CVS Health (NYSE:CVS) is one of the largest healthcare companies in the world. CVS operates multiple diverse segments, including pharmacy benefits management, retail through a brick-and-mortar network of nearly 10,000 locations, and healthcare benefits, which is primarily attributable to its 2018 acquisition of Aetna.
The health stock slid in the first quarter of 2019, falling from $70 to $52 following its annual earnings report. Management provided full-year profit guidance that was well short of analysts' expectations, owing to investment in the newly acquired Aetna business. The reduced earnings outlook has obvious ramifications for intrinsic valuation based on cash flows, but, more importantly, it also caused investors to question the company's strategic soundness.
CVS has rebounded in the last three quarters of the year, charging to $75 after positive earnings announcements and the revelation of Starboard Capital's involvement. Starboard is an activist hedge fund that has led successful campaigns at numerous companies, including Darden Restaurants and AOL. There is no public information available on the size of Starboard's position in CVS, nor is it known how the hedge fund is attempting to influence company management. But there are confirmed reports of friendly discussions between the activists and existing company leadership.
CVS raised its full-year adjusted operating income and adjusted EPS guidance in the Q3 earnings announcement. This followed a quarter with revenue growth across every business segment, with an overall 36.5% top-line expansion, primarily due to the Aetna acquisition. Even with the acquisition-related expenses and investment in unlocking new synergies of the combined entities, net profits still rose 10% over the prior year.
There are opportunities to deliver efficiencies in healthcare
CVS has operated a pharmacy benefits services business for some time, which has some strategic overlaps with healthcare plans in general. However, the company could exploit some less obvious synergies with its large footprint of stores. By operating a number of physical locations that consumers identify as resources for health, CVS is hoping to offer services that reduce the need for visits to hospitals and doctors for members of its health insurance plans. This inventive form of integration expands upon successful efforts made elsewhere in the healthcare sector to reduce expenses and improve overall population health.
CVS has attractive valuation ratios
The stock trades at a forward price-to-earnings ratio of 10.5, which is inexpensive relative to the 23.2 drugstore industry average and 17.0 healthcare plan average. Its price-to-free cash flow of 9.3 is roughly half of the health plan average, which indicates a meaningful opportunity for value investors using cash-flow-intrinsic valuation models.
CVS's combination of business units makes it difficult to identify an apples-to-apples peer, and there is substantial variation in capital structure among potential competitors in each of its target markets. Conducting a sum-of-the-parts, capital-structure agnostic analysis indicates that the drugstore segment would have an approximate EV/EBITDA ratio of15 if it were at the industry average, and the health plan/pharmacy services business EV/EBITDA would be around 11. This suggests that CVS should have a 12.3 EV/EBITDA multiple if it were to simply command an average value. The stock's EV/EBITDA ratio is 13, so this metric is sensible.
CVS pays an attractive dividend yield, which is meaningful for investors employing the dividend discount model, investors with specific income goals, or investors who are hoping to identify defensive stocks that produce dividends to ride out any upcoming market downturns. The stock's cash dividend yield is higher than any peers in the healthcare plan field at 2.65% — 110 basis points above the next highest, UnitedHealth.
CVS is not the cheapest stock by any means. But it has very reasonable valuations and a nice dividend yield, which is uncommon for a company that could be on the cusp of serious efficiency gains that could cause some market disruption if they are implemented effectively. If these synergies are not realized, then the acquisition of Aetna makes much less sense, and it will ultimately be an expensive use of resources with dubious value.
Nonetheless, there are signs that CVS is making transformative moves that could impact the way healthcare services are delivered across the industry. Investors have an opportunity to gain exposure to those fundamental prospects without paying a serious premium in terms of stock valuation.