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CVS: Overreaction to Earnings Gives Investors A Buying Opportunity

Published by Bob Ciura on May 4th, 2017

Shares of CVS Health (CVS) fell after the company reported first-quarter earnings. Profits sank from the same quarter last year, as the company is being challenged by customer losses and pressure from generic drugs.

Falling prescription drug prices is a major headwind not just for pharmaceutical companies, but for pharmacy retailers like CVS as well.

The headline numbers were weak, but CVS is still a highly profitable company with plenty of opportunities for growth up ahead.

And, CVS is a very strong dividend growth stock. It has increased its dividend for 14 years in a row.

It is a Dividend Achiever, a group of 264 stocks with 10+ years of consecutive dividend increases.

You can see the full Dividend Achievers List here.

Not only does the company raise its dividend, it does so at high rates each year. Last year, CVS raised its dividend by a very healthy 18%.

This article will discuss CVS’s most recent quarter, and why investors may want to use the dip in the share price as a buying opportunity.

Quarterly Performance Overview

A quick rundown of CVS’s first-quarter results:

CVS had a rough quarter, but the company deserves credit for navigating a very difficult operating climate.

CVS Results

Source: Q1 Earnings Presentation, page 4

The company dealt with a number of challenges last quarter—it faced the loss of a major customer, Tricare, a government program that provides coverage for military families.

Separately, falling drug prices hurt CVS’s bottom line on the drugstore side of the business.

Same-store sales, a key measure for retailers that shows sales at locations open at least one year, fell 4.7% year over year. This also caused a ripple-effect in terms of sales of products outside the pharmacy part of CVS’s stores.

CVS’s front-store comparable sales declined 4.9%. Falling pharmaceutical sales leads to falling traffic. Fewer customers filling prescriptions naturally leads to lower sales at the front of the store.

If all this weren’t difficult enough, CVS incurred a $199 million charge due to its decision to close 60 stores.

There were some mitigating factors that helped the company offset these pressures.

First, while the drugstore side of the business has been hurt by falling drug prices, CVS’s pharmacy benefits management business is thriving.

CVS Benefit

Source: JP Morgan Healthcare Conference, page 11

Strong results have continued in 2017.

Segment sales increased 8.5% last quarter, as growth in pharmacy network volumes more than offset the impact of higher generic volumes.

This is an important distinction for investors to keep in mind, since CVS’s pharmacy benefits management business accounts for approximately 70% of total revenue.

Growth in the pharmacy services segment helped CVS beat analyst expectations on both the top and bottom line.

Revenue came in ahead of forecasts, which called for $44.24 billion of sales. Excluding one-time costs, CVS reported adjusted earnings-per-share of $1.17 per share, which was $0.07 per share above expectations.

CVS management refers to 2017 as a rebuilding year. While a double-digit decline in earnings is a bad sign, CVS remains a high-quality company with a firm outlook for growth.

Growth Prospects

CVS still has significant growth ahead of it, thanks largely to its pharmacy benefits management business. This segment continues to grow profits at a high rate.

CVS is the largest pharmacy benefits management company in the U.S. It alone takes nearly 30% of a high-growth market.

Last quarter, pharmacy network claims processed increased 10.5%, from the same quarter in 2017.

Despite the weak first quarter, 2017 should be another highly profitable year for the company. CVS reiterated its forecast for 2017 adjusted earnings-per-share of $5.77-$5.93 per share.

At the midpoint, adjusted earnings-per-share would increase fractionally from 2017.

CVS continues to generate a great deal of free cash flow. The company still expects $6.0-$6.4 billion of free cash flow in 2017.

CVS Free Cash Flow

Source: Q1 Earnings Presentation, page 42

The company continues to generate high levels of free cash flow, because it operates in a strong industry. There will always be a need for consumers to fill prescriptions and purchase healthcare products.

This gives CVS’s earnings a solid floor. And, such strong free cash flow allows the company to invest in growth initiatives, while also rewarding shareholders with cash returns.

Share repurchases are another boost to earnings-per-share. In the first quarter, CVS utilized $3.6 billion to buy back 36 million of its own shares.

The company expects repurchases to total $5 billion in 2017.

CVS also rewards shareholders with high dividend growth.

Dividend Analysis

One of the most appealing parts of CVS is its dividend. Not just its dividend yield, but its dividend growth potential.

The stock has a current yield of 2.5%. This is a solid dividend yield, which exceeds the average yield in the S&P 500 Index by about 50 basis points.

CVS isn’t a high-yield stock, which might make it an unattractive choice for investors interested only in current yield.

But CVS’s yield can grow rapidly in a short period of time. Over the past five years, the company has increased its dividend at a 25% compound annual rate.

If that rate of dividend growth continues, CVS’s dividend will double every three years.

There is plenty of dividend growth potential for CVS. The annualized payout of $2.00 per share represents only 34% of 2016 adjusted earnings-per-share.

If CVS stabilizes its earnings and successfully returns to growth in 2018, there is a good chance the company can maintain its high dividend growth rates moving forward.

Final Thoughts

Drug price deflation is a significant headwind for the healthcare industry. CVS is not immune from these pressures.

However, investors should look past the company’s weak first-quarter performance, and focus on the bigger picture.

CVS has a leadership position in its industry. It has a highly profitable business model that generates a lot of free cash flow.

2017 may be a bumpy ride, but it is likely the company will return to growth in 2018 and beyond. With an above-average dividend yield and high dividend growth, CVS remains an attractive stock for dividend growth investors.

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