Summary
- Mail orders reached 40%+ of pharmacy sales, growing 3%+ QoQ.
- Premiums declined sequentially, but will return to growth soon.
- Minute Clinic provides deep penetration into the urgent care market and growth potential over the long term.
- Net debt-to-TTM EBITDA improved from 6.1x to 3.9x YoY and approaching 3.25x within two years.
- Valuation is cheap at 9.5x EV/FCF and 9x EV/EBIT.
CVS Health Corporation (CVS) has declined approximately 10% since my original Buy recommendation in May 2020 to $57/share today. Following the company's Q2 earnings report and this further valuation discount, I'm reiterating my Buy rating but have slightly adjusted my expectations given the recent margin deleveraging within retail. That being said, existing growth drivers such as mail orders, health insurance, and Minute Clinics will sustain operating performance and should reignite long-term earnings growth.
Two Headwinds
Normally, I like to address risks near the end, but given some negative factors have already materialized, they deserve to be discussed upfront.
1) Even though Retail/LTC revenue growth continued in the low single digits as anticipated, margins significantly deleveraged and operating income declined from $1.67 billion to only $1.06 billion, or a decrease of approximately $600 million. While that may not seem significant for a company that generates $14 billion in annual EBIT, it stalls earnings growth and delays the long-term growth that institutional investors have modeled out over a 5-10 time horizon. Nearly all of the cost increases were related to COVID-19, some of which are permanent and others temporary, according to the latest Q2 filing:
In accordance with governmental directions to shelter-in-place, eliminate large gatherings and practice social distancing, the Company has transitioned many office-based colleagues to a remote work environment. The various initiatives we have implemented to slow and/or reduce the impact of COVID-19, such as colleagues working remotely and installing protective equipment in our retail pharmacies, and the COVID-19-related support programs we have put in place for our customers, medical members and colleagues have increased our operating expenses and reduced the efficiency of our operations."
Some of the expenses related to remote working is transitory, e.g. purchases of computer hardware, but others such as video conferencing are more structural. The in-store cost increases are significant, but temporary for when the pandemic subsides (e.g. "deep cleaning" staff, sanitation stations, etc.).
Despite that most retail SKUs have taken off during the pandemic, consumer health and beauty (which tend to carry higher margins) were highlighted in the latest Q2 2020 conference call as being disproportionately lower relative to other categories. For context, makeup, hair care, perfume, and other beauty products carry gross margins that are 2x-2.5x higher than CVS' other categories. With net-net consumers looking to avoid in-store shopping whenever possible, it's fair to say that certain stores have been impacted from a sales per square footage standpoint. So, while same-store sales are holding up quite well for the store as a whole, storefront sales declined by 4.5% but should reverse and improve over time.
