CVS Health (CVS): Inherent Undervaluation Triggers Great Upside Potential

We previously covered CVS Health (NYSE:CVS) in October 2023, discussing its uncertain prospects as the regulatory scrutiny surrounding the managed healthcare industry increased, with its growth likely to decelerate as regulators tamp down on its future acquisitions and health care utilization normalized.

The ongoing correction in the Pharmacy-Benefit Manager space might also pose headwinds to its profitability, worsened by the tightened Medicare rating system.

Despite so, we had rated the stock as a Buy due to its inherent undervaluation, with the eventual re-rating likely to bring forth expanded upside potential, further aided by the robust dividend investment thesis.

In this article, we shall discuss why we are maintaining our Buy rating for CVS, with its vertically integrated health care offerings well balancing each other as the increased health care utilization triggers expanded pharmacy volumes.

It is important to note that the same headwinds are experienced by its health care peers as well, with the correction in the bottom lines being inevitable. Combined with the relatively healthy balance sheet and robust profitability, CVS continues to offer an attractive risk/ reward ratio here.

The CVS Investment Thesis Remains Promising, Due To Its Inherent Undervaluation

For now, CVS has reported a mixed FQ4’23 earnings call, with revenues of $93.81B (+4.4% QoQ/ +11.8% YoY) and adj EPS of $2.12 (-4% QoQ/ +6.5% YoY), with FY2023 numbers of $357.8B (+10.9% YoY) and $8.74 (+0.5% YoY), respectively.

Part of the QoQ bottom line headwinds is attributed to the increased health care utilization after the hyper-pandemic slow down, with the Health Care Benefits segment recording elevated Medical Benefit Ratio of 88.5% in FQ4’3 (+2.8 points QoQ/ +2.7 YoY) and 86.2% in FY2023 (+2.4 points YoY).

This is notably higher than the 85.7% reported in FQ4’19 and 84.2% in FY2019.

However, readers need not fret, since the same has also been observed in CVS’ health care peers, including:

• UnitedHealth Group (UNH) at 85% in FQ4’23 (+2.7 points QoQ/ +2.2 YoY)/ 83.2% in FY2023 (+1.2 points YoY), compared to 82.5% in FY2019.
• Centene (CNC) at 89.5% in FQ4’23/ 87.7% in FY2023, compared to 87.3% in FY2019.
• Elevance Health (ELV) at 89.2% in FQ4’23/ 87% in FY2023.
• Humana (HUM) at 90.5% in FQ4’23/ 87.2% in FY2023, compared to 85.6% in FY2019.

If anything, CVS has also reaped great benefits from the increased health care utilizations, with an expanded Health Services revenue of $49.14B (+4.7% QoQ/ +12.2% YoY) in FQ4’23 and $186.84B in FY2023 (+10.1% YoY).

This is on top of the growing Pharmacy & Consumer Wellness revenues of $31.18B (+8% QoQ/ +8.6% YoY) in FQ4’23 and $116.76B in FY2023 (+7.5% YoY), as prescriptions filled on a 30-day equivalent rise to 431.5M (+24.4M QoQ/ +8.1M YoY)/ 1.64B (+23.7M YoY), respectively.

As a result, we believe that the overall net effect remains somewhat positive, thanks to its well diversified health care offerings well balancing each other.

At the same time, the higher projected MBR of 87.7% in FY2024 (+1.5 points YoY/ +0.5 from previous estimates) has also directly contributed to CVS’ still decent FY2024 guidance, with raised revenues of $371.3B (+3.9% YoY) and lowered adj EPS of $8.30 (-5% YoY).

This is compared to the previous guidance of $366B (+2.2% YoY) and $8.50 (-2.7% YoY), respectively.

The Consensus Forward Estimates

The same profitability downgrade has also been observed in the consensus forward estimates, with CVS expected to generate an accelerated top line at a CAGR of +5% through FY2026 and decelerating bottom line at +5%.

This is compared to the previous estimates of +2.3%/ +7.2%, though somewhat nearer to the historical growth at +10.5%/ +5.9% between FY2016 and FY2023, respectively.

Even so, we believe that CVS’ dividend remains safe, based on the robust Free Cash Flow generation of $10.39B in FY2023 (-22.7% YoY) and the Seeking Alpha Quant Dividend Safety Grade of A-.

The same is observed in its Interest Coverage Ratio of 5.29x and Dividend Coverage Ratio of 3.13x, compared to the 5Y average of 5.10x and 3.69x, respectively, despite the elevated debt obligations.

CVS’ balance sheet remains liquid enough, with cash of $11.44B (-29.2% QoQ/ -27.1% YoY) and a somewhat reasonable debt-to-EBITDA ratio of 3.18x in FQ4’23 (compared to 2.45x in FQ4’22 and 3.94x in FQ4’19), though elevated compared to UNH’s leverage of 1.65x, CNC at 2.91x, ELV at 2.12x, and HUM at 2.08x.

CVS Valuations

As a result of the normalization effect from the hyper-pandemic trends, it is unsurprising that the market has also temporarily downgraded CVS’ valuations to FWD P/E of 9.15x and FWD Price/ Cash Flow of 7.77x.

This is compared to the 3Y pre-pandemic mean of 10.7x/ 8.69x and the sector median of 19.92x/ 16.29x, respectively.

However, readers must note that CVS is inherently cheap when compared to its health care peers, including UNH at 17.60x/ 14.32x, CNC at 11.52x/ 10.41x, ELV at 13.65x/ 11.99x, and HUM at 21.54x/ 21.09x, respectively.

With the market erroneously grading CVS nearer to its consumer staples peer, Walgreens Boots Alliance (WBA) at 6.59x/ 4.95x, it is apparent that there are great opportunities for value oriented investors looking for the great upside.

So, Is CVS Stock A Buy, Sell, or Hold?

CVS 5Y Stock Price

For now, it is apparent that CVS has been able to retain much of its gains from the September 2023 bottom, while appearing to be well-supported at the $70s floor.

Based on the FY2023 adj EPS of $8.74 and the discounted FWD P/E valuations of 9.15x, CVS appears to be trading below our fair value estimate of $79.90. With the correction from the hyper-pandemic heights behind us, the stock has also returned to its 2018 and 2019 trading ranges, offering interested investors with an improved margin of safety.

Assuming an eventual re-rating in its FWD P/E to normalized levels of 10.7x along with the estimated FY2026 adj EPS of $10.11, there appears to be an excellent upside potential of +43.7% to our long-term price target of $108.10 as well.

If not more, with CVS potentially offering an extremely bullish doubling to $161.70. This is based on a valuation re-rating nearer to its peers’ mean P/E of 16x, once the M&A synergy materializes by 2026, and its well diversified health-care operations are optimized to deliver consistent growth.

Either way, as the management guides minimal M&A activities ahead, we may see its balance sheet health also improve from current levels, while similarly realizing the much-needed financial synergy across its offerings, likely to trigger the improved market sentiments over the next two years.

Readers must also note that CVS remains a viable dividend investment thesis here, with an expanded forward yield of 3.50% based on the stock prices at the time of writing, compared to the 4Y average of 2.75% and the sector median of 1.57%.

As a result of its (prospective) dual pronged returns through capital appreciation and dividend payouts, we are maintaining our Buy rating for the CVS stock.