CVS Health Corporation BUY - Carleton University · management (PBM) services and retail pharmacy. Its pharmacy services business line focuses on pharmacy benefit management services,

Maximillian Yam

Sector Manager

B.Comm, Finance

Minor in Statistics

[email protected]

CVS Health Corporation – BUY NYSE: CVS USD $97.17

Target Price: USD $108.26

Figure 1: PPS vs. Daily Volume

Source 1: Bloomberg

Carlos Cantafio

Equity Analyst

B.Comm, International Business

Minor in Economics

[email protected]

Key Financial Data

Market Cap $109.42B

S&P Credit Rating BBB+

Debt to Equity Ratio 0.73

Forward Price to Earnings 15.12

EV/EBITDA 11.28

Dividend Yield 1.55%

EBITDA Margin 7.5%

Return on Assets 5.6%

Revenue Growth – 1yr 10%

Inside this Report

☐ Initial Research ☑ Updated

Research

☑ Price Target

Change ☐ Rating Change

Monday, February 29th, 2016

Research Highlights/Investment Thesis

Growth in Specialty Drugs Market

Although the Specialty Drugs market accounts for approximately a third of total

prescription spending in the US, it also accounts for 70% of total medication

spending growth. CVS’ acquisition of Omnicare further solidifies its sustainable

economic moat in this market relative to any other competitor. Thus, this

market is a significant growth driver for the company in the upcoming years.

Prescriptions to Boost PBM Market

With prescription drug spending growth projected to average 6.3% annually

from 2015 through 2024, CVS is presented with another sizeable opportunity

for its PBM segment. As more people join coverage plans, dispensing rates are

forecasted to increase. Also, with a 98% customer retention rate year over

year, CVS’s PBM segment will be absorbing prescription spending growth.

CVS’ Financial Stability

CVS’ consistent top and bottom line growth allows it to redistribute significant

capital to shareholders, through both buy backs and a yearly increasing

dividend payout ratio expected to reach 35% by 2018. Moreover, its balance

sheet signals stability with an interest coverage ratio above 11x, even when its

D/E doubled last year to secure its competitive positioning.

The ACA and America’s Ageing Population

As more US citizens reach a 65+ age and obtain health coverage, CVS’ PBM and

Retail Pharmacy markets are set to increase. Health care spending is expected

to grow on a yearly basis and CVS is well positioned to benefit from each dollar

spent, especially given its exposure to Medicare and Medicaid.

Equ

ity Research

SPROTT STUDENT INVESTMENT FUND

1 POSITION UPDATE – NYSE:CVS

Company Overview

Headquartered in Rhode Island, United States, CVS Health Corporation (CVS) is the largest

integrated pharmacy health care provider in the US. As well, it is ranked as the second largest

pharmacy chain based on revenues and ranks twelfth largest company in the world based on the same

criteria for 2014. Additional to its US operations, the company offers its services in Puerto Rico, and

has a small operation in Brazil. Presently, the company operates under the brand name of CVS

Caremark Pharmacy Services, Caremark, CarePlus CVS/pharmacy, RxAmerica, SilverScript, Novologix,

Coram, CVS/specialty, Navarro, and Accordant names.

CVS Health Corporation reports through two major business segments: pharmacy benefit

management (PBM) services and retail pharmacy. Its pharmacy services business line focuses on

pharmacy benefit management services, which include drug mail orders, administration of health

plans, specialty pharmacy services, formulary management, Medicare Part D services, prescription

management systems, clinical services, disease management programs, medical pharmacy

management, and retail pharmacy network management services. Moreover, its retail segment sells

prescription drugs and an assortment of nationally advertised brand name and proprietary brand

merchandise. Front store categories include over-the-counter (OTC) drugs, beauty products and

cosmetics, personal care products, photo finishing services, seasonal merchandise, greeting cards and

convenience foods, with tobacco products eliminated last year.

With current market trends, the Company has been focusing on seizing primarily opportunities

regarding its PBM business line. In this line, the company has as its main customers employers,

insurance companies, unions, government employee groups, health plans, managed Medicaid plans,

plans offered on the public and private exchanges and other sponsors of health benefit plans and

individuals throughout the US, amounting to about 70 million people in 2015. Additionally, CVS has

vast exposure to the US Federal Government’s health initiatives through its PBM services. Through its

Figure 2: Revenue by Product (in $ Billions)

Source 2: Bloomberg & Analyst Forecasts



SilverScript Insurance Company subsidiary, CVS became a national provider of drug benefits to eligible

beneficiaries under the Federal Government's Medicare Part D program.

As of FY 2015, the company reported a 10% revenue growth from its previous year and a 3.4%

profit margin consistent with historical performance. CVS’ PBM segment entails 57% of total revenues,

with the other 43% remaining coming from its retail pharmacy line. It is noteworthy that there is

overlap between the reporting of these segments and at the end of the fiscal year there is an

intersegment elimination amounting to approximately 12.2% of total revenues. In addition to the

previously explained operating lines, the company holds a corporate segment, yet it consists only of

areas involving HR, legal, compliance, IS, finance, and executive management. For that reason, there is

no yearly revenue attributed to this segment.

Industry Dynamics

The United States spends more on health care than any other country in the world. Presently,

government spending on healthcare forms about 18% of the country’s GDP. This share is expected to

increase in the next 5-10 years given present US demographic trends. Furthermore, 27% of the US

Federal Budget, as can be seen on Figure 3, represents health care spending per year. Additionally, as

shown on Figure 4, the combined spending of welfare and health care amounts to approximately 50%

of the US government’s spending on a per dollar basis. In 2010, 15.8% of all Americans were covered

by Medicaid. Until 2015, this share had increased to over 20% to cover approximately 70 million

people. Unlike Medicaid, Medicare is not bound to lower incomes or a certain state of poverty and

covers about 50 million people with some overlap existing, although not significant.

While the market size for healthcare firms continues to expand as more US citizens grow older and

as the government attempts to bring under the Affordable Care Act (ACA) umbrella more citizens,

margins for the industry have been declining due to several reasons. Cost reduction forces, driven by

government policies, are causing industry consolidation in the healthcare industry. Recent acquisitions

Figure 3: 2016 US Federal Budget

Source 3: The White House, Office of Management and Budget



by the US’s largest pharmaceutical retailers, CVS and Walgreens, have changed the competitive

landscape for healthcare firms as these larger corporations begin to increase the scope of their

operations. Walgreens is now a multinational retailer focusing on its retail drug store segment, while

CVS could be considered a PBM with a retail drug store arm. Both retail drug giants have been moving

away from their core 30-40 years business lines, with Walgreens repositioning more recently as

compared to CVS, which transitioned earlier.

While 11.7 million Americans were added to the health coverage under the ACA during 2015, this

particular grouping was not the force driving consumer spending in the industry. The most significant

driver was spending in specialty treatments, which include medicine for viral diseases, cancer and

auto-immune disorders. Spending on specialty medicines increased by $54 billion in the last five years,

and contributed 73% of overall medicine spending growth during that period, according to IMS.

Meanwhile, spending on cancer and autoimmune drugs rose 16.8% and 24%, respectively, and

spending on multiple sclerosis medicines increased 24.4%. This trend is expected to continue in the

future. For 2014-24, health spending is projected to grow at an average rate of 5.8% per year.

One vast segment has been absorbing the effects of enlarged health spending and industry

consolidation. Prescription spending is expected to experience significant growth in the upcoming 5

years. The Centers for Medicare & Medicaid Services (CMS) outlines two major forces aiding growth in

prescription drug spending. Firstly, new specialty drugs are increasingly taking share in the prescription

drug market as a percentage of health expenditures. Secondly, it is expected faster growth in the

number of prescriptions dispensed, given the stronger US economic growth and changes in benefit

management that increase adherence. The aging of the U.S. population will also serve to boost

prescription utilization.

Figure 4: US Spending per Dollar, 2014

Source 4: Heritage Foundation: US Spending and Budget, 2014



Competitive Positioning

CVS operates in an environment that is both stable and certain, yet it features intense competition.

Macroeconomic fluctuations reflect poorly on CVS’ yearly performance. Consumers, experiencing

economic turmoil, tend to shift their purchasing patterns towards low priced goods, which CVS offers

through generic drugs, and no name brands. Additionally, in a booming economy, CVS also performs

well as branded drugs and specialty drugs begin to have strong sales. A significant source of strength

stems from its operating model. CVS holds significant market share in both the retail and the PBM

services market. No other competitor has such a competitive position in both markets. For that

reason, CVS can be considered as fully integrated, which significantly reduces its dependency on

suppliers and allows it to have more competitive pricing. Moreover, the business’s competitive

positioning is boosted by its exposure to the ACA and the increased number of private players seeking

to arrange drug plans to meet government requirements. Ultimately, CVS’ competitive advantage was

solidified given its recent entry in the specialty drug market with the Omnicare acquisition.

Competitor Analysis

Walgreens Boots Alliance Inc. (NYSE:WBA Market Cap. $85.71B) – Retail Pharmacy

Walgreens Boots Alliance is the biggest competitor to CVS in the retail pharmacy segment. It has

the largest pharmacy retail footprint with 12000 stores worldwide. Although a usual trend setter,

Walgreens has lacked competitive initiatives in the last 5 years. Not only it was one of the last ones to

have a consumer loyalty program integrated with its online platform, but Walgreens only recently

began to enter the PBM market due to margin pressures. CVS is able to avoid these margin pressures

as it is its own supplier of drugs, which allows it to forecast better for reimbursement rate changes.

Nonetheless, Walgreens does pose a significant threat to CVS as it has stated that is attempting to

acquire Rite Aid, a strong player in the PBM market.

Figure 5: PBM Market Share

Source 5: CSI Market Estimates, 2015

Figure 6: Retail Pharmacy Market Share

Source 6: CSI Market Estimates, 2015



Express Scripts Holding Company (NASDAQ: ESRX Market Cap. $48.37B) – PBM Services

Headquartered Missouri, Express Scripts is the largest PBM in the US, although CVS is not far

behind. Express Scripts advantage arises from focusing specifically in drug dispensing and tight control

of its supply chain. It should be mentioned that CVS manages to obtain double the operating margins

of ESRX, and has done so historically. That advantage is given by CVS' retail footprint across Caremark's

plan sponsors, giving the company pricing power and opportunities to reduce overlapping costs. That

has allowed CVS to withstand falling wholesale drug prices and PBM demands on retailers to accept

lower reimbursements. However, Express Scripts decided to pursue a $29 billion acquisition of Medco

Health, giving it a significant market share and operational efficiencies.

AmerisourceBergen Corporation (NYSE:ABC Market Cap. $18.17B) – PBM Services

AmerisourceBergen, based in Pennsylvania, handles about 22% of all of the pharmaceuticals sold

and distributed throughout the United States. Last year, AmerisourceBergen acquired PharMEDium for

$2.58 billion as a response to aggressive industry consolidation, especially within the drug supplier

segment. The move gives the company ownership over a drug type that is not sold commercially but

specially created by pharmacists. Hospitals have been tapping large-scale suppliers like PharMEDium

for these drugs. That is, ABC is scaling up its exposure to the specialty drug market, and aided by its

deal with Walgreens, it could pose a threat to CVS’ growth.

United Health Corp. (NYSE:UNH Market Cap. $115.4B) – PBM Services

Previously a small threat to CVS’ top line, UNH’s acquisition of Catamaran has provided it a

competitive edge, placing UNH as a leveled competitor to CVS and Express Scripts in the PBM market.

Scalability will result in greater negotiating power with manufacturers and pharmacies. As the

company’s cost of acquiring prescription drugs decreases, it will be able to offer more competitive

prices to consumers and secure its position in the market. This is likely to translate into a higher

volume of contracts from groups that pay for drugs and hence a higher share in incremental market

revenues. Again, its lack of retail footprint still causes a reduction in margins below CVS’ average.

Figure 7: Health Care Market

Source 7: CSI Market Estimates, 2015 & Bloomberg



Growth & Risk Analysis

Growth Outlook

PBM Growth & Positioning: PBM is a service in which the processing of drug prescriptions (typically

for insurance firms or large corporations) is handled by a third party. This entity typically charges fees

for its work, and it is expected to deliver cost savings through relationships with drug companies and

pharmacies. The increase in the number of people covered by health insurance plans is currently

driving revenue growth for firms in this sector. With PBM being over 50% of CVS’ revenues, the

company is well positioned to capitalize on this market trend. Consistent with past years, this health

giant continues to have a strong client retention rate of about 98% in this segment. According to

analyst estimates, the PBM market in the US is to grow at a rate of 7% during 2015-2019.

Specialty Drugs Market: Specialty pharmacy sales increased by 31% in 2014 and experienced

similar growth during 2015. CVS Health expanded its presence in this rapidly growing business through

the acquisition of Omnicare earlier in 2015. The deal gives CVS national reach in dispensing

prescription drugs to assisted living and skilled nursing homes among other care providers. The

company expects Omnicare to add about 20 cents to adjusted earnings per share in 2016. The

acquisition of Omnicare also creates new opportunities for CVS to extend its pharmacy programs to a

broader population of chronic care patients as they transition across the care continuum. Ultimately,

with Omnicare, CVS will significantly expand its ability to dispense prescriptions in facilities serving the

senior patient population, which is expected to grow significantly in the near future.

Retail Footprint and MinuteClinics: CVS not only acquired Omnicare, but also decided to expand its

retail footprint during 2015. CVS Health presently runs about 9600 retail drugstores. The Target deal

added 1,672 new pharmacies into CVS Health's retail segment, which expanded its retail footprint by

more than 20% (originally 7900). Moreover, customers are responding positively to the network of in-

store clinics CVS has to offer. More than 1,000 of its retail pharmacies currently operate a

MinuteClinic, and management is committed to have more than 1,500 up and running by 2017. The

Target acquisition also gave CVS 79 more clinics, ending the year with 1,135 clinics across 33 states

plus the District of Columbia. CEO reports that MinuteClinic is the largest walk-in clinic operator in the

US. Additionally, with the US currently facing a shortage of primary care physicians, MinuteClinic

should prove to fill the demand-supply gap. Furthermore, with 30 million additional Americans

expected to be included under healthcare coverage, the demand is expected to outweigh the supply

by about 45,000 doctors by the end of this decade, thus reinforcing CVS’ positioning.

Ultimately, both the Omnicare and Target pharmacies acquisitions are expected to expand the

company's foothold in the PBM and retail pharmacy space as well as counter competition from other

retail giants like Walgreens Boots Alliance.



Prescriptions and the ACA: With prescription drug spending growth projected to average 6.3%

annually from 2015 through 2024, CVS is presented with another sizeable opportunity. Be it both,

generic or branded, prescription drugs comprise a significant portion of the company’s PBM service

line. Furthermore, prescriptions spending, combined with present government programs, represent a

bigger growth scenario given CVS’ strong positions in both the Medicare and Medicaid markets. The

United States is in the middle of what CVS calls a “silver tsunami,” with some 10,000 baby boomers

turning 65 every day. This translates into 17 million new people that will be eligible for Medicare by

2019. In addition, the number of people age 65 and older is expected to grow from 47.8 million in

2015 to 65.9 million in 2025. The company serves this market through its SilverScript Medicare Part D

prescription drug plan. At the same time, the growth of managed Medicaid over traditional fee-for-

service models has been driven by states seeking cost savings advantages. It is also noteworthy that

Medicaid accounts for 14% of prescriptions dispensed at CVS/pharmacy locations. An increased retail

footprint, as well as a complex network for drug dispensing, should allow CVS to increase its share.

Major Risks

Industry Consolidation: The healthcare industry is characterized by its intense competitive

environment, with key determining factors being prices and availability of drugs. In the retail pharmacy

business, a severe competitive threat is arising from the $17.2 billion merger between Walgreens and

Rite Aid. With Rite Aid giving Walgreens an entry into the PBM market, CVS’ primary source of

revenues could experience a lower growth rate as other industry players – namely Walgreens – could

absorb market share. Additionally, this threat is further reinforced as Walgreens’ retail footprint is

approximately one third larger than CVS’ store count. Hence, increasing movements towards

aggressive industry consolidation could prove to be a potential risk for the long term health of CVS.

Figure 8: 2014 U.S. Spending for Prescription Drugs

Source 8: Centers for Medicare & Medicaid Services



Margin Pressure: The PBM industry has been experiencing negative margin pressure as a result of

a stronger competition and an increased client demand for lower prices and enhanced service

offerings. In that regard, CVS maintains contractual relationships with generic pharmaceutical and

brand name pharmaceutical manufacturers that provide for purchase discounts and rebates on CVS

dispensed drugs. These rebates usually depend on CVS’ ability of maintaining a specific market share,

plan formularies, and even clients. Also, market dynamics and regulatory changes have impacted the

company's ability to offer certain discounts. The ACA has been regulating the industry in order to bring

consumers lower costs and a lower rate of price growth on drugs.

Inorganic Growth and Leverage: It is important to note that CVS has been funding its long run

growth strategy in the previous years with debt. This means that future mergers could halt until the

leverage falls back to historical levels. CVS has made leveraged buyouts - Omnicare and Target - to

improve its positioning. A cap on the price of medicines will certainly erode profits and affect the

company’s ability to cover debt obligations. Both Walgreens and CVS have added debt to the balance

sheet the last few years with WBA's debt-to-capital increasing from 9% to 22% while CVS’ increased

from 14% to 29%. These are not significantly adverse debt burdens relative to their capitalization,

nonetheless such debt levels can slow dividend hikes and repurchases as cash-flow is allocated from

equity to debt investors. Both drugstore giants saw their forward EPS and revenue estimates peak

earlier in 2015 and turn lower as 2015 ended. In addition, both CVS and WBA issued weaker 2016

guidance the last quarterly call. Specifically for CVS, this may be a cause for concern as two significant

acquisitions were completed in the previous fiscal year. Potential downside in the return on invested

capital could be expected following the company’s guidance on growth.

Reimbursement Rates: Nearly 9 in 10 prescriptions filled in the U.S. are for generic drugs. And

while generic drugs are typically cheaper than brand-name medicines, the prices for generics have

been increasing following uncertainty with the market. Further, retailers’ (pharmacies)

reimbursements have not been keeping up with that pace of price hikes. Generic price inflation,

combined with time-inconsistent reimbursement rates have been hurting pharmacies. Not even the

largest operators in this field, using scale to their advantage, could avoid a hit to their bottom lines.

When a company fills a prescription for a drug that cost an inflated price, the company is exposed to

getting a non-updated reimbursement rate, thus causing a loss on sale. In the past two years, generic

drug prices have risen on average 40%. Chain pharmacies like CVS and Walgreens also lose money

filling generic prescriptions. However, the fact that CVS has PBM services of its own puts it in a better

position to manage these headwinds as it can better control for uncertainty in generic drug pricing.

Relative to WBA, which is just attempting to enter the PBM market with the acquisition of Rite Aid,

CVS holds a stronger stance to defend its margins.



Financial Statement Analysis

Profitability

As previously mentioned, with the increase in prices for both generic and branded drugs, CVS has

seen a reduction in its gross margin year over year. Also, this reduction is heavily linked to the

increasingly selling of specialty drugs, which carry higher initial acquiring costs. Nonetheless, as the

company has grown in scalability, operating expenses have decreased and efficiencies have been

obtained with more standardization of its operations. Hence, EBITDA margins have been able to

remain stable in the last 5 years along with profit margins. It is crucial to highlight that all three ROE,

ROA and ROIC reflect positively on management guidance. As can be seen on Figure 9, CVS’ return

metrics have been increasing year over year, and are expected to remain at those levels or slightly

below as the company integrates both the Omnicare and Target acquisitions fully into its operations.

Source 9: Bloomberg, Student Estimates

Figure 9: Financial Condition Ratios

Ratio Analysis 2011 2012 2013 2014 2015

Profitability

Gross Margin 19.2% 18.3% 18.8% 18.2% 17.3%

EBITDA Margin 7.4% 7.3% 7.8% 7.7% 7.5%

Profit Margin 3.2% 3.4% 3.6% 3.7% 3.4%

ROE 9.1% 11.2% 12.1% 13.6% 14.1%

ROA 5.4% 6.4% 6.4% 7.0% 5.6%

ROIC 15.2% 17.6% 17.8% 20.0% 17.1%

Growth Ratios

Revenue Growth NM 15% 3% 10% 10%

Operating Income Growth NM 13.5% 10.5% 8.3% 7.6%

Net Income Growth NM 22% 9% 12% 1%

Solvency Ratios

Debt to Assets 0.14 0.14 0.18 0.16 0.28

Debt To Equity 0.24 0.24 0.34 0.31 0.71

Debt to EBITDA 1.17 1.02 1.30 1.08 2.27

Int. Coverage 10.84 12.94 15.79 14.67 11.28

Liquidity Ratios

Current Ratio 1.56 1.42 1.64 1.37 1.31

Quick Ratio 0.62 0.56 0.84 0.64 0.62

CAPEX Ratio 3.13 3.29 2.91 3.81 3.55

Activity Ratios

AR Turnover - 19.21 25.13 25.37 28.31

Inv. Turnover - 11.16 11.48 11.68 10.95

SH Ratios

Dividend Payout Ratio 20% 22% 24% 28% 30%

Dividend Growth NM 10% 9% 17% 7%



Growth

Although these metrics focus on long term trends, it can be seen that overall, the company has

seen consistent growth in both its top and bottom line with vast variability over the years. Variability is

due to yearly events such as acquisitions, market conditions, and more specifically to the difference

taxation that the company has received, ranging from 35% to 40% with changes every year. What is

important to note is how increasing COGS have impacted operating income and this is a trend that is

expected to stabilize once CVS fully integrates Omnicare to its operations. A full integration is expected

to reduce costs associated with specialty drug distribution.

Solvency

With overall stable and improving debt levels, during 2015 CVS got more levered in order to

complete its Omnicare and Target acquisitions. Given these acquisitions, various debt-related metrics

have more than doubled from 2010 to 2015. Nonetheless, CVS’ interest coverage ratio still remains

over 11x EBIT, which signals that its current debt levels do not represent a significant negative burden

with the company’s present performance. With its D/E ratio now standing at 0.7, the company’s S&P

rating is that of BBB+.

Liquidity

Over the years, the company has demonstrated significant stability regarding its liquidity ratios. It’s

larger than 1 current ratio serves as proof of the company’s liquidity. Similarly, in figure 9, the CAPEX

ratio shows the company produces cash from operations on average 3x its operating capital

expenditures, simply proving the coverage of operating expenses is not in question.

Activity

The company’s inventory turnover is in line with its competitors, whose average is 10. Over the last

5 years, the company has hovered around that average. Having neither a significantly lower nor higher

inventory turnover relative to the average states that efficiency for the industry also stands around the

same metric. The company’s activity ratios place CVS at par with its peers suggesting no specific risk or

opportunity arising from them.

Shareholder Ratios

CVS has a dividend payout ratio of 30%, which more than doubles 2010’s level. In addition,

management is still on track to reach the 35% targeted payout ratio by 2018. The compounded annual

growth rate in dividends has been 28% since 2011. Lastly, CVS has nearly $7.7 billion left in share

repurchase authorizations and Management continues to expect to repurchase $4 billion in 2016.



Comparable Metrics Tables

Figure 10: Comparable Figures 1


Company CVS Health Average Walgreens WalMart Rite Aid

United

Health

Group

Express

Scripts

Holdings

Market Cap ($mm) 107,202$ 93,920.35$ 83,678$ 207,034$ 8,298$ 111,875$ 45,434$

Enterprise Value ($mm) 132,165$ 114,233.41$ 95,830$ 251,428$ 15,440$ 132,689$ 57,848$

S&P Credit Rating BBB+ - BBB AA B*+ A+ BBB+

D/E 0.74 0.73 0.47 0.62 98.94 0.95 0.90

EBIT to Interest Exp 11.01 8.68 6.89 9.46 2.12 13.95 8.67

P/S 0.71 0.56 0.74 0.43 0.27 0.72 0.46

P/E 20.10 24.32 17.01 14.60 57.26 19.90 17.05

PEG 1.05 2.55 1.25 8.67 1.00 0.76

P/B 2.89 5.12 2.74 2.57 16.57 3.32 2.65

P/C 12.94 11.11 15.60 7.57 9.42 11.58 9.53

P/FCF 18.01 17.06 23.43 13.01 24.00 13.78 10.14

EV/EBITDA (T12m) 11.49 11.29 15.23 7.65 12.24 10.46 10.69

Inventory Turnover 9.78 16.11 10.22 8.06 7.35 - 45.14

Figure 11: Comparable Figures 2


Company CVS Health Average Walgreens WalMart Rite Aid

United

Health

Group

Express

Scripts

Holdings

Cash Conversion Cycle 43.13 27.63 19.73 11.05 46.24 - 17.97

Gross Margin 17.31 21.47 26.03 25.13 28.56 23.57 8.26

Operating Margin 6.17 4.97 4.21 5.00 3.18 7.01 4.26

Profit Margin 3.42 4.10 4.08 3.05 7.95 3.70 2.43

Current Ratio 1.31 1.09 1.19 0.93 1.70 0.74 0.70

Revenue growth (1yr) 9.99 11.65 35.41 -0.73 3.93 20.41 0.86

Revenue growth (5yr) 9.86 8.45 8.94 2.71 0.66 10.78 17.74

Net Income growth (1yr) 12.77 148.91 118.43 -10.20 745.65 3.45 23.35

Net Income growth (5yr) 8.85 8.47 15.08 -2.16 - 4.64 15.96

Dividend Yield 1.74 2.10 1.86 3.09 - 1.70 -

ROE 14.58 16.69 19.22 17.60 - 17.26 14.76

ROA 6.24 8.69 7.64 7.29 20.47 5.88 4.63

ROIC 10.18 7.47 9.18 12.36 -2.28 10.97 4.44



Valuation

Discounted Cash Flow

Assumptions: A Bloomberg-calculated WACC of 7.5% was utilized as the discount rate. A self-

calculated WACC yielded a 7.6% discount rate, but in order to reduce uncertainty surrounding the

choosing of the unlevered Beta, the Bloomberg-calculated WACC was used. Revenues were grown

using various markets metrics as well as company specific assumptions. Different assumptions were

used to develop revenue forecasts concerning CVS’ PBM and retail pharmacy business lines. The PBM

market was expected to grow at industry growth plus an additional growth premium that was added

to capture inflation in the specialty drug market. The Retail Pharmacy segment was forecasted to grow

at a combination of disposable income growth in the US for OTC products and health spending

forecast rates for sold prescriptions. Finally, small premiums were added, based on segment specific

performance, to account for the integration of the acquisitions completed over 2015.

Acquisitions were forecasted at average per year acquisitions done by the company with operating

CAPEX being also forecasted at average company year over year spending. Depreciation expense and

changes in the working capital were forecasted following the same approach as CAPEX. Ultimately, the

terminal growth rate was assumed to be 3.5% in this base case scenario to reflect inflation in the long

term as well as company specific performance in the US assuming it consistently reevaluates its

competitive advantage and adjusts to market changes efficiently vis a vis its competition. Following

these assumptions, a per share value of $110.32 was obtained, yielding an undervaluation of 13.5% to

the February 29th

closing price. A sensitivity table is provided in Appendix A.

Figure 12: DCF Calculation – Base Scenario


7.50%

3.5%

150,768.5

2459

33205.19

1088

110.32$

DCF Value Per Share Calculation

WACC

PV - Future Cash Flows

CV Growth Rate

Base (Excess) Cash

Market Value of Debt

Shares Outstanding

DCF Value Per Share



Source 13: Student Estimates, Bloomberg Consensus for Peers

Figure 13: Relative Valuation Calculations EV Ratio

Name P/E P/S P/FCF EV/EBITDA

20.10 0.71 18.01 11.49

17.01 0.74 23.43 15.23

14.60 0.43 13.01 7.65

57.26 0.27 24.00 12.24

19.90 0.72 13.78 10.46

17.05 0.46 10.14 10.69

Mean 24.32 0.56 17.06 11.29

CVS Impied Share Val. 124.59 87.14 66.24 127.52

Weighting 25% 25% 25% 25%

Weighted price 101.37$

Current Price 97.17$

Undervalued by 4.33%

WBA

WMT

Rite Aid

United Health Corp

Express Scripts Holding

CVS Health

Price Ratios

Source 14: Student Estimates, Bloomberg Consensus for Peers

Figure 14: Valuation Summary

Target Price Value Probability

DCF - Base $110.33 75%

DCF - Bull $132.49 15%

DCF - Bear $79.35 10%

Weights

DCF - Probability Adj. $110.56 75%

Relative Valuation $101.37 25%

Target Price $108.26

Current Price $97.17

Undervalued by 11%

Scenario Analysis: In order to capture potential market changes, several scenarios were evaluated. A

15% probability scenario was built under a bullish assumption in which the demand for specialty drugs

increases at a faster pace, translating into price inflation and driving CVS’ growth into a more

aggressive rate and potentially expanding its CAPEX to have more exposure to that growth.

Conversely, a bearish scenario was also examined attributing it a 10% probability of occurring. This

scenario implies that there is a cap on the pricing of drugs additional to margin compression.

**A valuation summary including all scenarios is provided below in Figure 14.

Relative Valuation

To assess the intrinsic value on a per share basis for CVS, the following competitors were used:

WBA, WMT, ESRX, UNH, and RAD. These were chosen as an attempt to combine similar business

models as well as company size. As can be seen in Figure 13, CVS trades at a premium when evaluated

on a P/S and P/FCF basis, yet it trades at a discount relative to P/E and EV/EBITDA. Overall, the relative

valuation lists CVS’ shares as undervalued by approximately 4%. The metrics chosen represent widely

used multiples used to value consumer spending driven companies. Lastly, an equal weighting was

assigned to each multiple to avoid biases among implied values given before weighting adjustments.

Valuation Summary

Figure 14 provides the final target recommendation. Probabilities were assigned to the different

DCF scenarios in order to arrive at a final per share value. Additionally, a 75% weight was assigned to

that value, with the remaining 25% attributed to the relative valuation’s per share value. These

weightings were selected to favour the DCF’s yielded value as it is expected to predict more accurately

the intrinsic value of the company given all variables that can be forecasted whereas the relative

valuation can be significantly skewed towards market risk and investor behaviour rather than being a

direct proxy of the company’s fundamentals. A final per share value of $108.26 was obtained, being

this an 11% undervaluation of the February 29th closing price.



Investment Recommendation Buy, Price Target $108.66

Investment Positives

- CVS Health provides a win-win scenario for any investor during both an economic recession and boom.

Considering that a slowdown pushes consumers to buy cheaper generic drugs, CVS will be able to

provide these generics at a better deal than other competitors. Conversely, if the economy is growing

at a fast pace, consumers will tend to spend more money in branded and specialty drugs, both of

which belong to CVS’ product portfolio.

- This health-giant holds a significant sustainable competitive advantage over its peers due its vertical

integration. As the PBM service line grows, CVS can produce better offerings, better pricing schemes,

and better margin controls.

- CVS’ financial stability allows it to allocate significant capital towards its equity investors while covering

its debt obligations. Given that market trends translate into a panorama of growth opportunities for

the company, there are no expectations for the company to not deliver a positive financial

performance. Thus, the company should be able to realize same or higher than present returns and

reach its dividend target in the next 2 years.

- Both industry dynamics and economic factors represent growth opportunities for the company. From

increasing its exposure to the specialty drugs market, to benefiting from an American ageing

population rapidly obtaining health coverage through the ACA, CVS should deliver exceptional returns

in the upcoming years.

Investment Negatives

- The major source of risk stems from industry consolidation which severely increases competitive

intensity for the industry. As more firms attempt to become vertically integrated, the market share for

CVS could become affected and so its bargaining power.

- Any drastic regulatory changes for the industry, especially those focusing on drug pricing, will have an

impact on the bottom line of the company. The industry must be closely monitored as changes to the

ACA following the 2016 US Presidential Elections could change the panorama for PBMs and potentially

reduce the market growth rate. This change can result in lower investment return rates for CVS.

- Lower operating margins arising from cap on prices and inefficiencies driven by time-inconsistent

reimbursement rates will adversely reflect on the company’s net income. Moreover, a significant

impact from operating margins could reduce the company’s ability to cover its debt obligations and

realize the expected returns from the richly valued acquisitions completed during 2015.

Given the above, there is ample evidence suggesting the positives of investing right now outweigh the

negatives and that is why a final recommendation of a BUY is brought forward.



Disclaimer

This report was written by a student currently enrolled in a program at the Sprott School of Business.

The purpose of this report is to demonstrate the investment analysis skills of Sprott students. The

analyst is not a registered investment advisor, broker or an officially licensed financial professional. The

investment opinion contained in this report does not represent an offer or solicitation to buy or sell any

securities. This report is written solely for the consideration of this student managed investment fund

and should not be used by individuals to make personal investment decisions. Unless otherwise noted,

facts and figures included in this report are from publicly available sources. We cannot guarantee that

the information in this report is 100 percent accurate, although we believe it to be from reliable

sources. Information contained in this report is only believed to be accurate as of the day it was

published, and it is subject to change without notice. It cannot be guaranteed that the faculty or

students do not have an investment position in the securities mentioned in this report.



Source: Bloomberg, Student Estimates



Appendix A

A1: Sensitivity - WACC vs CV Growth Rate Base Scenario

A2: Key Return Figures – Historical

A3: Profitability – Historical

110.32$ 2.5% 3.0% 3.5% 4.0% 4.5%

5.50% 164.11$ 198.65$ 250.46$ 336.80$ 509.50$

6.50% 115.50$ 133.32$ 157.07$ 190.33$ 240.22$

7.50% 86.29$ 96.97$ 110.32$ 127.49$ 150.37$

8.50% 66.80$ 73.82$ 82.24$ 92.53$ 105.39$

9.50% 52.86$ 57.77$ 63.49$ 70.25$ 78.37$

10.50% 42.40$ 45.99$ 50.09$ 54.82$ 60.34$

CV Growth RateW

AC

C

Documents

CVS Health Corporation BUY - Carleton University · management (PBM) services and retail pharmacy. Its pharmacy services business line focuses on pharmacy benefit management services,