CVS reported 3Q17 adjusted EPS of $1.50, above $1.49 consensus. Management raised guidance for 2017 to $5.87-$5.91 from $5.83-$5.93. For Q3 net revenues increased 3.5% driven by 8.1% sales gains in PBM business. Hurricanes disrupted retail operations – sales were down -2.7 and same store sales growth was negative -3.2%, which has put the stock under pressure today -$2.4.
On 10/26 shares fell 9% as CVS is rumored to be in talks to purchase Aetna health care insurance company. We would view this deal favorably as a vertically integrated business model will help CVS’ existing businesses. PBM’s have come under pressure as health insurers (like Anthem) have questioned pricing tactics and started fulfilling the PBM function internally. Buying Aetna would provide a better footing for the PBM business and potentially reduce pricing issues.
Current Price: $66.8 Price Target: $90
Position Size: 2.28% Performance since inception 2/17/17: -14.5%
Thesis Intact. Key takeaways from the quarter:
1. Consolidated revenue was up 3.5%, operating margins declined by 40bps
a. Retail sales were down -2.7% and SSS -3.2%, driven by continued reimbursement pressure and hurricanes which closed over 900 store costing $55m.
b. PBM sales +8.1% with margins down 90 bps due to timing of Medicare payments
c. MinuteClinic grew revenue +8%
d. Retail/LTC operating margin fell 135bps due to continued retail reimbursement pressure and restricted networks that exclude CVS.
e. Bought back 5.0M shares in the quarter ($400m) , and paid $512M in dividend, returning $912M to shareholders in the quarter
2. Raising the lower end of 2017 guidance
a. Guidance: Adjusted EPS of $5.87-5.91
b. Net new business wins are projected to be $1.8B for the 2018 season
c. Retention rate expected to be strong at 97%
d. Long term EPS growth rate of at least 10%. Update will be given in December 2017 during the Analyst Day
3. Valuation: we are maintaining our price target of $90
a. Currently trading at 11.3x forward P/E, CVS is trading well below its historical 15x P/E
b. FCF yield of ~12% is very attractive
Thesis on CVS
• Market leader: largest pharmacy benefit manager (PBM) in the US. This gives CVS scale advantage and negotiating power with pharma companies to obtain better drug pricing discounts. Also the largest US pharmacy retailer, giving it more touch points with consumers/patients. Finally, market share leader in long-term care pharmacy sector thanks to its Omnicare acquisition.
• Stable and predictable top line and margin profile. CVS benefits from an ageing population in increasing needs of prescription drugs.
• shareholder friendly, offering a 7% shareholder yield (5% share repurchase + 2.6% dividend yield)