– By Robert Abbott
It is unusual to find the GuruFocus system has given a company a 10 out of 10 rating for valuation. That means the stock is selling for a discounted price.
CVS Health Corporation is one of the few, with a modestly undervalued rating according to the GuruFocus Value Line:
The trouble with this stock is, if you buy the bargain, you also buy the company’s debt, which has grown considerably in recent years:
Not that the debt has been frittered away; in recent years CVS has made several major acquisitions that have rounded out its business. That has opened the door for higher revenue and earnings in the future. Among the acquisitions were:
- 2014: Coram, a specialty infusion services and enteral nutrition business unit of Apria Healthcare Group Inc.
- 2014: Navarro Discount Pharmacy, the largest Hispanic-owned drugstore chain in the U.S.
- 2015: Omnicare, the leading provider of pharmacy services to long-term care facilities.
- 2015: Target’s 1,600+ pharmacies and clinics.
- 2018: Aetna, a health insurance company, for $70 billion.
The acquisition of Aetna was based on the idea that together, they could create an integrated health care company, one in which CVS pharmacies would be hubs for medical and patient services.
These integrated operations are called HealthHUBS. At the end of the second quarter, 205 of them were up and operating, and it expects to have 1,500 in place by the end of 2021.
Obviously, CVS is a company with an ambitious vision for the future, and the financial resources to pursue it. Will this make it a company worth buying for a term of five years, ten years or longer? Let’s take a look.
CVS has borrowed heavily over the past decade and especially over the last couple of years. Note that its debt situation compares unfavorably with its competitors in the healthcare plans industry and, with one exception, its own past borrowing.
We also know the debt load is heavy because the company’s interest coverage is only five times its interest payments, meaning it only generates enough operating income to pay its interest expenses five times over. That’s relatively weak.
The debt burden is also reflected in the Altman Z-Score, which, at 1.88, suggests the company is financially stressed.
Offsetting the rapidly growing debt, to some extent, is the rise in cash and cash equivalents (including Aetna’s financial contributions):
Investors are also given some reassurance from the Piotroski F-Score of 7, which indicates a healthy financial situation.
In the second quarter earnings presentation, CVS reported it would make debt reduction a continued priority, along with maintaining the dividend. In addition, it noted it had repaid $2.75 billion of scheduled debt principal in July. Share repurchases have been postponed until it meets its leverage target (not defined in the latest earnings release or most recent 10-K).
Overall, the financial strength rating is sapped by the presence of debt, but the debt level is not a serious problem at this point, in my view.
At first glance, we might wonder why CVS gets a strong profitability rating when its margins are lackluster when compared with other industry players. The reason is the several other elements that are involved in the rating:
- Operating Margin %
- Piotroski F-Score
- Trend of the Operating Margin % (five-year average)
- Consistency of the profitability
- Predictability Rank
The operating margin is mediocre, but the Piotroski F-Score is strong. The operating margin is in a downward trend (averaging 6.5% per year over the past five years). Predictability is as good as it gets, with 5 out of 5 stars, and profitability as measured by Ebitda has not been consistent but certainly shot up in 2019.
The revenue growth and profitability metrics on the last three lines of the table show single-digit improvements, but they compare unfavorably with those of their competitors.
Starting with the broader context, the stock price has been on a downward trend since 2015:
The current pricing gets a GF Value rating of modestly undervalued, meaning there should be a small to medium margin of safety.
Otherwise, the price-earnings ratio is low at 9.14, barely above its previous low of the past decade, which was 9.05. The median over the past 10 years was 16.46, while the maximum was 27.17.
The PEG ratio, at 7.08, is certainly high (a reading of 1.00 is considered fair-valued). That’s because the Ebita’s five-year growth rate is low at 1.3% (notwithstanding the big jump in 2019).
The discounted cash flow (DCF) calculator also concludes CVS is undervalued, with its share worth almost $10 more than their $57.49 close on Sept. 15. That would provide a margin of safety of 14.59%.
Dividend and share buybacks
CVS currently offers a dividend yield that compares favorably with its industry peers and with its own history. The median yield over the past 10 years is 1.33, suggesting the company has raised its dividend payments. This 10-year chart shows it was doing that, but stopped two years ago:
At 32%, the dividend payout ratio is relatively low, indicating the company intends to keep spending on growth. This ratio leaves 68% of free cash flow available for capital expenditures.
The three-year dividend growth rate is good and well ahead of current and anticipated future inflation rates.
Combining the current yield and the dividend growth rate, we arrive at a five-year yield-on-cost of 6.36%. That’s a good rate, but will be consumed by capital losses if the 10.4% average annual decline in the share price continues:
The forward dividend yield is the same as the trailing 12-months yield, so there has not been a dividend increase in recent quarters.
If capital losses weren’t enough, the company has been issuing more shares than it has been buying back, therefore diluting the value of its shares (and the fortunes of its shareholders).
A large part of this is due to the big 2018 deal, where Aetna shareholders received 0.8378 of a CVS share for each share of Aetna they held, plus $145 in cash.
Despite the capital losses and share dilution, a sizeable number of gurus hold positions in CVS. By share volume, many of them have been trimming their positions, though:
Presumably, those who still hold the stock expect CVS to significantly improve its finances and profitability as the Aetna purchase and strategy changes take hold in the coming years.
Dodge & Cox held the largest stake at the end of the second quarter, with 16,001,738 shares, good for a 1.22% stake in CVS and representing 0.96% of their assets under management. The firm reduced its holding by 23.3% in the quarter.
Barrow, Hanley, Mewhinney & Strauss, as well as PRIMECAP Management (Trades, Portfolio), also trimmed during the quarter, but not as much. The former cut its position by 13.6% to end the quarter with 9,657,391 shares, while the latter trimmed by 2.36% to 5,135,945 shares.
Where investors will stand on this stock will depend on what they expect from the future, and how well its acquisition of Aetna will work out in the next five to ten years.
Bears will point to the capital losses and dilution of share value. Combining these two factors, even a potential dividend yield of more than 6% won’t make this a money-making stock. Bulls will point to the corporate strategy that sees CVS becoming much more than just a chain of pharmacies, and the profit potential of this new approach.
There is a margin of safety, according to the DCF and GF Value data, but value investors may also see a heavy debt load and look elsewhere. Growth investors will be looking for an upward trend in the share price before they put their money into it. Income investors will look elsewhere until CVS can offer a dividend that isn’t negated by capital losses and dilution.
Disclosure: I do not own shares in any of the companies named in this article.
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This article first appeared on GuruFocus.