CVS: Turnaround or Value Trap?

I’m sure I’m not the only one that has watched CVS’s stock price get chopped in half after peaking in 2014 at $112 a share. On an annualized basis that loss is 15.3 percent. All while the US market kept powering higher. Unfortunately for CVS, it has been at the nexus of two trends that have impacted a lot of companies:

  1. Amazon “destroying” retail; and
  2. A growing clamor to fix our healthcare system.

Granted, if an investor decided to buy at the peak in 2014 he was buying in when their P/E ratio was 21.7x. What’s fascinating is that CVS’s earnings continued to grow at a healthy clip for the next three years. It’s only for estimated 2019 earnings that the year-over-year is expected to be negative before growing once more in 2020 and 2021.

CVS

As the chart above shows, CVS is now trading for only 7.5x earnings so it begs the question: is this a value trap or a turnaround situation?

What you got – you know I want it.

While I’m not a huge fan of CVS’s store layouts, I have to admit that they have the following things going for them:

  1. 9,900 locations with 70 percent of the US population living within 3 miles of a CVS retail store. No matter where you live or where you travel in the US, there’s often a CVS you can pop into if you need something. I can’t tell you the number of times I’ve stopped in to grab a birthday card, some razor blades, deodorant, batteries, baby stuff, or any number of other things that I didn’t want wait on Amazon to deliver to me.
  2. Pharmacies: Part of the reason CVS still gets a lot of retail traffic is that people have to go there to get prescriptions filled anyways. So if I’m going to be there to pick up a prescription for my wife, I might as well grab those random household items that I need.
  3. MinuteClinics: this and telemedicine are the community colleges and MOOCs (massive open online classrooms) of the healthcare industry. Because of their value proposition, they cover the basics at a reasonable price and they’re likely to become more common as we work to drive down healthcare delivery costs. 1,100 of CVS’s 9,900 retail locations contain a MinuteClinic. MinuteClinic’s can handle about 80 percent of the work a primary care physician typically does.
  4. Aetna: while it might seem strange that CVS bought Aetna, the long-term plan is to steer the people they insure, especially the ones with chronic conditions, into a MinuteClinic or one of their new HealthHUBs. MinuteClinics and HealthHUBs employ nurse practitioners, who typically earn ~$100,000 per year instead of a primary care physician’s ~$200,000. They can run tests and prescribe drugs, and the wait time to get in to see one is usually considerably less than most traditional primary care providers.

The factors above should allow CVS to survive the retailpocalypse. There’s just too many times where it’s easier to pop into a store than to order online. Additionally, even though I am hopeful that our healthcare system gets reformed, we still need stores and distributors to actually deliver the goods and services necessary to provide ongoing care. Between CVS’s MinuteClinics and their purchase of Aetna, they should stay decently positioned to be part of the health delivery system going forward.

Why did the stock get cut in half?

The above pieces and parts are all well and good, but Sears and JCPenney had a giant retail footprint and we all know how that worked out. However, I think the big difference in the long-term is that CVS’s retail store format is significantly smaller and cheaper, plus CVS is retooling as a health hub instead of a pure retail play.

In the short term, the reason their stock price was cut in half is because of four main issues:

  1. Amazon of course. In response, CVS has reduced its inventory and gotten rid of lower-margin items while increasing the number of home health items used to help manage recovery from surgery or chronic conditions.
  2. Prescription drug rebates that CVS is on the hook for via its Caremark division. These contracts are structured in a way that assumes prescription costs keep rising. However, the assumptions underlying the contracts, mainly higher prescription pill inflation, hasn’t occurred. It’ll take another two years for CVS to reprice these contracts and get the profitability of this segment back up.
  3. The push to reign in healthcare costs: if Caremark’s pretax margins are brought in line with the rest of the drug supply chain, then a recent analysis by Lance Wilkes of Bernstein estimated that pretax profits could fall to $3 billion from $5 billion. While this isn’t likely to happen immediately, it does show that there is likely to be pressure on their earnings.
  4. Capex: to continue its transformation CVS is going to have to spend a lot of money on acquisitions of physicians groups, urgent care centers, and store build-outs. While these expenditures will help them in the long-run, it’s going to compress their free cash flow in the short-run.

How to Trade CVS

If you think that CVS represents a good reward to risk play then selling covered calls via their weekly options might further tip the odds in your favor. Since the stock has gotten cut in half there seems to be a lot of people who want to buy the upside via options without taking the downside risk. Or maybe it’s just a volatile stock that is subject to headline risk and the next tweet. Regardless, weekly ATM calls are trading hands for ~$1 per contract while weekly calls that are ~4 percent OTM are trading hands for $0.44 on a stock that’s priced a little over $53.

Personally, I think this is one to hold for a while so buying the underlying and taking advantage of the premium offered is the way to play it.

 

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