CVS Health Stock: A Terrible Earnings Report, But An Undervalued Stock (NYSE:CVS)

CVS Health (NYSE:CVS) reported first-quarter net income well below Wall Street’s expectations, while also lowering next year’s guidance. The stock traded sharply lower after the May 1st report, down nearly 20% during parts of the day before closing 17% lower, a record one-day loss for the company. I have a small long position in CVS Health and I am reviewing the position as I try to decide if the stock is a buy, sell or hold.

The Bad and the Ugly, with Just a Little Bit of Good

Total revenue rose by 3.7% year-over-year to $88.4 billion, but fell short of the analyst consensus of $89.2 billion. However, the knee-jerk sell off was most closely associated with costs, which soared much faster than expected. Thus, on the top-line revenues did reasonably well last quarter, but on the bottom-line CVS badly missed earnings expectations with overall adjusted earnings per share coming in at $1.31/share in Q1 vs. $2.20/share for Q1 2023. CVS Health has been caught up in the woes of the insurance industry, suffering from unlucky timing as it expanded its long-prosperous Medicare business just as regulators clamped down on costs. While the expansion was intended to capitalize on the growing demographic shift of Americans to an older population more reliant on Medicare, the financial impact has been brutal. CVS Health is not alone, Humana Inc (HUM) has also been crushed this year as the result of lower Medicare reimbursement.

Worse, the guidance that management forecast for the coming year was drastically reduced, not just this quarter’s earnings. Adjusted earnings per share for the coming year were cut to at least $7.00 from a previous analyst consensus forecast of $8.30. Interestingly, the reduction in share price for CVS Health of 17%, was roughly equal to the decrease in forecast earnings for the coming year ($7.00/$8.30 = 84.3% or a 15.7% reduction in forecast earnings). So if a 17% reduction in the price of CVS stock seems unfair, remember that the forward P/E of the company remains almost the same. This is the brutal math of the stock market, but it also hints at something deeper. Below is a table of the actual stock price as of before and after the earnings announcement, along with the price implied by an 8x forward earnings multiple.

From this observation the following conclusions are drawn:

• Constant Valuation: The consistency of CVS’s forward P/E ratio at around 8x suggests that the market’s valuation of the company is more constant than the tumultuous change in the stock price might suggest. Thus, investors may have lost confidence in CVS Health’s long-term value and are choosing to apply a short-term multiple to the company.
• Earnings Revision Impact: This leads to the conclusion that moving forward CVS investors will be very unforgiving regarding short term changes that effect the bottom-line. Should next quarter’s report reduce guidance again, don’t be surprised if an 8x multiple is applied to reach a new price for CVS Health. This could be bullish or bearish, depending on which direction the revision takes.
• Investor Rationality: At first, the massive sell-off in CVS Health seemed overdone. However, the nearly proportional change in the stock price to forward earnings suggests that investors are reacting rationally to new information. This was not a panic sell-off, leading to the conclusion that the drop will be long-lived and not to expect a reversal.

Moving forward, the costs of CVS Health increase faster leading to a fall in the stock price to eight times forward earnings, is it reasonable to expect these cost increases to be durable? After all, the stock price of CVS Health discounts the value of the company into the distant future. Is it reasonable to expect that forward earnings will be permanently impaired? After all, if management can simply contain their spending while leaving revenues unencumbered CVS Health should have a good runway in the future and perhaps May 1st 2024 will only be a speed bump along the way.

While these are reasonable questions, it must be noted that they will take a long time to answer. Don’t expect a quick rebound in CVS Health, my conclusion is that the stock is a HOLD at best. In the meantime, we can further research the company to focus on the longer term implications that the market may be overlooking.

CVS Health: The Good Old Days Vs. Recent Underperformance

One factor that I take into account is the long-term performance of a company. If a company has in the past created shareholder value then that is a sign of a robust business. CVS Health in the past was a very robust business. Since going public in 1996, CVS Health produced fabulous returns, significantly outperforming the S&P 500.

But something happened after the stock peaked in 2015, even though the peak was revisited in 2022, since it has been a very bumpy ride and presently the stock trades near $55/share, a price lower than 10-years ago.

A picture is worth one-thousand words:

Why has Recent Underperformance been so Protracted

There are many reasons for this protracted period of dismal returns for CVS Health. Perhaps if we understand them that will give some insight into whether CVS Health has value, or is simply a value-trap:

• Excessive valuation: One can make the case that CVS Health was excessively overvalued around its peak in 2015:
  • Around 10 years ago CVS Health traded at a P/E of 27.3x earnings (GAAP – trailing), a price/book of 3.4 and a price/sales of 0.88.
  • As of this writing CVS Health trades at a P/E of 9.86, a price/book of 0.95 and a price/sales of 0.23.
  • Clearly the valuation of the company was very strained in the past and now has reached deep-value territory.

• High Debt Levels: Following its acquisition of Aetna in 2018, CVS Health took on significant debt. CVS has debt/EBITDA of approximately 3.17, while manageable, this has certainly been a headwind in the era of rising interest rates.
• Excessive Competition: CVS Health was an up and comer in its pharmacy business, but so were Walgreens Boots Alliance Inc. (WBA) and Rite Aid Corp. (OTC:RADCQ). There was an oversupply of drug-stores leading to excessive competition. This is presently flushing out the weaker players: with Rite-Aid filing for Chapter 11 bankruptcy last year.

Simply because CVS Health has gone down in price doesn’t make it a bargain. There are a number of headwinds for the business that must abate before a turnaround can occur, however, the impediments listed above are largely abating, except for the debt load.

Clearly, CVS is now trading at a low valuation: the price/book, price/sales and trailing price/earnings have rarely been cheaper. We will consider this in the framework of a discounted cash-flow model later, but in the framework of historical valuation, CVS Health has reached a nadir.

CVS has been actively managing its debt levels, but this is still a work in progress. Following the Aetna acquisition CVS set clear deleveraging targets to reduce net unsecured debt to an EBITDA ratio of “low 3x”. Following the merger debt peaked near 4.6x EBITDA with the goal of rapid deleveraging to “low 3x” EBITDA. Below is a slide from around when the merger with Aetna expanded the debt.

This goal of reducing debt was accomplished. As of December 2022, CVS’s net debt to EBITDA ratio was significantly reduced to 2.4x EBITDA. Since then debt has ticked higher in 2023 returning to around 3.2x. Clearly, “low 3x” is subject to some interpretation, it could easily be misread as “below 3x” and CVS remains in the “low 3x” multiple of debt to EBIDTA.

However, the debt situation at CVS Health has clearly reversed and deleveraging has concluded with an uptick in Dec-2023. This factor must be watched closely by investors, particularly in the era of high interest rates. With the dividend yield nearly equal to the yield on an average CVS bond (see below), the company has little flexibility to use debt to finance growth.

Finally, the difficulty of excessive competition is being dealt with. As mentioned above Rite Aid has entered Chapter 11 bankruptcy and Walgreens stock has performed even worse than CVS Health. As such, the major players are in damage control mode, with minor players removed from the competitive landscape. It remains possible that large players like Amazon (AMZN) could still enter the fray. This is a major risk factor, but I continue to believe that pharmacies and the benefits they provide will continue to have a physical presence in brick and mortar stores.

Valuing CVS Health by Discounted Cash Flow

Valuentum, *Latest Investment Research* – Valuentum Securities Inc., a website that I subscribe to, performs an in-depth discounted cash flow analysis of many companies. Today, it could be argued based on past growth and projections that CVS Health is very cheap.

This analysis depends on several factors, notably:

• Projected revenue growth: the model expects continued growth of CVS’s revenue from $356.6 billion in Dec-2023 to $428.0 billion in Dec-2028 at the valuation mid-point. The low-point of valuation expects roughly flat revenue growth to $370.2 billion. This is only 3.7% revenue growth over 5-years, when the just reported revenue annual growth rate was equal to that. As such, the low end of the valuation model seems very reasonable. In other words, if CVS can simply grow revenues at the rate of inflation AND control its costs and debt, it should prove to be a wise investment over time.

• Net Balance Sheet Impact: CVS’s balance sheet contains significant debt (as previously discussed). The capital structure of CVS is 40.1% debt vs. 59.9% equity. CVS has been growing through acquisitions (Aetna among others) and the debt has accumulated as a result. At 3.2x EBITDA the debt is manageable and the company demonstrated the fiscal discipline to significantly reduce debt from 4.6x since the Aetna acquisition down to 2.4x before it crept up in the past year. Personally, I would have preferred to keep it at 2.4x while staying more cost conscious. The total liabilities of $157.9 billion are very meaningful considering that 2023 free cash flow was $10.4 billion (Total debt is $81.8 billion). While most of this debt was taken out at lower interest rates, a current bond 126650CW8 trades as of this writing at a YTM of 5.52% (maturing in March 2025), thus debt payments are consuming a good portion of free-cash-flow and CVS Health needs to address this, particularly for the health of its generous dividend (5.5% of $81.8 billion is $4.5 billion). With the dividend yield nearly equal to a CVS bond coupon payment, (at 4.93% – as of this writing) management should be discouraged from resorting to debt to fuel growth.

• Discount Rate: Interest rates have been rising lately and CVS’s DCF valuation is dependent on the discount rate applied. The model assumes an average after tax cost of debt of 4.7%, perhaps slightly low given the recent increase in bond yields (see above). The first phase of the company’s valuation is described above (years 1-5), with growth anticipated to decrease to 2.3% over years 6-20 and 3% thereafter. This leads to a final mid-point valuation of approximately $110.7 billion ($85/share).

In totality, the valuation of CVS’s brand should be seen as uncertain (like the market sees it, hence the volatility of the stock). However, given the assumptions above an investment in CVS seems underpriced, even when the low-end of the valuation range expects very low revenue growth.

Is CVS Health a Value-Trap?

Issues that have made CVS a value-trap for the past 10 years, except for excessive debt, are largely in the rear view. It is regrettable that the issue of debt was not even addressed on the latest conference call. Management clearly has their work cut out for them and Karen S. Lynch must step up as CEO and manage growth while simultaneously restraining costs.

Lynch contributed mightily to the current situation of unconstrained costs, under her watch CVS made seniors an enticing offer last fall: If they signed up for the company’s Aetna Medicare plans, they would receive free pickleball paddles. Enrollment increased, but costs surged more and a significant chunk of shareholder value has been destroyed as those costs have hit the bottom-line. A silver lining may be that over the longer term enrollment will continue to drive revenues.

The debt situation, while manageable could snowball and CVS stock, yielding 4.93% (as of this writing), could even face the prospect of a dividend cut. Since many investors hold the stock for the dividend this would be a very negative announcement likely pushing the stock down further.

However, amid this bleak landscape, there are certainly many possible reasons that CVS Health could perform much better in the next ten years than in the last ten. We already discussed the problems with the business, but where will growth come from in order to excite investors to purchase the stock moving forward? There are a few possible catalysts including:

• Biosimilars: Biosimilars are generic forms of biologic drugs. Increased molecular complexity causes these products to be more difficult to bring to market than small-molecule generics. On the most recent earnings call, CEO Karen S. Lynch spoke specifically about the importance of biosimilars. The details on how this will occur, what products will be offered remain a work in progress. CVS has a wholly owned subsidiary named Cordavis, based in Dublin, Ireland that is working directly with manufacturers to bring biosimilar products to the U.S. market. This could be an exciting driver of shareholder value in the future, leveraging CVS’s expansive brand, while reducing healthcare costs to consumers.
• Aetna Acquisition Integration: Continued integration of Aetna could continue to drive cost synergies while creating revenue opportunities.
• Growth in Healthcare Services: With the population of the United States aging, general demographic trends should be favorable to the company’s business model. Even if in the near-term Medicare Advantage has been challenged.
• Regulatory Environment: CVS Health has been caught as its insurance business has suffered, similarly to Humana. These strains have been intense, but should abate. If they do the stock may be over discounting cost pressures on the overall business.

Overall, CVS Health’s business should have several solid catalysts. The market is so dour on the stock that simply reestablishing profit margins and returning to forward earnings guidance of $8.30/share should get the company back to where it was trading only a few days ago. However, to create substantial shareholder value more milestones will have to be achieved.

Conclusions

CVS Health has moved from being overpriced at an all-time closing high of $103.61/share in February 2022 to undeniably cheap at ~$54/share (as of this writing). CVS Health is not going away, even if its costs have spiked, resulting in forward guidance being slashed. The market has gone from pessimistic, to pricing in extremely low expectations. While major growth prospects noted above may still lift the stock, serious issues must be overcome before this will happen. These serious issues include, not only debt and overspending, but also the recent trends of Medicare Advantage which have notably impaired earnings for the 2024 fiscal year.

In conclusion, investors in CVS Health at these prices should be rewarded, even if recent performance has been subpar. The company is undoubtedly underpriced and the market is heavily discounting serious issues that need to be resolved. However, management needs to be more focused on keeping costs under control and effecting this turnaround. It will take some time for the market to digest these recent setbacks, even if the longer-term prospects are bright.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.