1 Cash Cow with Massive Upside

CVS Health (NYSE:CVS) share price declined by over 23% over the past twelve months. Hurting shareholders was the recent leadership transition from CEO Karen Lynch to David Joyner, a shift that brought uncertainty to the company’s direction as investors questioned the company’s stability while facing ongoing challenges.

Adding to the woes and weighing further on shareholders was CVS’ retail pharmacy operation that struggled on the back of fierce competition from major retailers like Amazon and Walmart, as well as tightened profit margins.

The disappointing results brought the very structure of the company into question with a proposal that will ultimately boost shareholder returns and improve segments with poor results.

In spite of CVS share price improving over the past month, rising by around 27% as sector optimism rose amid upbeat reports, the longer term price decline has caused the stock to trade at a discount compared to industry peers at 10.48 times forward non-GAAP earnings, while the sector median is at 20.7. So is CVS finally on sale or just a value trap waiting to ensnare new buyers?

Key Points

• CVS shares fell 23% in a year due to leadership changes and retail pharmacy challenges, but a 27% rebound raises hope for a rebound.
• Q3 revenue rose 6.3% to $95.4B, but adjusted EPS fell 51% amid healthcare segment struggles.
• CVS supports a 4.71% dividend yield, and benefits from Medicare Advantage expansion, a $1T market by 2030.

CVS Sales Up, Profits Down

In the last reported quarter ending September 30, 2024, CVS saw total revenues increase by 6.3% year over year to $95.4 billion, supported by growth in the Health Care Benefits and Pharmacy & Consumer Wellness segments.

In spite of the decent top line results, earnings declined with adjusted operating income falling by 42.8% from the year-ago quarter amid a decline in the Health Care Benefits segment.

Adjusted income attributable to CVS Health came in at $1.37 billion versus $2.85 billion, leading to a decline in adjusted EPS to $1.09 from $2.21 in the prior year quarter. This was in part attributable to a decline in the Health Care Benefits segment’s results, which showed continued utilization pressure and premium deficiency reserves.

Is CVS Health Stock Undervalued?

CVS is substantially undervalued at this time, both according to analysts who have a $65 price target on the stock, and a discounted cash flow forecast analysis that puts fair value at $74 per share.

There are some decent tailwinds that can support CVS, including an expanding healthcare market, which is growing thanks to an aging population and chronic diseases becoming more common.

For investors, a tailwind that cannot be ignored is management’s decision to buy back shares aggressively. There’s also a really attractive 4.71% dividend yield that cannot be overlooked and will prove sufficiently attractive to keep many income investors on the hook. Another piece of good news is that the dividend has been hiked in each of the past 3 years.

For those worried about the sustainability of the dividend, the payout ratio of 66% is elevated but by no means at altitude levels that would be cause for concerns.

A further metric to suggest undervaluation is the price-to-sales ratio of 0.2x, which is really low and suggests much of the bad news has already been baked into the current price. It’s quite extraordinary for a company producing $367 billion in revenues to have a market cap of just $71 billion and product $5 billion of net income but that’s where CVS sits.

CVS Is a Cash Cow

While it’s clear that CVS has a struggling retail footprint, it also generates enormous free cash flows. In 2021 it produced $15.7 billion while in 2022 that number was $13.3 billion and in 2023 it was $8.5 billion. These numbers are staggering and all the more important in light of the higher-interest-rate environment where companies dependent on debt financing are being squeezed.

The solid balance sheet and consistent cash flows are what enabled management to authorize an aggressive buy back of shares and grow dividends while still reducing leverage, something the market may not be fully pricing in. Management’s return of cash to shareholders without compromising long-term investments makes it an appetizing play for value-oriented investors.

One under-the-radar growth avenue for CVS too is its increasing dominance in Medicare Advantage, an area where it holds a structural edge due to its vertical integration. Via its Aetna insurance arm and extensive pharmacy network, CVS can control costs and drive higher retention among Medicare beneficiaries, a competitive edge versus rivals who may struggle to replicate the pricing approach.

Last year, CVS’s Medicare Advantage enrollment growth exceeded expectations, eclipsing those of many rivals as seniors gravitate toward plans with embedded pharmacy benefits. Combine pricing power with drug manufacturers and the ability to cross-sell healthcare services, and shareholders may be in for higher margins over time. With the Medicare Advantage market expected to grow to over $1 trillion by 2030, CVS may have a growth engine long-term that’s currently being underestimated by Wall Street. If management executes well, this segment alone might well be a major catalyst for multiple expansion.