Should I Buy CVS Stock? 3 Pros, 3 Cons

by Will Ashworth | November 5, 2013 1:17 pm

Should I Buy CVS Stock? 3 Pros, 3 Cons

CVSCaremarkRAIfinal Should I Buy CVS Stock? 3 Pros, 3 Cons[1]CVS Caremark (CVS[2]) delivered strong third-quarter earnings Tuesday morning that exceeded expectations, and as a result, we got some raised fiscal 2013 guidance for CVS earnings.

The record results had CVS stock up nicely in early trading as investors bought into its good earnings report, but what lies ahead? And more pointedly, should you buy CVS stock now?

To see, let’s look at the pros and cons of America’s largest drug-store chain.

CVS Stock Pros

CVS Earnings: According to its guidance, adjusted CVS earnings per share for full-year 2013 will be at least $3.94 (excludes gain from legal settlement), and perhaps as high as $3.97. In the first nine months, CVS’s pharmacy services segment — which provides pharmacy benefit management services to employers, insurance companies and other sponsors of health benefit plans — saw its operating profits increase by 33% year-over-year to $2.2 billion, 20 percentage points better than its retail pharmacy segment. PBM clearly is a driver of CVS earnings growth.

Free Cash Flow: CVS expects its free cash flow to be as high as $5.1 billion in 2013. At its current market cap of $78.5 billion, CVS has a free cash flow yield of 6.5%. According to Heartland Funds, the S&P 500′s free cash flow yield at the end of 2012 was 7.3%[3]. With 26% appreciation in the index year-to-date, I’d guess its yield has lost at least 100 basis points over the end of 2012. While a 20-basis-point advantage over the index might not seem like much, it is when you consider that the median yield is probably much less.

Same Store Sales: Ever the bellwether in the retail industry, CVS’ same-store sales in the third quarter gained 3.6% year-over-year with a strong showing from its pharmacy business, which saw comps jump 5.7%. Driving the pharmacy segment’s success was a 4.5% increase in same-store prescription volumes. Although the front-of-the-store saw same-store sales decline by 1% in Q3 due to weaker traffic, CVS was able to increase the amount purchased by each customer — and more importantly, at a higher margin.

CVS Stock Cons

Front-of-the-Store Traffic: This isn’t a new problem for CVS or its competitors. In the second quarter, its front-store comps were down 0.4% also due to lower traffic. Granted, much of the decline in Q2 was due to a calendar shift of Easter from April in 2012 to March in 2013. Nonetheless, CVS was delivering much better comps in 2012. It’s definitely something to keep an eye on.

Generics: Although the increased dispensing of generic drugs has improved CVS earnings, it has come at the expense of top-line revenue growth. In the third quarter, CVS’s pharmacy services segment saw revenues increase by 7.8%, which is nothing to sneeze at, but they could have been higher if not for the introduction of new generic drugs in the quarter.

Share Repurchases: In the CVS earnings release, CEO Larry Merlo indicated that the company would return $5 billion to shareholders in 2013 in the form of dividends and share repurchases. As I mentioned previously, CVS expects to generate as much as $5.1 billion in free cash flow in 2013. If so, it will have just $100 million to use for acquisitions, debt repayment and investing in its business. What’s worse, the company repurchased just $1.5 billion of CVS stock in 2010 when its average share price was $32, yet it’s repurchasing approximately $3.9 billion in 2013 when its average price year-to-date is almost $55 per share. To me, that’s the definition of wasteful.

Verdict

Although CVS’ share repurchase history in recent years is frustrating, you certainly have to marvel at the company’s ability to generate free cash flow. It’s the hallmark of any good business.

Lest we forget about CVS earnings, you have to admit they also are very healthy. While the company’s top line might be sacrificed by the growth of generics, its bottom line has never been better. Margins are strong in all parts of the store, including the front end. As I always say, same-store sales aren’t always what they’re cracked up to be. CVS is going after profitable business, not just volume.

As for CVS stock, I consider it fairly valued.

So should you own CVS stock? Yes … but only if you’re a long-term investor. If you only want to hold for less than a year, I’d have second thoughts due to its valuation.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

Endnotes:
  1. [Image]: http://investorplace.com/wp-content/uploads/2012/06/CVSCaremarkRAIfinal.jpg
  2. CVS: http://studio-5.financialcontent.com/investplace/quote?Symbol=CVS
  3. was 7.3%: http://www.heartlandfunds.com/financial-professionals/Value-Investing-Market-Insight/Value-Investing-Market-Insight-Briefs/Free-Cash-Flow-Near-20-Year-High.htm

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