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A disappointing investment that's poised to take off



March 04, 2011 – Comments (3) | RELATED TICKERS: CVS


CVS is a stock that has been my nemesis for around a year now. I initiated a position in the company in two of my accounts back in April of last year. I am currently down a little over 10% on my position. I realize that this is not a long time ago nor is that a major loss, but still this is one of the very few red marks in the sea of green that the recent bull market has so graciously brought us so it bothers me.

The company is frustrating because its management never seems to execute properly, but today I came across the second bullish write-up on the company that I have seen in as many days so I figured that I'd mention it.

First, here's what I had to say about the company last April:

My investment strategy now involves finding cheap, dividend-paying stocks that have some sort of free embedded call option that could act as a catalyst for significant earnings improvement down the road.

While its dividend isn't as high as I normally like (around 1%), CVS is much cheaper than its main competitors. Looking at the stock at a simplistic level and comparing its P/E ratio to its main competitors we see that CVS currently trades at around 14.4 times its real trailing earnings (not some analyst's guess of how it will do in the future). That compares very favorably to its number one competitor in the pharmacy segment, Walgreen (WAG) which trades at around 17 times trailing earnings (I'm ignoring the mess that is Rite Aid).

The great thing about CVS is that it's not just a pharmacy, it also engages in pharmacy benefit management (PBM) through its Caremark division. PMBs are hot, hot, hot. Take a look at companies like Express Scripts Inc. (ESRX), which trades at over 33 times trailing earnings, or Catalyst Health Solutions (CHSI), which trades at 30 times.

Granted, Caremark hasn't exactly been knocking the cover off the ball to use a baseball analogy (heck it is spring after all), but its business seems to have stabilized. Anyone who uses Caremark now has made a conscious decision to do so because their contract likely had to be renewed so we are unlikely to see any mass client defections in the near future. Besides Caremark has been left for dead by investors. It's super cheap compared to its competitors.

Now onto the good part, the catalysts. They include the following:

- The likely influx of new customers created by the expansion of healthcare that the government recently passed.

- Increased profitability as a result of the coming wave of generic drug introductions, which are more profitable for pharmacies and PBMs than branded medications.

- A demographic tailwind from aging customers who will need more medicine.

So there you have it. A cheap, dividend-paying stock, with specific event driven catalysts that could significantly improve the company's results, and in turn its stock price in the years ahead. The majority of my personal portfolio now consists of companies like this. If I find some time, I'll write up a short blurb on another one.

Now on to the much more recent write-ups.

The first is Sum Zero's weekly investment idea:

CVS Caremark Corp. (CVS) - Sumbitted By: Greg Nathan (First Pacific Advisors, LLC)

I won't post the entire article, what would be wrong and anyone can read it using the above link, but here's the key takeaways:

- CVS stock is currently trading at $33/share. The Author of the Sum Zero piece believes that it is currently worth $40.39 and that it has an upside of $48 two years from now.

- "solid earnings growth opportunities (generic wave, growing 65+ year old population, etc.) over the next 5 years that are as close to guaranteed as I've ever seen"

- "One of the best parts about an investment in CVS at the current price is that your downside is well protected. Even if you believe Caremark's business is worthless (hardly the case) and you want to assign a 10% discount to CVS drugstores (compared to WAG because one believes there is more margin expansion opportunity there due to a more immature store base) then CVS is worth $23.50 or immediate downside of -28.7%."

- "Retail pharmacy chains make on average about 40% higher gross profit dollars per generic prescription compared to the average branded drug." This is important because a huge wave of new generic drugs is slated to hit the market.

- "By 2020 there should be almost 55 million people over the age of 65 in the U.S. compared to ~40 million today. The 3.1% CAGR of the 65+ U.S. population over the next 10 years should translate into about a 1% per annum growth in drug consumption since the average 75-year old living independently consumes 4.2 scripts (and 8.1 scripts living in an assisted living/skilled nursing facility) vs. 1.1 for the average American. It is worth noting that from 2000 to 2010 the 65+ year-old population increase from ~35 million to ~40 million or cumulative growth of just 15% vs. 36% expected growth for this decade."

- "Free Call Options 1" In 2014 an additional ~32 million people could gain healthcare (including prescription drugs) coverage. Applying CVS' 18% market share would result in the following: 32 million x 18% x 2 Rx per person x 12 months = 138.2 million prescriptions x $15 gross profit = ~$2.1 billion of incremental pre-tax profit.

- "Free Call Options 2" Rite Aid is in a financial disaster that might eventually have to file for bankruptcy. It has significant territorial overlap with CVS so its demise would benefit the company greatly.

Most of these points are what I mentioned when I wrote up CVS last year, but this author included a lot more details. I might have been able to do a similarly detailed write-up if that whole full-time job thing didn't get in the way :) (thank goodness it has).

The second write-up that I mentioned was by Jon Jacobson from Highfields Capital. He spoke positively about CVS in this month's issue of Value Investor Insight:

[Jacobson] believes the market is ascribing almost no value to the company’s Caremark pharmacy benefits management business, which he believes could again earn $1 in EPS. Applying a peer multiple to PBM earnings and a 12-13x multiple on growing drugstore earnings, his target price for the shares is in the mid-to-high $40s.

CVS has been a somewhat disappointing investment thus far, but I am holding onto my position because I believe that may of the reasons that I bought stock in the company have yet to play out. I still feel that it has significant upside from here.

Have a great weekend everyone.


3 Comments – Post Your Own

#1) On March 04, 2011 at 6:09 PM, alstry (< 20) wrote:

You love WELFARE RECIPIENT companies don't you.

The only way this company makes money is from bankrupt medicare and medicaid....

Just keep the deficit printing presses going as we bankrupt our children.

Soon they will tell us to go to heck...then what?

Do you really think you can borrow your way to prosperity?

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#2) On March 05, 2011 at 1:52 PM, Starfirenv (< 20) wrote:

#1 is a troll and spammer.

Deej, also their aquisition of Long's Drugs, a discount drug/variey chain of stores (best place to get many things, from fishing gear to booze) out here in the West should add to the bottom line. Looks like a good bet. Where's the love?
Thanks, Best +1 rec

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#3) On March 10, 2011 at 10:28 AM, MKArch (99.82) wrote:

This ones off topic Deej but I just got back from vacation and read an HRG headline that they bought the insurance company with the cash they recently raised. They bought some other company as well. I don't have clue one how to value the insurance company but it looks like they paid 22% of book. I would imagine that would make it some sort of distressed asset in need of fixing up. I'm assuming the deal with the other insurer is part of the plan. I'd be interested in your take.

The market seems underwhelmed but at first glance this one does seem like a hair ball.They raised the $350M to do the deal with the 11% bonds so I was expecting some sort of way undervalued turn around story. From what I can tell that's what we have. Now I guess the question is how do we turn this company around and what's normalized earnings for this company compared to the cost of the bond? What say you Deej?

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