CVS -- Enticing Risk/Reward Premium

We find CVS to be significantly undervalued on fears of Healthcare reform

Disclaimer — I hold and will continue to hold shares of CVS

Every election year we hear the same talk about health care reform. This year is no exception. As a result a number of health insurance companies are trading at discounts relative to their historical averages. Yet assuming that fears of health care reform are legitimate, we feel that CVS offers enticing risk/reward premium with upside of nearly 40%.

We arrived at our fair valuation of CVS by using an excess cash flow model. For the twelve trailing months CVS has a free cash flow of 13.6 Billion. After reviewing their last 10-K we came up with a Weighted Average Cost of Capital (Equity and Debt) of 7%. We calculated total debt at the end of the fiscal year as 89B. Market cap at end of fiscal year was 96.64B. This leaves a total invested capital of 185.65B

Annual Cash Flow (TTM) — 13.6B

Net Debt (FYE) — 89B

Market Cap (FYE) — 96.64B

Total Capital (FYE) — 185.65

Multiplying the Total Capital by the 7% Weighted Average Cost of Capital (WACC) leaves us with a minimum expected return of just under 13B.

This means that our Annual Cash Flow exceed the expected return by around 600M.

To calculate the Present Value of the Excess Return we divide the 600M by the 7% minimum expected rate of return. This yields a Present Value of the Excess Return of 8.6B

So our fair business value (Total Capital + Present Value of the Excess Return) is 194B.

Subtract out the debt and that leaves a fair equity value of 105B.

CVS current market cap is 76B.

As you can see there is a significant gap in how the business was valued at 12/31/2019 (FYE) and how it’s being valued today.

This leaves us with 2 questions to answer:

1.) Has anything changed within the pandemic to permanently impair value from CVS?

2.) Is the risk of regulation so extreme that it impairs 40% of the value of the future business?

We would answer no to both of these questions.

1.) Has anything changed within the pandemic to permanently impair value from CVS?

In looking at the past 6 months of earnings, CVS’ total revenue during the pandemic has increased Y/Y. Additionally increased usage of CVS’ clinics for diagnostic purposes has increased awareness of it’s medical services segment which is a key part of CVS’ future growth plans. Mailed prescriptions have increased YOY indicating an increase in the use of digital technology. A new partnership with Teladoc should also contribute to an increase in these fields. All of these are key reasons to believe that CVS’ core business strategy has not been impaired by the pandemic.

2.) Is the risk of regulation so extreme that it impairs 40% of the value of the future business?

While we can’t say for certain we believe the fears are overblown.

First, neither Donald Trump nor Joe Biden have advocated a ‘health care for all’, government funded public insurance program that would significantly impair the value of private insurers.

Second any significant changes would require a complete sweep of the House, Congress and Presidency by one party. The probabilities of this are low. Even were this to happen, neither party has a complete lock step in ideology at the moment.

Third, even if they were to completely sweep, a reformative healthcare package could take years to complete in order to prevent gaps in coverage. Especially during the midst of a global pandemic is this highly unlikely.

Finally, even in a reformative health care environment CVS has an advantage that no other insurer has. They can use Aetna as a funnel to drive business into their pharmacy and retail operations. This is what I believe to be the most anti-fragile part of their business. This omni-channel, multi-tiered revenue approach will allow CVS as a business to continue to function in spite of impairments to Aetna’s business model. Furthermore in many of those cases Aetna would likely be able to pick up business from other insurers who may not be able to offer as comprehensive and available a network as Aetna/CVS can offer. In other words, CVS/Aetna have pricing power over a number of steps in the healthcare process. This allows them to make up for losses where others can not.

Conclusion

We believe that in any situation CVS looks to be undervalued by the market. However we don’t believe this will last long. The options market shows open interest in Nov 20 $60-75 bullish call options with the $70 call having the most open interest (15,844). The Jan 15 calls are even more bullish with the $90 call having an extreme amount of open interest (101,429).

We feel the potential upside in CVS based on options, analyst pricing and our own fair value estimates to be nearly 40%. Potential downside is likely less than 10% (stock currently trades around 9% off it’s March lows).

Of course none of these scenarios are factoring in a second wave of COVID19 in the fall, but in all likelihood this would be likely to drive growth in CVS medical offerings if at the expense of it’s retail business.