Shares of CVS (NYSE:CVS) dropped sharply on Wednesday, Feb. 20, after the pharmacy retailer reported mixed fourth-quarter numbers that included an underwhelming fiscal 2019 profit guide. Investors were disappointed. CVS stock dropped more than 5% in response and now trades just a few percentage points above its five-year low.
At these levels, CVS stock looks undervalued — so long as historical trends hold up. The forward earnings multiple is a hair under 9.5. Assuming top-line growth continues to stabilize in the low-single-digit range and margins gradually improve with the acquisition of Aetna, then a single-digit forward P/E multiple is just too low for CVS stock.
The problem is that historical trends may not hold up here. The Amazon (NASDAQ:AMZN) threat looms large. Many fear — and with good reason — that Amazon is preparing a big launch into the pharmacy space. Such a launch could have a catastrophic impact on CVS. Revenue growth won’t stabilize in the low-single-digit range. Margins won’t move higher.
Instead, CVS will follow in the footsteps of other companies Amazon has disrupted, like Macy’s (NYSE:M) and Kohl’s (NYSE:KSS). With those two companies, revenue growth slowed — and even occasionally went negative — while margins fell by a whole bunch. If that happens to CVS stock, then a single-digit P/E multiple today is warranted, and the stock may actually be due for further weakness ahead.
Overall, the bull thesis on CVS stock hinges on the Amazon threat. Because there’s a lot of risk surrounding that threat, there’s a lot of uncertainty surrounding the bull thesis on CVS stock. As such, risk-adverse investors would be wise to sit on the sidelines and wait for more clarity.
CVS Stock Is Undervalued If This Happens
Fourth-quarter numbers affirmed one positive trend for CVS: business remains normal for the time being.
Amazon hasn’t made its big push into the pharmacy market yet, and the numbers at CVS say as much. Fourth quarter revenues rose 12.5%, with a boost from Aetna. They rose roughly 5% on a full-year basis. Pharmacy revenues inched just over 2% higher in the quarter and for the year. Operating margins were largely stable, and the guide implies improvement in margins next year.
Numbers like this (low-single-digit revenue growth and gradual margin expansion) could turn into the norm if: 1) Amazon doesn’t make a pharmacy push, or 2) Amazon’s big pharmacy push is unsuccessful. In such a world, CVS has clear runway for healthy profit growth over the next several years. Indeed, assuming low-single-digit revenue growth and gradual operating margin expansion back to 6.5%, then $8.75 in EPS seems doable by fiscal 2025.
Based on a historically average 14 forward multiple, that equates to a fiscal 2024 price target for CVS stock of over $120. Discounted back by 7% per year (three points below my normal 10% discount rate to account for the yield), that equates to a fiscal 2019 price target of over $85.
CVS stock currently trades hands at $64. Thus, in a best case scenario where CVS brushes off the Amazon threat, this stock has huge upside potential from here.
CVS Stock Is Overvalued If This Happens
Although fourth-quarter numbers were good, the bear argument is that the numbers here are only temporarily good. Eventually, Amazon will launch its own pharmacy business — and do to traditional pharmacy retailers over the next several years what it did to traditional apparel retailers over the past several years.
In that scenario, revenue growth at CVS will slow significantly. CVS will be lucky to grow revenues by 0-1% per year. More importantly, margins will be killed. Many traditional retailers saw their operating margins sliced in half as a result of low-priced Amazon competition. While such a dramatic cut may not happen in the pharmacy industry given less competition, big margin drops will happen if Amazon successfully steals share in this market.
If revenue growth slows to barely above zero and margins drop a few points, then CVS may only be looking at $5 in EPS by fiscal 2025. Following the same math above, that equates to a fiscal 2019 price target of under $50 for CVS stock. Thus, in a worst case scenario where CVS is adversely impacted by the Amazon threat, this stock has sizable downside potential from here.
Bottom Line on CVS Stock
CVS stock is undervalued here if — and only if — the company can successfully navigate through the upcoming Amazon threat without materially and adversely impacting profits.
Given what happened in traditional retail, that seems unlikely. As such, the bull thesis on CVS stock lacks clarity at the current moment. So long as this remains true, the stock will struggle to hold onto gains.
As of this writing, Luke Lango was long AMZN and M.