Jul.
1, 2019 5:45 PM ET | Daniel Schönberger
Summary
Judge Leon will
decide about the CVS-Aetna merger in July, and there is a lot of uncertainty
what will happen if the merger is blocked retroactive.
At the beginning of
June, CVS also held its annual investor day and presented the path back to
double-digit growth and debt reduction.
CVS remains deeply
undervalued and the current stock price doesn't seem to match the growth
expectations of management as well as analysts.
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About four months
ago, I published my last article on CVS Health Corp. (CVS). The stock was trading at a similar
level as right now. In the months before, the stock dropped pretty quickly from
about $80 to $52 and is since then trading more or less at that level and even
positive quarterly results didn't lead to a turnaround in the stock price.
For several months,
CVS traded in a very small range between $52 and $57 and impulses to drive the
stock price higher again (or maybe even lower) have been missing. Before CVS
will report its quarterly results next week (on July 8th) and might get
impulses again, that will lead the stock higher or lower, we will take a closer
look at the company and the stock.
Larry J. Merlo vs. Richard J. Leon
As I have already
written in the last article, I think CVS is severely
undervalued. The main reasons for the depressed valuation, in my opinion, are
the high levels of uncertainty and the high debt levels CVS has to deal with
(among some other aspects).
A big concern right
now for CVS is US District Judge Richard Leon in Washington, that must finally
authorize the decision under the Tunney Act and the judge signals broad
anti-trust concerns. The Justice Department demanded that Aetna already
divested its Part D business before approving the merger last year, but there
are still concerns that CVS might become too powerful and end up in a position
where it can set prices because of missing competition.
CVS Health - along
with Express Scripts (NASDAQ:ESRX) and Optum - is
controlling 70% of the Medicare prescription drug market nationally, and we,
therefore, have three very powerful players in the healthcare sector: Optum is
owned by UnitedHealth (UNH) and Express
Scripts is owned by Cigna (CI) - two large
companies and big players in the United States healthcare market. Currently,
there is a huge concern that further concentration might lead to higher prices
as well as premiums the customers have to pay. Diana Moss, the president of the American Antitrust
Institute, testified that "premiums will increase as a result
of consolidation" and expressed concerns about the CVS and Aetna merger.
She also advised that it is sometimes most effective to block a merger. Dr.
Neeraj Sood, an economist that testified for the American Medical Association
also expressed significant competitive concerns as a consequence of the merger.
He also explained that there would be far less competition and the pressure -
especially on low-income patients - could be immense.
(Source: CVS Investor Day Presentation)
It is true that CVS
is creating an integrated data platform and an integrated data ecosystem and is
combining front stores, MinuteClinics, and the retail business, with pharmacy
benefit management, external data, and also Aetna's business. From the
standpoint of an investor, this is positive as it creates a powerful moat
around the business.
But it remains
unclear if the judge can actually stop the CVS-Aetna deal as the two companies
are already operating as one company for several months. CVS has already sold
the assets the Justice Department required it to divest. There are several
voices claiming that the merger can't be blocked anymore, but the uncertainty
remains and it probably will be a huge relief for CVS and its investors when
there is finally a decision.
Investor Day: Key
Findings
The same day, judge
Peon held his hearings, CVS held its annual investor day and provided
information on how CVS will transform in the next few years and reach
double-digit growth again. CVS wants to create the most consumer-centric health
company, which has not only a recognized and trusted brand but also a deep
local footprint and which will become a powerful healthcare decision-making
engine informed by data and analytics. Management wants to achieve medical cost
savings, membership growth, expanded use of CVS's assets (like the pharmacy or
MinuteClinic), and open platforms and new businesses (based on data and
analytics products).
(Source: CVS Investor Day Presentation)
CVS sees itself
uniquely positioned among managed care peers as the company not only offers
medical and pharmacy benefits but also retail pharmacies as well as retail
clinics. And while CVS will not really expand its HealthHubs in 2019 (so far,
CVS is testing the concept in three stores and is expecting to expand to four
HealthHubs at the end of 2019), management is expecting that it will have
opened 1,500 locations by the end of 2021. According to surveys by CVS, the
customer satisfaction and customer experience improved by the HealthHubs. When
looking at the numbers, CVS is certainly well positioned and was growing much
fast than the industry. In 2018, CVS grew about three times faster than the
industry, and over the last few years, CVS has increased its pharmacy retail
share from 23.5% at the beginning of 2017 to 26.3% right now.
(Source: CVS Investor Day Presentation)
CVS also seems to be
on track to reduce the levels of outstanding debt, and for 2019, management
expects about $9.8-10.3 billion in net cash provided by operating activities
and about $4.2-4.6 billion should be available for debt repayment. As
originally planned, the leverage ratio should be between 3.0 and 4.0 in 2021,
and in 2022, the leverage ratio should be close to 3. CVS is also expecting to
save about $900 million in integration synergies and about $1.5-2.0 billion in
savings from enterprise modernization (i.e. technology enhancements or
productivity improvements) from 2022 going forward.
Over the long term,
CVS assumes that from 2022 going forward, there will be about $10-12 billion in
cash available annually for enhancing shareholder value in the long term. In
2022, earnings per share should be at least $8.00 (according to different
estimates) and when the company would pay out about 30% of its earnings as
dividend (as it did in the past), a 20% dividend increase could be possible.
And as the company currently only needs $2.6 billion for dividend payments,
there is a lot of room to not just increase the dividend but also restart the
share buyback program.
(Source: CVS Investor Day Presentation)
Technical Analysis
When looking at the
daily chart and the price action during the last few months, we see that the
stock sold off pretty quickly after the merger between CVS and Aetna was
completed in November 2018 and dropped from $80 to about $52. The stock price
seems still well supported around $52, but the stock also hasn't managed to
break out to the upside. And considering the lower highs the stock has set
since March 2019, it would not surprise if CVS would break through the support
level once again and we see stock prices below $52.
I also assume that
the next major move (upwards or downwards) might be news-driven. We will either
see a break-out above the declining trend line (dotted green) or a further
decline breaking through the red line. If Judge Leon should block the merger, I
wouldn't be surprised if the stock sees a major one-day drop and a close below
the red line. In my last article, I suggested it might be possible that the
stock will drop to $48 or maybe even to $40. Although the last number might
seem rather unrealistic, it could happen for example if the ruling of Judge
Leon catches investors on the wrong foot or in case of a short-term panic.
Intrinsic Value Calculation
But the stock
behavior in the short-term doesn't matter much. Over the long term, I am
confident we will see higher prices as the stock is deeply undervalued right
now - probably because of the high levels of uncertainty surrounding the stock
and the company. In my last article, I calculated an intrinsic
value of $52, and for that calculation, I assumed that CVS won't be able to
grow its free cash flow ever again (using a 10% discount rate). And although
CVS expects only moderate growth for the next three years, it seems totally
unrealistic that CVS won't be able to grow its revenue and free cash flow in
the future years. For 2022 and the following years, CVS is even expecting
double-digit adjusted EPS growth again.
(Source: CVS Investor Day Presentation)
According to Seeking Alpha Earnings Estimates, adjusted EPS
is expected to decline a little in 2019 but will then continue to accelerate
growth once again - about 4-5% in 2020 and 2021 and about 9% and 2022 and 2023.
CVS is presenting an
astounding asymmetry: Almost everybody (i.e. management or different analysts)
is confident that the company can report high growth rates over the long term
(maybe even double digits), but the stock is trading at very depressed levels
and doesn't reflect the growth expectations at all.
Conclusion
In July, there are
two important dates where the stock might gain momentum, and we see a
news-driven break-out of the current range. On July 8th, the company is
reporting quarterly earnings and either a surprise or a disappointment might
move the stock. And finally, somewhere near the end of July, the judge ruling
might also move the stock quite a bit.
In my opinion,
investors might win either way. If the merger is blocked, it will be messy for
CVS for a few quarters, and we really don't know what will happen, but as CVS
is extremely undervalued and will be able to restructure or repay the massive
amounts of debt (which is a major concern), it might also be positive for the
company. And when the merger is approved, one major uncertainty has gone away
limiting the reasons to give CVS such a depressed multiple right now.
Disclosure: I am/we are
long CVS. I wrote this article myself, and it expresses my own opinions. I
am not receiving compensation for it (other than from Seeking Alpha). I have no
business relationship with any company whose stock is mentioned in this
article.
https://seekingalpha.com/article/4273028-cvs-health-trapped-growth-expectations-uncertainty
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