The goal of value investing is to pick established stocks with steady growth rates at a price below their intrinsic or fair value. This combination of steady growth and discounted valuations is pursued with the belief that it will lead to total returns greater than the broader markets.
While it can be tricky to identify value stocks, I would argue that the pharmacy chain and health insurer CVS Health (CVS 0.42%) is the epitome of one. But what makes it a value stock capable of beating the market? Let's dig in to find out.
A strong showing in the third quarter
CVS Health exceeded both analysts' revenue and non-GAAP (adjusted) earnings per share (EPS) estimates when it reported its third-quarter results on Nov. 3 for the period ending Sep. 30.
CVS Health generated $73.79 billion in revenue during the third quarter, which works out to a 10% growth rate against the year-ago period. This sales growth allowed the company to beat analysts' average revenue forecast of $70.52 billion by 4.6%. For context, this was the 14th consecutive quarter that CVS Health surpassed expectations for revenue. What was behind the revenue beat?
First, the company grew its medical membership base for its Aetna health insurance plans in the healthcare benefits segment by 1.7% year over year to 23.7 million as of the third quarter of this year. Second, the pharmacy services segment grew its total equivalent of one-month prescriptions filled by 6.9% year over year to 564.4 million during the third quarter. And finally, increased foot traffic due to COVID-19 vaccinations and testing helped the retail segment boost its revenue. High-single-digit revenue growth rates in each of CVS Health's three primary segments and double-digit revenue growth in the corporate/other segment led to robust overall top-line growth in the quarter.
CVS Health's profits managed to significantly grow during the third quarter as well. Due to its higher revenue base and a 30-basis-point expansion in its non-GAAP net margin to 3.6% during the third quarter, CVS Health's non-GAAP EPS surged 18.7% year over year to $1.97 for the period. This enabled CVS Health to blow analysts' predictions of $1.79 in non-GAAP EPS out of the water by 10.1%, which is the 23th consecutive quarter that the company delivered an earnings beat.
CVS Health's quarter also prompted the company to raise its non-GAAP EPS guidance for this year to a midpoint of $7.95, which represents a nice 6% growth rate over the $7.50 produced last year. This is essentially in line with the annual earnings growth rate that analysts are forecasting for the company over the next five years.
A healthy balance sheet
CVS Health is a doing well from an operating fundamentals perspective. But how is the company's balance sheet doing nearly three years after its $78 billion acquisition of the insurer Aetna closed in November 2018? Let's answer this question by taking a look at CVS Health's net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio.
CVS Health's net debt as of the third quarter was $45.55 billion, which is a massive $8.24 billion reduction since the end of last year. Against the $17.18 billion in trailing twelve-month earnings before EBITDA, this works out to a net debt-to-EBITDA ratio of 2.7. And assuming that CVS Health can continue its pace of reducing net debt approximately $2.7 billion each quarter through the end of next year, the company's net debt would be brought down to approximately $32 billion. Even if EBITDA were to remain flat during that time, the company's leverage ratio would fall below two to about 1.9.
This means that CVS Health could hypothetically repay all of its net debt in less than two years with its EBITDA. Of course, the company couldn't actually eliminate its net debt quite this quickly since it pays a dividend to shareholders and needs to pay income taxes. But its profitability and ability to greatly reduce its net debt year-to-date demonstrates this is a business at minimal risk of insolvency.
A dividend ready to soar
When asked about the company's capital deployment strategy, CVS Health's CFO Shawn Guertin indicated in his remarks during its Q3 2021 earnings call that: "We're nearing the end of a sort of three- or four year deleverage cycle." Given that CVS Health's net debt to EBITDA ratio should be be less than two by the end of next year, Guertin's comments are a reflection that the balance sheet is well managed.
Since next year would be the fourth full year since the deal for Aetna was closed and CVS Health began deleveraging, it isn't unreasonable to expect that the company will announce its first dividend hike since the end of 2016, the year before the deal for Aetna was first announced. This would represent a return to CVS Health's policy of hiking its dividend each year, which it had done for 14 consecutive years before its planned acquisition of Aetna.
And with CVS Health's non-GAAP EPS payout ratio set to be 25.2% using the company's midpoint guidance for this year, management has plenty of room to grow the dividend going forward.
A high-quality discounted stock
Given CVS Health's bright outlook both operationally and financially, you wouldn't expect it to be trading at a sizable discount to its industry. Yet, that's exactly what the stock is doing, even with its 35% year-to-date returns outperforming the healthcare plan industry's 19% during that time.
For context, CVS Health's forward price-to-earnings (P/E) ratio of 11.6 is still well below the healthcare-plan industry average forward P/E ratio of 15.7. This is what makes the stock such an appealing value play. Admittedly, CVS Health isn't a pure-play healthcare plan company like many of its peers. But I believe this large of a discrepancy between the company and its industry is too large for the market to ignore, especially as CVS Health completes its deleveraging next year and (hopefully) returns to generous dividend increases.
As value investors wait for the market to award the stock a higher valuation closer to its industry average, CVS Health will reward patient investors with a 2.2% dividend yield. That's well above both the S&P 500 and healthcare plan industry average of 1.3%, which makes it that much easier for investors to wait for CVS Health to get the love that it deserves from the market.