When I first wrote my bull thesis about CVS Health (CVS) on Aug 15, 2021, the price was so attractive that I recommended a leverage play using call options. Since then, the total return has been almost 25% and some readers asked if the bull thesis is over or not.
In this article, you will see that now is still an excellent time (maybe the second-best time) to buy CVS Health in a decade. This analysis shows that its valuation is still near a cyclical low and still offers an enticing entry opportunity. While on the other hand, its business fundamental prospects are at a cyclical high. For the near term, management just raised its 2021 full-year earnings guidance. For the longer term, 2021 is a milestone for its Aetna integration. This large-scale merger has reached a landmark as the Aetna members are offered a plan that leverages CVS’ retail infrastructure.
Considering the combination of valuation and business fundamentals, an investment here still provides excellent prospects for near double-digit annual returns in the long term with a good margin of safety.
The last decade is disappointing and is over
As seen from the next three charts, CVS investors have been somewhat disappointed in the past decade. The stock delivered about 151% of total return (assuming dividend reinvestment) over the past decade, translated into a CAGR of 9.6%, far lagging the overall market.
The above return was driven by three factors as illustrated in the next two charts. EPS growth is the first driver as seen from the second chart. Over the past decade, CVS was able to grow the EPS at 7.3% CAGR – actually a quite healthy growth. Second, however, it suffered from a PE contraction as seen in the second chart, which contributed a negative 0.45% CAGR into the total return. Lastly, dividend reinvestment contributed the remaining 2.8% (as a sidenote, illustrating the role of dividend reinvesting for a dividend growth stock).
Now looking forward, the natural questions are: is the last cycle over or not? And will the return be different in the next decade?
And my answers to both questions are a definitive yes. And we will see why by closely examining the return drivers immediately below.
How would the PE change?
In short, the current PE is near a cyclical low and I expect it changes to go up from here. The following chart shows the annual average PE of the stock in the past decade. You can see the contraction of CVS’s valuation over the past decade and at the same time also the cyclical nature. As seen, the average is 14.7x and the standard deviation is ~3.0. The current FW PE is about 12.9x.
Admittedly, the current PE is not as attractive as when I first wrote about it in Aug 2021. At that time, the PE was about 10x and exactly at the cyclical low point. But its current PE of 12.9x is still significantly below the historical average as you can see.
The PE contraction over the past decade is certainly justified by many fundamental reasons. The healthcare business went through a transformation as the development of digital commerce entered the sector. Also, CVS acquired Aetna in 2018. The acquisition was largely financed by debt and stretched its financial flexibility. And the synergies since then were quite uncertain like any large-scale synergies. However, as we will see next, CVS has maneuvered successfully and its investments are beginning to pay off.
Would the EPS growth continue?
My take on this question is yes. I expect the EPS to grow a bit slower in the next decade than in the past one. But the growth will still be a healthy upper single-digit annual growth.
When I think of long-term growth (like in 10 years or more), the framework I use is the following – in the long term, the growth rate is “simply” the product of ROCE and reinvestment rate, i.e.,
Long-Term Growth Rate = ROCE * Reinvestment Rate
ROCE stands for the return on capital employed. So to estimate the long-term growth rate, we need to estimate two things: ROCE and reinvestment rate.
Detailed analysis of the ROCE has been published in my earlier article here. And I here will just directly quote the results as shown in the next chart. As seen, CVS was able to maintain a respectably high ROCE over the past decade: on average 28% for the past decade. To put things in perspective, as detailed in my previous articles for Lockheed Martin (LMT) and General Dynamics (GD), ROCEs for these defense business leaders, who almost enjoy a monopoly moat, are also “only” in the range of 20% to 30%.
Now let’s see the reinvestment part. In recent years, the following is how CVS has been allocating its operation cash (“OPC”). As you can see, the company enjoys a large degree of capital allocation flexibility. The two big-ticket items for CVS have been maintenance CAPEX and dividend, which represented about 50% of the OPC. For the remaining whopping 50% of OPC, it has been deploying it to buy back shares, pay down debt, and retain it to strengthen its balance sheet. Finally, the business has been reinvesting at about somewhere between 7 and 10% to fuel growth in recent years.
Now with both ROCE and reinvestment rate estimated, we can estimate the long-term growth rate by simply multiplying the ROCE (~28%) and the reinvestment rates (7~10%). And the resulting annual growth would be about 2% to 2.8%.
Finally, the above rate is the real growth rate and I think it is justifiable to add 2.5% of inflation to the growth rate. So the nominal growth that we commonly quote would be between 4.5% to about 6%. CVS has demonstrated in the past it has the pricing power to adjust for inflation in the long term.
Putting it all together
Now we can put all the pieces together and make some observations for the outlook in the next decade.
What I always like to do is a reality check as shown in the chart below. It is essentially a back of envelope calculation to estimate what is the growth rate and valuation required to deliver a target ROI in the next 10 years. And see if such growth rate and valuation can pass a common-sense test. To make it really simple, let’s assume dividends and earnings grow at the same rate, and dividends are not reinvested.
As an example, if we require a 10% annual ROI, represented by the black line (10% annual return translates to 160% total return in 10 years because 1.1^10=260%), the growth rate will have to be about 7.0% if the PE ratio does not change from its current level – a bit toward the high end based on our above analysis but not entirely impossible. And if the PE further contracts to 10x (the historical record low in the past decade) as shown by the green line, the growth rate would have to be about 11% to deliver the required 10% ROI – an unlikely combination.
With the above background, the purple box symbolizes what I think would be the expected region for the next 10 years. Based on the discussions we had in the earlier sections, the reasons are:
1. For the valuation – I expect the PE to expand in the next decade for the fundamental reasons analyzed above. A PE reversion to the historical average of 14.7x would be reasonable.
2. For the growth rate – as aforementioned, I consider it to be somewhere near the single-digit range (say around 4% to 6%) given the average ROCE and the reinvestment rate that makes sense to me for a business at CVS’s scale.
Under the above arguments, the expected return would be 3.7% to about 9% in the next 10 years as highlighted by the purple box. And it is likely that the stock can deliver the high end of the return. All we need is a moderate growth rate and some luck – but not too much – for the valuation to revert to the historical average. A 9% annualized return would translate into a 130% total return – quite sizable considering the quality of the business.
First, CVS heavily depends on debt financing after its Aetna acquisition, and there are some risks with Fed’s plan to raise interest rates in the near term. CVS’s current long-term debt is about $58B. Hence, a 1% increase in its interest rate would translate into $580M of additional interest expenses. Its net profit is about $10.4B in 2021. Therefore, the additional interest expenses are about 5.5% of its net profit, a non-negligible risk. Although the reality is more complicated and could be better or worse than my estimate here. For example, there’s always the possibility that the interest rates rise more dramatically than the Fed’s current dot-plot, or that VZ’s borrowing rates rise faster than the Fed rates. On the other hand, CVS’s debt (like any sensible company) is well-laddered. So the effects of higher interest costs will be gradual and not abrupt to give management time to respond and adapt.
Second, margin pressure and COVID interruptions remain uncertain too. While CVS margins remained healthy overall, they were unable to match those enjoyed in the 2020 period due to price compression and an unfavorable reimbursement environment. Moreover, the COVID-19 pandemic continued to be a risk. Although the vaccination is progressing extensively, the pandemic is far from over yet and uncertainties like the delta and omicron variants still exist. The interruptions continue to hurt store foot traffic. And for CVS, light store traffic can take a toll on high-margined front-end sales.
Conclusion and final thoughts
This is still a good time, probably the second-best time in a decade, to buy CVS. After being disfavored by the market since 2015, its valuation is near a cyclical low but its business fundamental prospects are at a cyclical high. In particular,
- Shareholders will start to reap the benefits from its investments made in recent years, especially its Aetna acquisition and integration. The stock is well poised to capitalize on these tailwinds thanks to its scale, high ROCE, and effective capital allocation.
- These drivers are expected to deliver healthy earnings growth. The EPS is expected to grow a bit slower in the next decade than in the past one. But the organic growth alone will still be a healthy upper single-digit rate (say ~6%).
- Considering the combination of valuation and business fundamentals, an investment here still provides excellent prospects for near double-digit annual returns in the long term with a good margin of safety.
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