Despite the market’s recent pull back in recent weeks, the S&P 500 is still trading close its all-time high and at a historically elevated P/E multiple of 24.5.
However, that doesn’t mean that there still aren’t great bargains to be found, even when it comes to high-quality dividend growth stocks.
CVS Health (CVS) is a possible example. The company’s stock has declined 25% year-to-date, setting up an interesting investment case. CVS stock now yields 2.3%, well above its 1.4% average dividend yield over the last five years.
Don’t let the low yield turn you off – management has increased the dividend by 25% per year over the last decade and raised the payout by 20% in 2016. The company is also a Dividend Achiever with over 10 consecutive years of dividend increases.
[drizzle]Find out if CVS Health could be one of the most attractive income growth opportunities available today, and if now might be a great time to add this fast-growing blue chip to your own diversified dividend portfolio.
CVS Health is one of America’s most dominant healthcare players. It operates the nation’s second largest pharmacy chain (9,652 retail pharmacies in 49 states, DC, Puerto Rico, and Brazil) under the CVS, Longs Drugs, Navarro Discount Pharmacy, and Drogaria Onofre pharmacy brands.
CVS also operates as one of the nation’s largest pharmacy benefits managers (PBMs), with almost 80 million plan members who used CVS to file 1.2 billion medical care claims in 2015. CVS acquired Caremark RX for $21 billion in 2006 to become the second biggest PBM.
The pharmacy benefits business operates under the CVS Caremark, CarePlus CVS Pharmacy, CVS Specialty, Accordant, SilverScript, NovoLogix, Coram, Navarro Health Services, and Advanced Care Scripts names.
This fast-growing business segment provides vital services to employers, insurance companies, unions, government employee groups, health plans, managed Medicaid plans, and plans offered on public and private exchanges.
Specifically, CVS Health’s PBM business helps clients with pharmacy services such as plan design and administration, formulary management, Medicare Part D services, mail order and specialty pharmacy services, retail pharmacy network management services, prescription management systems, clinical services, disease management programs, and medical pharmacy management services
In the first half of 2016 the majority of CVS’s sales came from its PBM segment, which, thanks to a faster growth rate than its retail pharmacy business, is likely to only grow more important over time.
|Business Segment||% of YTD Revenue||% of YTD Operating Profits|
Source: CVS Health Earnings Release
However, thanks to continued high margins on prescription refills, the retail/long-term care business remains the key profit driver; at least for now.
The aging of the U.S. population represents one of the largest demographic megatrends of the coming decades and is expected to result in massive increases in medical costs. For example, Ventas (VTR) projects national health expenditures to grow 5.8% per year from 2014 through 2024 to reach $5.4 trillion.
To put things in perspective, consider this: between 2010 and 2029, 10,000 baby boomers will turn 65…every single day. And between 2010 and 2050 the population of those over 65 will more than double to 88.5 million, which is more U.S. seniors than the entire population of Germany.
CVS Health is attempting to position itself to take advantage of this tsunami of healthcare cash by becoming one of America’s biggest providers of integrated health solutions. That includes its massive and still growing network of pharmacies, which benefits from the recently completed integration of Target’s (TGT) in-store 1,667 pharmacies and 79 clinics, which it acquired last year for $1.9 billion.
However, more important to CVS’s long-term growth ambitions is its PBM business, which saw a major boost from 2015’s $12.7 billion purchase of Omnicare.
Why is the PBM segment such a boon to CVS? Mainly because, as rising costs and increased regulatory complexities under the Affordable Care Act (i.e. ObamaCare) set in, many organizations, including health insurance companies such as Aetna (AET), are willing to outsource the nitty gritty logistical details of managing various health programs to PBMs such as CVS.
This is because PBM’s are responsible for saving their clients as much money as possible, through things like negotiating price breaks with pharmaceutical companies and medical component makers.
And better yet they are willing to sign long-term contracts, like the 12 year deal that Aetna inked with CVS back in 2010, which gives management a lot of future cash flow predictability with which to plan its further growth efforts. Thanks to this vertically integrated model, over 80% of CVS’s total revenue comes from health related products, with the remainder generated by the retail side of its nearly 10,000 national stores.
In other words, CVS Health has evolved beyond just a chain of pharmacies and stores, turning into one of the most important names in US health insurance. Thanks to the continued expansion of its PBM business, CVS is able to generate large economies of scale, which means some of the lowest per claim costs in the industry. That helps CVS maintain market share which only further grows its moat and helps maintain high retention rates (97% last quarter) with PBM customers.
Even better is that CVS Health’s moat, consisting of an increasingly more cost effective medical claim processing system (projected to process more than 1.3 billion claims in 2016), means not only fast growing revenue (about 20% this year) but also industry leading margins and returns on capital.
Note that while it may initially look as if CVS has just industry level profitability (operating margins were just 6% last year), you need to keep in mind that its retail business, being very capital intensive, drags down its overall margin and return on capital figures. Since its PBM business is growing faster than its retail side, its relative profitability should continue to improve over time.
This is especially true as management is focusing on growing its specialty pharmaceutical claim business, which has higher margins and should greatly help the bottom line in the years to come.
All told CVS Health has proven itself to be capable of sustaining strong growth in both good economic times and bad, especially considering that its trailing 12 month sales are a staggering $167 billion. Equally important, management has been achieving this impressive growth while maintaining stable, strong or increasing margin, and returns on capital.
This indicates that the company’s management team remains disciplined, and rather than attempting to reach for “growth at any price” it is being selective with its acquisitions and growth strategies. That should hopefully allow investors to continue to benefit from strong sales, earnings, cash flow, and, of course, dividend growth in the coming years.
There are two main risks to CVS Health’s growth thesis that all current and prospective investors need to understand.
First, the rising cost of healthcare could result in calls for further government price caps. This is especially true given that the vast majority of healthcare costs are incurred at the end of life, by the oldest and sickest patients.
For example, the top 5% and 1% of healthcare consumers are estimated to consume about $43,000 and $95,000 annually, respectively. The top 5% of healthcare consumers account for roughly 49% of total health expenditures.