Wall Street has become pretty pessimistic on the broader market's near-term growth prospects. Consensus estimates call for just 4% earnings growth for the S&P 500 in 2023. Growth could trail the S&P 500's historical average of 10% for longer than that if we enter a recession.
So how do investors find outperformance when growth is out of favor? You might need to go into the bargain bin to find a diamond in the rough. Healthcare company CVS Health (CVS -1.62%) could be a great pick.
The stock has plummeted more than 30% over the past year, but shareholders' fortunes could soon improve. The stock could be a big winner moving forward. Here is why.
1. The selling is arguably overdone at this point
Traditionally, CVS has been a pharmacy business. It sells prescriptions at little profit, counting on the foot traffic of customers who buy higher-margin items like food, beverages, and household items at their pharmacies.
CVS has invested heavily in reinventing itself in recent years. It bought health insurance company Aetna for $69 billion in late 2018 (when it closed). Today, there are two significant pending acquisitions; CVS is spending $8 billion to acquire healthcare platform Signify Health and another $10.6 billion for primary care company Oak Street Health.
The market hasn't liked CVS's aggressive spending on acquisitions. The company is levered at more than 4 times EBITDA, which will likely increase as these acquisitions settle. That's a lot. I consider anything over a ratio of 3 to be noteworthy, and it helps explain the stock's decline over the past year or so.
CVS Free Cash Flow Yield data by YCharts
But investors could be getting carried away. CVS is still generating cash flow, and its free cash flow yield is now at nearly 14%, among its highest in over a decade. In other words, you're getting a better deal on CVS's cash profits now than at almost any point in recent history.
CVS can pay both a dividend and its bills
High-interest rates hurt companies with a lot of debt; interest expense takes away from a company's earnings. CVS paid more than $2.2 billion in total interest expense over the past four quarters, compared to $4.1 billion in net income. Additionally, CVS is a dividend stock. It recently began raising its payout again after holding it steady for a few years after the Aetna acquisition.
The dividend yields 3.25% at the current share price, so cutting it would be significant for shareholders. Fortunately, it doesn't seem that you have to worry. The dividend payout ratio is very low at just over 21% of cash flow, leaving about $10 billion in cash flow to pay down debt.
CVS Cash Dividend Payout Ratio data by YCharts
There's no reason CVS can't at least maintain the dividend (if not grow it) and make reasonably quick progress in getting its balance sheet healthy again. There's approximately $52 billion in long-term debt right now, meaning a good three to four years of aggressive deleveraging.
A reversal in sentiment could drive market-beating returns
The market's punishment of CVS's debt load has pummeled the valuation. As we know, the free cash flow yield is high; from an earnings standpoint, the stock trades at a price-to-earnings ratio (P/E) of just 8 using 2023 EPS estimates. That is less than half of its average over the past decade.
But CVS has a solid growth outlook, despite its debt. Analysts believe the company can grow earnings per share (EPS) by an average of 7.3% annually over the next three to five years. Assuming no change in the valuation, the stock could produce 10% annual total returns based on its earnings growth and dividend alone.
However, CVS's massive interest expenses mask the company's full profits. Money going to service debt will steadily go to earnings instead as CVS pays its loans off. That will not only increase EPS but could easily change the market's sentiment toward the stock -- meaning a higher valuation for the stock.
It could take a few years, but CVS's potential 10% returns via growth and dividends, plus a massive upgrade in the stock's valuation, could make it a big winner over the next three to five years. It's hypothetical, of course, but the risk-versus-reward looks pretty favorable here.
