earnings multiple would still be on the cheap side compared to how shares were valued in the past, as seen in the above graph. Based on current estimates for 2023’s EPS, shares could thus trade at ~$105 three years from now. Compared to a current share price of $57, this equates to a quite large upside of around 80%, while investors also get some above-average dividends on top of that.

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CVS also looks quite cheap compared to its peers:

Source: Stock Rover

The company sports the lowest EV/EBITDA multiple and the lowest trailing price to earnings multiple. Also, its valuation is the lowest on a relative basis when compared to how shares were valued in the past (last column).

Risks To Consider

Healthcare is not a cyclical industry, nor is CVS a cyclical company. However, there is a key risk that political pressure on healthcare companies, and especially insurance companies, is increasing. In the past, all political talk has not resulted in declining revenues or margins for insurers. I thus do not see meaningful pressure as overly likely, but this is still something investors should keep in mind. If politicians really want to go all-in on reducing healthcare costs in the US, this could have a meaningful negative impact on CVS. At the current very low valuation this seems to be priced in already, however.

The new “most favored nation” executive order that seeks to limit prices of prescription drugs also is a potential risk for CVS. Likely, the biggest impact will be felt by drug manufacturers, but distributors and retailers may also feel some headwinds. I personally do not believe that this will be a huge headwind for CVS, but investors should keep an eye on that in any case.

Takeaway

The market oftentimes has a very short-term view, and right now there are no large shareholder returns as the company is still focused on debt reduction. But a couple of years from now, CVS should be a company with higher profits, lower debt, a growing dividend, and ample surplus cash to return to shareholders, and I believe that the market will reward the company for that. I thus see ample upside potential for shares over the next couple of years, which makes CVS worthy of a closer look for long-term oriented investors.

One Last Word

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.



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