Sunday, August 18, 2013

CVS is Still a Buy

Sometimes the best thing to do in investing is nothing. In the case of the pharmacy chains CVS (NYSE: CVX) and Walgreen(NYSE: WAG), this policy has been a winning one over the last year.

Their stock prices have risen by 34% and 39.4% respectively in that period, mixed with short downward moves as investors looked to cash in. Meanwhile, both companies continue to generate huge amounts of cash flow, and according to analyst estimates, they're set for double-digit growth in the near future. The "good news" is that the market marked down CVS following its results, and this looks like a good entry point for long-term investors.

CVS’s optical illusion

The stock market apparently lives in a "shoot first, ask questions later" world, since CVS seemed to fall almost at the moment that its management updated guidance.

CVS adjusted its 2013 EPS forecast to a range of $3.90 to $3.96, from the previous $3.89 to $4.00.  Eagle-eyed readers will note the midpoint has been lowered to $3.93 from around $3.95. Before you rush to pull the sell trigger, you should consider a few things.

First, CVS outlined that it has had to delay share purchases this year while it reached a settlement with the SEC over previous actions. In other words, the ‘S’ bit in ‘EPS’ is larger than it was expected to be at this stage in the year. Moreover, CVS outlined that the timing issue could reduce full-year EPS by “as much as $0.04.”  In other words, it could reduce earnings by more than it just lowered its mid-point by. In this sense, CVS just raised guidance.

Secondly, on the conference call, CVS argued that its key target of retaining 60% of the customers gained following the Express Scripts/Walgreen debacle was well on track. Management declared that it was “very confident” that at least 60% would be retained in 2013, and this augers well for the next few quarters.

Thirdly, all of its long-term growth prospects remain in place. The trend towards increasing generic drug sales continues apace, even if last year’s strong growth will make the second half’s comparables a bit tougher for CVS.  CVS and Walgreen are both key beneficiaries of this trend, because generics tend to come with higher margin for the retailer. However, though they slow revenue growth due to being more cheaply priced.

Another positive trend-welcomed by cost conscious consumers is each store's increase in private-label brands. In addition, CVS and Walgreen are both keen to personalize offerings by using the huge amounts of data that they both have on their customers' spending habits. In particular, Walgreen is trying to increase retail traffic by using its balanced reward card program.

Still a good value

Analysts will spill a lot of ink debating the merits of Walgreen vs. CVS, but frankly, both stocks look good value on a historical basis. There is no rule of investing that says you can’t hold both. Both stocks have seen some dramatic increases in cash flow generation as the long-term benefits (discussed above) start to drop into the bottom line.

Readers should note that  during the time period in the following chart, Walgreen lost some of its business because of the Express Scripts impasse.

WAG Free Cash Flow TTM data by YCharts

In addition, don’t let CVS’s trailing free cash flow numbers fool you. In its conference call, management reaffirmed guidance for $4.8 billion to $5.1 billion in free cash flow for 2013. This figure represents around 6% of its current enterprise value, which suggests there is plenty of room to grow its dividend.

The bottom line

In conclusion, the market has somewhat overreacted to these results. Despite its strong rise over the last year, CVS still looks like a good value. Long-term demographic trends favor the drugstore industry, and there was even some noise about CVS following Walgreen’s lead in terms of making substantive international investments. There is plenty of upside potential in the sector, and it represents one of the safer ways to invest in health care right now.

You rarely find stocks with double-digit growth prospects and high free cash flow yields, but when you do, it usually makes sense to pick some up.

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