Despite the market’s recent pull back in recent weeks, the S&P 500 is still trading close its all-time high and at a historically elevated P/E multiple of 24.5.
However, that doesn’t mean that there still aren’t great bargains to be found, even when it comes to high-quality dividend growth stocks.
CVS Health (CVS) is a possible example. The company’s stock has declined 25% year-to-date, setting up an interesting investment case. CVS stock now yields 2.3%, well above its 1.4% average dividend yield over the last five years.
Don’t let the low yield turn you off – management has increased the dividend by 25% per year over the last decade and raised the payout by 20% in 2016. The company is also a Dividend Achiever with over 10 consecutive years of dividend increases.
Find out if CVS Health could be one of the most attractive income growth opportunities available today, and if now might be a great time to add this fast-growing blue chip to your own diversified dividend portfolio.
CVS is one of America’s most dominant healthcare players. It operates the nation’s second largest pharmacy chain (9,652 retail pharmacies in 49 states, DC, Puerto Rico, and Brazil) under the CVS, Longs Drugs, Navarro Discount Pharmacy, and Drogaria Onofre pharmacy brands.
CVS also operates as one of the nation’s largest pharmacy benefits managers (PBMs), with almost 80 million plan members who used CVS to file 1.2 billion medical care claims in 2015. CVS acquired Caremark RX for $21 billion in 2006 to become the second biggest PBM.
The pharmacy benefits business operates under the CVS Caremark, CarePlus CVS Pharmacy, CVS Specialty, Accordant, SilverScript, NovoLogix, Coram, Navarro Health Services, and Advanced Care Scripts names.
This fast-growing business segment provides vital services to employers, insurance companies, unions, government employee groups, health plans, managed Medicaid plans, and plans offered on public and private exchanges.
Specifically, CVS’s PBM business helps clients with pharmacy services such as plan design and administration, formulary management, Medicare Part D services, mail order and specialty pharmacy services, retail pharmacy network management services, prescription management systems, clinical services, disease management programs, and medical pharmacy management services
In the first half of 2016 the majority of CVS’s sales came from its PBM segment, which, thanks to a faster growth rate than its retail pharmacy business, is likely to only grow more important over time.
|Business Segment||% of YTD Revenue||% of YTD Operating Profits|
Source: CVS Health Earnings Release
However, thanks to continued high margins on prescription refills, the retail/long-term care business remains the key profit driver; at least for now.
The aging of the U.S. population represents one of the largest demographic megatrends of the coming decades and is expected to result in massive increases in medical costs. For example, Ventas (VTR) projects national health expenditures to grow 5.8% per year from 2014 through 2024 to reach $5.4 trillion.
To put things in perspective, consider this: between 2010 and 2029, 10,000 baby boomers will turn 65…every single day. And between 2010 and 2050 the population of those over 65 will more than double to 88.5 million, which is more U.S. seniors than the entire population of Germany.
CVS Health is attempting to position itself to take advantage of this tsunami of healthcare cash by becoming one of America’s biggest providers of integrated health solutions. That includes its massive and still growing network of pharmacies, which benefits from the recently completed integration of Target’s (TGT) in-store 1,667 pharmacies and 79 clinics, which it acquired last year for $1.9 billion.
However, more important to CVS’s long-term growth ambitions is its PBM business, which saw a major boost from 2015’s $12.7 billion purchase of Omnicare.
Why is the PBM segment such a boon to CVS? Mainly because, as rising costs and increased regulatory complexities under the Affordable Care Act (i.e. ObamaCare) set in, many organizations, including health insurance companies such as Aetna (AET), are willing to outsource the nitty gritty logistical details of managing various health programs to PBMs such as CVS.
This is because PBM’s are responsible for saving their clients as much money as possible, through things like negotiating price breaks with pharmaceutical companies and medical component makers.
And better yet they are willing to sign long-term contracts, like the 12 year deal that Aetna inked with CVS back in 2010, which gives management a lot of future cash flow predictability with which to plan its further growth efforts. Thanks to this vertically integrated model, over 80% of CVS’s total revenue comes from health related products, with the remainder generated by the retail side of its nearly 10,000 national stores.
In other words, CVS has evolved beyond just a chain of pharmacies and stores, turning into one of the most important names in US health insurance. Thanks to the continued expansion of its PBM business, CVS is able to generate large economies of scale, which means some of the lowest per claim costs in the industry. That helps CVS maintain market share which only further grows its moat and helps maintain high retention rates (97% last quarter) with PBM customers.
Even better is that CVS’s moat, consisting of an increasingly more cost effective medical claim processing system (projected to process more than 1.3 billion claims in 2016), means not only fast growing revenue (about 20% this year) but also industry leading margins and returns on capital.
Note that while it may initially look as if CVS has just industry level profitability (operating margins were just 6% last year), you need to keep in mind that its retail business, being very capital intensive, drags down its overall margin and return on capital figures. Since its PBM business is growing faster than its retail side, its relative profitability should continue to improve over time.
This is especially true as management is focusing on growing its specialty pharmaceutical claim business, which has higher margins and should greatly help the bottom line in the years to come.
All told CVS has proven itself to be capable of sustaining strong growth in both good economic times and bad, especially considering that its trailing 12 month sales are a staggering $167 billion. Equally important, management has been achieving this impressive growth while maintaining stable, strong or increasing margin, and returns on capital.
This indicates that the company’s management team remains disciplined, and rather than attempting to reach for “growth at any price” it is being selective with its acquisitions and growth strategies. That should hopefully allow investors to continue to benefit from strong sales, earnings, cash flow, and, of course, dividend growth in the coming years.
There are two main risks to CVS’s growth thesis that all current and prospective investors need to understand.
First, the rising cost of healthcare could result in calls for further government price caps. This is especially true given that the vast majority of healthcare costs are incurred at the end of life, by the oldest and sickest patients.
For example, the top 5% and 1% of healthcare consumers are estimated to consume about $43,000 and $95,000 annually, respectively. The top 5% of healthcare consumers account for roughly 49% of total health expenditures.
As America’s aging demographics continue to put a strain on Federal entitlements (Medicare most of all), government price caps could be mandated that would blow a big hole in the value proposition of PBMs. Specifically, the idea that a PBM such as CVS can help health consumers cut costs via negotiating with medical suppliers.
Indeed, the PBM business model is coming under increased scrutiny. They are supposed to lower prices for consumers, but the industry remains quite opaque with where and how profits are moving around. I recommend reading the article I linked to if you are interested in a deeper look at PBMs’ risks. .
A second major and related threat is ongoing consolidation in the health plan industry. Specifically, as health insurance companies combine via M&A they may create their own PBM services and thus not need CVS anymore.
For example, Aetna is currently trying to buy Humana (HUM), which the Department of Justice is attempting to block on antitrust grounds. However, should the deal go through, some analysts speculate that Aetna will attempt to create a more vertically integrated business model, via an in-house PBM.
Not only would that potentially cost CVS 7% of its business as early as 2019 (via an early escape clause in its most recent contract), but it could further represent increased low cost competition that could put pressure on CVS’s PBM margins.
Finally, it’s worth touching on CVS’s latest results. CVS announced earnings on November 8 and warned that it could lose 40 million prescriptions next year. The company’s earnings guidance for 2017 missed analysts’ expectations by roughly 10%.
The company’s prescription losses are primarily driven by exclusive networks Walgreens has arranged with other players in the drug chain to let patients get their prescriptions at a discount, reducing the need for CVS’s network in most cases. Here is the slide CVS presented for its earnings call:
Dividend Safety Analysis: CVS Health
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.
CVS has a Dividend Safety Score of 99, indicating that it is among the safest dividends of any stock in the market today. This rock solid safety rating begins with its healthy payout ratios, which on a full year 2016 EPS and free cash flow, or FCF per share, basis are expected to ring in at 34.3%, and 26.5%, respectively.
In other words, CVS Health is generating far more earnings and cash flow than it needs to keep the current dividend safe, even in the event of another great recession like economic downturn. With that said, the business has proven to be recession-resistant. Sales dipped just 2% in fiscal year 2010.
Better yet, thanks to the low payout ratios, CVS is retaining sufficient cash to continue buying back shares at an aggressive rate (3.7% CAGR over the last five years).
Specifically, management expanded the company’s share repurchase authorization by $15 billion this morning, bringing it up to $18.7 billion. This could reduce the share count by more than 5% annually at today’s share price.
This helps both long-term dividend security and growth because a smaller share count over time means that EPS and FCF per share will grow faster and allow stronger, longer, and more sustainable payout growth.
In fact, when it comes to maintaining a conservative payout ratio, CVS management has proven itself a master of balancing the growth of the dividend against maintaining fortress-like payout security, even during times of immense economic distress such as 2008-2009.
As seen below, CVS’s EPS payout ratio has roughly tripled over the last decade but remained low and stable every year.
Of course, a vital component of this conservative, safe dividend strategy includes maintaining a strong balance sheet, which allows CVS great financial flexibility no matter what interest rate or economic conditions may be present.
The key things to focus on with CVS’s credit metrics, are its high interest coverage ratio, which at 8.7 shows the company easily able to service its debt obligations. The company’s total book debt could also be covered using cash on hand and 2.9 years’ worth of earnings before interest and taxes (EBIT), which is reasonable. S&P assigns the company a BBB+ credit rating (for comparison’s sake, Walgreen’s credit rating is BBB).
While some of CVS’s debt metrics may seem high, remember that the pharmacy business is relatively capital intensive, meaning that higher debt loads are to be expected. This is acceptable to me because the underlying business is stable and generates loads of reliable free cash flow, which can be used to service debt and pay dividends.
Overall, CVS’s dividend payment is about as safe as they come. The company maintains low payout ratios, generates consistent free cash flow, provides nondiscretionary products and services, and keeps a reasonable balance sheet.
Dividend Growth Analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
CVS’s Dividend Growth Score is 97, indicating that dividend investors can likely expect many more years of higher and sustainable payout growth. As seen below, CVS has increased its dividend by 25% per year over the last 10 years and by 29.1% annually over the last three years.
Since spinning off from Melville Corporation in 1997, the modern CVS has never cut its dividend. In fact, it has one of the most impressive dividend growth track records of any dividend growth stock, with 13 consecutive years of payout increases that are likely to continue for a long time.
That’s because, as CVS’s sales, earnings, and cash flow grow, management is able to gradually increase the payout ratios over time, without sacrificing capital needed to continue investing into the business. For example, excluding acquisition related integration costs, the EPS payout ratio was 31% in CVS’s most recent quarter.
Management is guiding for that to grow to 35% by 2018, and given the impressive rate at which EPS and FCF have been, and are likely to continue to grow, this means that dividend investors can probably expect around 13% or so annual dividend growth over the coming years. That’s thanks to management’s long-term guidance (which it has a history of meeting or exceeding), or about 12% adjusted EPS growth, and low payout ratios with plenty of room to expand. I wouldn’t be surprised if CVS goes on to become a Dividend Aristocrat one day.
CVS is down 25% since the start of the year and hit a 52-week low this morning after reporting earnings. Even after lowering guidance for next year, CVS’s stock trades for just 12.5x forward earnings guidance – a 21% discount to the S&P 500’s forward P/E multiple of approximately 15.9.
CVS also offers a 2.3% dividend yield, which is much higher than the stock’s five-year average yield of 1.4%. CVS’s dividend yield is also likely to take a major jump (e.g. 15-20%+) because historically management raises the dividend each December.
If CVS hikes the payout for 2017 by 20%, which would be in line with its historic dividend growth rate, then CVS will be offering a better-than-market yield of 2.8%.
At first glance, CVS’s valuation looks appealing; especially for a company that has 21.5% annual free cash flow per share growth over the last five years.
Indeed, if CVS can deliver double-digit earnings growth annually over the next few years as management and analysts expect, the stock appears to be a bargain with potential to deliver 10%+ annual returns over the next 5-10 years.
At the end of the day, given CVS’s relatively low P/E multiple and relatively high yield compared to history, a decision to buy the company is essentially all a bet on how confident one is in the company’s growth prospects. If you believe management’s earnings growth expectations and truly understand how CVS makes money (especially its PBM operations), the stock looks cheap.
If you are more skeptical about growth in light of the changing healthcare landscape, it might still be best to stay away.
While there will always be a lot of potential political risk when it comes to any company in the healthcare industry, CVS Health has historically proven itself far more nimble and adaptable than many of its rivals over the years. Favorable demographic trends should also serve as a growth tailwind for the company.
However, at the end of the day, it’s hard for me to wrap my head around all of the changes happening across the entire healthcare value chain. From increased drug price scrutiny to reimbursement rate pressures and the potential for PBM business models to structurally change in ways that would harm CVS’s long-term profitability, there are a number of concerns bubbling up that make it difficult for me to gain conviction in CVS’s long-term growth potential (and value).
For those reasons, I am passing on CVS because it is outside of my circle of competence. I do not own the stock in our Top 20 Dividend Stocks portfolio.
With that said, CVS could very well indeed be an attractive and timely opportunity for long-term dividend growth investors who are seeking potential bargains and willing to deal with a greater level of uncertainty. It’s rare to find a stock that trades for 12.5x forward earnings and has potential for double-digit earnings growth.
As Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.” However, he also cautioned about venturing outside of one’s circle of competence.
I am very impressed that any analyst would conclude that a stock was “outside my circle of competence”. That is very refreshing!
I have followed CVS for some time and have been very impressed. But I agree that there is just too much going on here to feel comfortable.
I commend Brian on a great article.
Thanks, Steve. Over the years I have realized that there are many stocks outside of my circle of competence! The good news is that we can sit back and wait for a pitch we recognize and can hit. There are no strike outs for taking pitches.
Thank you. The stock took a beating today.
You’re welcome. Thanks for reading!
Thank you for your analysis on CVS.
“However, at the end of the day, it’s hard for me to wrap my head around all of the changes happening across the entire healthcare value chain.”
Well, you hit the nail there. I really like your scores for CVS, but the advantage of the health market (expanding) might easily become the problem – curb health costs?!
In Feb/16 you wrote about CAH. More or less the same scores. But you wrote then that you might buy some CAH, which is right in the middle of the healthcare value chain. Do you consider CAH´s business more protected in that chain?
Thanks for your note. I view CAH as being incrementally more protected but for different reasons. Both companies seem to face a lot of uncertainty with all of the changes happening in health care, so I would prefer to remain on the sidelines.
Very interesting, and good to know.
It would be very cool if you could write another article about the other big high – yield REIT´s like OHI, Ventas, HCN, HCP, Vereit and Care Capital. Especially the spinoff happening in HCP
(I own OHI, HCN, HCP, Vereit and Care Capital)
Thanks, Arne. I have some of those REITs on my list for future research and appreciate the feedback.
Great analysis SSD. Love the company and the concept of the business. Similarly, I purchased CAH. But I am putting a hold on healthcare related purchases until the dust settles with the major changes that are looming. What I am most curious about is how a drastc change in the industry that has been planning for Obamacare willimpact past investments and gambles company’s placed on future revenue streams.
But overall, I love what CVS has done. Getting into Target is a huge benefit. I was shocked about how diversified the company is behind the scenes and the fact that they are not just a storefront. Definitely bodes well in my eyes. Thanks for taking the time to put this analysis together!
Thanks, Bert. I’ve put a hold on most of healthcare as well. Sure seems like the list of winners and losers could shuffle depending on what Congress is able to accomplish. Time will tell, but thanks for reading!
Thank you for the article. It seems that you are mostly positive about CVS, but with some reservations. Others are representing both very positive and very negative views.
Seeking Alpha posted an article by Faloh Investment (“CVS Is Set For Further Decline”), which evaluated that the loss of the Department of Defense contract to Walgreens would cost CVS $4.6 bilion in cash flow. They estimated the current fair value of CVS at $59 and next year’s fair value (after the DoD contract ends) at $46.
On the other hand Benzinga (http://www.benzinga.com/analyst-ratings/analyst-color/16/10/8520512/what-it-means-for-cvs-to-be-removed-from-tricare-network) is saying that the effect of the loss of the DoD contract and $2.2 billion revenue is less than 2% on EPS. They reduced their target price from $111 to 104$, so they are still very optimistic and say this has no effect.
The huge difference between these estimates makes me uncertain. Of course, the estimates were made without exact numbers, which means that the first one may be overly negative. The recent drop in share price is likely caused by the loss of the contract, so perhaps all the negative effects have already been accounted for. What do you think?
The range of outcomes for CVS underscores my conclusion that the stock is “too hard” for someone with my risk tolerance and circle of competence. If I only need to own 20-40 companies, I would prefer to buy other companies with seemingly clearer long-term visibility. Healthcare is changing quite rapidly. It doesn’t mean CVS isn’t a good stock for some investors – just not for me personally.