I analyzed CVS (CVS) a year ago, and I stated that in my opinion investors should have some exposure to this great company. In retro perspective, I should have been more bullish on CVS as the company has proved to be a great investment with a total return four times higher than the total return of the S&P 500 over the last twelve months.
CVS is a healthcare company in a different industry than companies I recently covered such as Medtronic (MDT) and Bristol-Myers (BMY). The company is one of the holdings in my dividend growth portfolio since 2017, and I added some shares over the years. In this article, I will focus on CVS as a dividend growth investment after the dividend has been raised again.
I will analyze the company using the graph below, which represents my methodology for analyzing dividend growth stocks. I am using the same methodology to make it easier for me to compare analyzed stocks. I will look into the company’s fundamentals, valuation, growth opportunities, and risks. I will then try to determine if it’s a good investment.
The company’s revenues have grown by 63% over the last five years. CVS is growing its sales through a combination of organic growth and M&A activities. The most prominent M&A activity was the acquisition of Aetna, an insurance company, which transformed CVS from a pharmacy chain into a healthcare powerhouse. According to the consensus of analysts, as seen on Seeking Alpha, investors should expect revenues to grow at mid-single digits growth rate.
The EPS has grown slower than the revenues. EPS has grown by 24% when using GAAP earnings and by 42% when using non-GAAP earnings. Despite sales growth and margin expansion, the company’s EPS growth still lagged behind revenue growth, and this is due to the massive share issuance that was needed to fund the acquisition of Aetna. As the company resumes buybacks, it will support additional EPS growth. According to the consensus of analysts, as seen on Seeking Alpha, investors should expect flat EPS in 2022, followed by high single digits annual growth.
The company could have been a dividend aristocrat by now, as it has paid dividends for 25 years without reducing them even once. The company is not an aristocrat since it has frozen the dividends for four years to deleverage following the Aetna acquisition. The company resumed increasing the dividend in the February 2022 dividend with a 10% increase. The company’s payout ratio is low at 33% using GAAP earnings, and less than 30% with non-GAAP earnings. The current yield may not look too enticing at 2%, yet the company has plenty of room to grow.
In addition to dividends, the company is also returning cash to shareholders using share repurchases. The number of shares outstanding has not changed over the last decade. The company has bought back almost a quarter of its shares only to issue them back to fund the acquisition of Aetna. Since the acquisition, the number of shares grew slowly due to employee compensation, and now as the company has deleveraged, buybacks are returning. Last December the company announced a $ 10B buyback program which is equal to 7.5% of the shares outstanding.
The forward P / E ratio of CVS is just 12 when taking into account the company’s forecast for 2022. The graph below shows how the company has enjoyed multiple expansions over the last twelve months. Last year shares have traded for less than 9 times forward earnings, and investors were skeptical. I believe that shares are attractively valued even at the current valuation.
The graph below from Fastgraphs.com strengthens my position. The company despite a significant run over the last twelve months is still undervalued. The shares of CVS have traded for an average valuation of 15 times earnings. Even after the run, shares still have additional room to run to before they reach the average valuation. Following the EPS stagnation in 2022, the forecasted growth rate is roughly 10%, and it can justify a better valuation.
To conclude, CVS is a solid dividend growth company. The company enjoys top and bottom-line growth. After paying some long-term debt, the balance sheet is stronger, and the company is returning more capital to its patient shareholders. The company returning capital using both buybacks and dividends, and the current valuation is attractive when taking the growth into account.
The first growth opportunity is the company’s diversification. The company has two businesses – the retailing business as well as the insurance business. Both of them have room to grow, and the diversification allows CVS to pursue growth on both of them simultaneously. The company is expanding its insurance offering while turning its CVS locations into centers where additional primary healthcare services can be obtained.
In addition, there are significant synergies between the businesses. It is not only the cost-cutting when it comes to general and administrative expenses, the company is leveraging Aetna to offer better and unique services in its retails, and using CVS to deliver drugs to Aetna clients. The company intends to keep leveraging both businesses together to offer added value when competing against other insurers and retailers.
Another growth opportunity for CVS is its digital transformation and adaptation of the omnichannel approach. Clients of CVS can buy in retail stores, can enjoy curbside pickup, and delivery at home in some places in the country as fast as one hour. The company is also adopting telemedicine. The company maintains the traditional services and adds a layer of digital services which offer high added value.
The most significant risk is the competition. CVS has three main types of competitors. The first type is giant retailers, and Amazon (NASDAQ: AMZN) is prominent there with its relatively new offering of prescription drugs. In addition, the company is also competing with other pharmacy chains such as Walgreens (WBA) as well as local pharmacies. The third type of competitor is insurance companies as they are competing with Aetna’s health insurance business.
Following the acquisition of Aetna, CVS had to deal with a net debt to EBITDA ratio of almost 6. In the following years, the company has paid debts aggressively to lower the debt to EBITDA levels back to 3 as they were before the acquisition. However, the debt is still challenging as the company has more than $ 56B in debt. Since interest rates are about to climb due to inflation, investors should take into account higher interest expenses, and less flexibility when it comes to future M&A.
Another risk that has emerged following the acquisition of Aetna is the regulatory risk. CVS as a pharmacy chain was a retailer, and it had to deal with limited regulations due to the sale of drugs. However, as the company acquired Aetna is now also an insurer, and it will be affected by any healthcare reform in Washington DC Right now, there is no significant reform on the table, but it is a source of future uncertainty.
CVS is a good addition to your dividend growth portfolio. The company has strong fundamentals, with growth across the board. The management is focused on returning capital to shareholders, and the shares are attractively valued at a current forward P / E of 12. Moreover, the company has several prominent growth opportunities in the medium and short term.
The company’s risks are manageable in my opinion. The debt was managed well, and the company is still addressing it. Competition and regulation are two risks that the company has dealt with in the past, and proved that it can be agile enough to react. At the current price, with a 2% dividend yield, and high single digits growth rate, I believe that investors in CVS will gain a 10% total return in the medium term, and probably in the long-term as well.