Growing Competitive Pressures, Leverage Drive Our Reduced Fair Value Estimate of CVS Health (Walgreens, Too)
publication date: Nov 17, 2020
author/source: Callum Turcan
By Callum Turcan
On November 9, we reduced our fair value estimate of CVS Health Corporation (CVS) (which operates pharmacies, walk-in medical clinics, retail centers, and a large health insurance business). Our new fair value estimate is $55 per share, down from $73 per share previously. CVS Health’s 52-week share price range has been $52-$77, and the company yields 2.7% at the time of this writing. We recently wrote an article here explaining some of the major broad-based drivers behind why fair value estimates can, do, and should change over time as future expectations change.
From our perspective, CVS Health’s near- and medium-term outlook has become increasingly stressed. Though investors have bid up shares of CVS in the wake of the latest U.S. election results (the potential for a split US Congress, depending on how the January 2021 run-off elections for two Senate seats in Georgia play out, means wide-reaching structural changes in the domestic healthcare sector now appear far less likely to occur), we caution that CVS Health remains heavily burdened by a large net debt load and growing competitive pressures. This is why, in part, we removed shares from the newsletter portfolios in February 2018, almost two years ago now. Here’s what we said at that time:
We think we’ve seen enough with the myriad risks that have found their way into the CVS “story.” From the Amazon (AMZN)-Whole Foods scare to Amazon teaming up with Berkshire Hathaway (BRK.A, BRK.B) and JP Morgan (JPM) to form a new healthcare company, the long-term outlook for CVS has become even more cloudy. Its purchase of Aetna (AET) may have been the straw that broke the camel’s back to our thesis, and we can neither see relief with respect to the structural dynamics of the industry in which it operates, nor can we see its increased leverage and competitive environment a positive for the dividend.
At the end of 2019, CVS Health had a net debt position (inclusive of short-term debt) of $62.8 billion. That burden becomes a bit more manageable when factoring in CVS Health’s $17.3 billion in ‘long-term investments’ line item at the end of this period, which was primarily represented by non-current debt securities available for sale. With that in mind, however, CVS Health also carried $1.6 billion in short-term operating lease liabilities and $18.9 billion in long-term operating lease liabilities at the end of 2019, indicating that the firm’s balance sheet remains bloated. As noted in the block quote previously, back in 2018, CVS Health acquired Aetna (offers health, vision, and dental insurance along with related services) through a cash-and-stock deal worth ~$78 billion when including the assumption of debt.
Recent favorable clinical trial data regarding potential COVID-19 vaccines out of the Pfizer Inc (PFE)/BioNTech SE (BNTX) partnership (we covered that news in detail here) and from Moderna Inc (MRNA) (more info on that here) are welcome signs, especially as CVS Health is working with the Centers for Disease Control and Prevention (‘CDC’) to supply safe and viable COVID-19 vaccines to customers across its vast operational base. With that in mind, any revenue generating opportunities from CVS Health working with the CDC will likely prove to be both modest and temporary in nature, though CVS Health may be in a position to build up its “sticky” customer base should everything proceed smoothly.
Not only does the company have a balance sheet that we don’t like due to both on-balance sheet and off-balance sheet liabilities (operating leases), from 2017 to 2019, CVS Health’s GAAP operating margin fell from ~5.2% to ~4.7%, and its annual interest expense roughly tripled during this period (reaching over $3.0 billion in 2019). The company’s reported diluted EPS from continuing operations fell from $6.45 in 2017 to $5.08 in 2019, too, largely in part because CVS Health’s weighted average outstanding diluted share count grew by almost 28% during this period. On the plus side, CVS Health’s free cash flow grew from $6.1 billion in 2017 to $10.4 billion in 2019, though competitive pressures are building.
A couple years ago, Amazon acquired PillPack. For those that may not be familiar with the company, PillPack is “a pharmacy designed to provide the best possible customer experience in the U.S. for people who take multiple daily prescriptions. PillPack delivers medications in pre-sorted dose packaging, coordinates refills and renewals, and makes sure shipments are sent on time.” According to Amazon’s 2018 Annual Report, the firm paid ~$0.75 billion in cash (net of cash acquired) for PillPack. Though Amazon’s foray into the pharmacy space will take time and will require Amazon to navigate the many legal and regulatory hoops that are inherent within the U.S. healthcare sector, these types of competitive pressures represent a long-term hurdle to CVS Health’s business that won’t go away.
The rivalries in the pharmacy space continue to intensify. Just this week, on November 17, CNBC reported that Amazon was launching Amazon Pharmacy in the US, which reportedly will include free delivery for Amazon Prime members. Shares of CVS Health sold off sharply after the news broke, as did shares of Walgreens Boots Alliance Inc (WBA). Here, we would like to highlight how recognizing competitive threats (both existing and future) represents one of the qualitative overlays we use during the enterprise cash flow analysis process to model expected future financial performance of the company. These competitive dynamics had a large influence in our decision to reduce CVS Health’s fair value estimate. Note, we also reduced our fair value estimate of peer Walgreens Boots Alliance to $43 per share from $60 per share on November 9, too.
Looking ahead, CVS Health plans to pare down its large total debt load to improve its financial standing. We appreciate the company’s desire to deleverage, though we would like to stress that these efforts will take a couple more years to complete. During CVS Health’s latest earnings call management noted that the firm “paid down $4.75 billion of net debt in the quarter…(and that it) remains committed to achieve our low three times leverage target in 2022.” In our view, dividend increases will take a back seat to deleveraging activities, and its huge debt load translates into a very poor Dividend Cushion ratio (debt is punitive in the calculation). We once liked CVS Health, but the long-term landscape has changed, and our recently-lowered fair value estimate reflects our growing concerns.
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Callum Turcan does not own shares in any of the securities mentioned above. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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