EUR 850.00 For Business Accounts Only

Morningstar | First-Quarter Results at CVS Support Our Bullish View; Shares Remain Deeply Undervalued

Narrow-moat CVS reported first-quarter results that surpassed our expectations. Strength was broad based, with adjusted profitability meeting or beating our expectations in each of the firm's three segments. Further, improved same-store performance at retail and accelerating growth in medical enrollment at Aetna provide an early indication that the benefits of the merger are beginning to take root, underpinning our positive moat trend rating. While there are many moving pieces to consider as we update our model, we don’t foresee making a sizable change to our $92 per share fair value estimate. With shares currently priced near 8.5 times our current 2019 adjusted earnings estimate, 5-star CVS remains a compelling opportunity for long-term investors.

While management intends to provide a more comprehensive long-term outlook for the business at next month's investor day, the May 1 results and discussion provided an early look into how the strategy is progressing. The initial pilot of the firm's health hub strategy appears to be hitting the mark, and the company intends to fill out its Houston service market with health hubs accounting for 15% of the store base in the area at scale.

Script growth across the enterprise was a standout following disappointing results from Walgreens released a few weeks ago. At retail, CVS posted same-store script volumes up nearly 6.7% following a growth rate of 9.1% in 2018, although we'd note pharmacy reimbursement is tracking toward our estimate of a 200-basis-point decline for the full year.

At Caremark claims volume grew by 2.8%, although we'd note weaker than anticipated retention at the PBM for the its 2020 selling season. The company indicated a retention rate nearer the mid-90% range, versus historical performance that fell consistently near 97%-98%. This will be an important metric to watch throughout the rest of this season and into next year, as the stickiness of PBM relationships helps support our narrow moat rating.

Both firmwide results and management commentary gives us confidence in our positive moat trend rating for the franchise. While profitability in the company's retail business is likely to suffer for the bulk of the year driven primarily by weakness in the firm's long-term care pharmacy, management indicated changes made at Omnicare are on track to produce cost savings over time. Additionally, as noted last quarter, the initial $750 million synergy target associated with the Aetna merger is on track on be surpassed by the end of 2020. We think these efforts help support the notion that 2019 will mark the low point in overall returns on capital reported by the combined entity, with our model implying acceleration in ROIC and economic profits over the coming five years.

Aside from transaction-specific synergies, management also quantified its recently discussed enterprise cost savings initiative that should help support its competitive position in the retail segment, create more a compelling offering for the firm's various constituencies, and drive bottom-line growth over time. These efforts should help improve the company's cost structure by $1.5 billion to $2 billion on a run-rate basis by 2022, representing roughly 10% upside to our current 2023 operating profit estimate. While we'll wait to see how these initiatives progress over the next few years, these efforts underscore our favorable assessment of the CVS/Aetna combination.

Finally, management indicated it has already repaid roughly $4 billion in debt following the transaction's close in late 2018. This is modestly ahead of our $3.5 billion estimate for the full year and puts the firm on track to reach a net leverage ratio near 3 times by the end of 2020.