Why This Health Care Stock Is Still a Good Value

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It is getting ever harder to find value in the defensive growth sector. Sharply rising markets tend to take all stocks with them, and if equities in the health care and consumer staples were trading at a premium before the move upwards then they are arguably overvalued right now. Of course this creates problems for those of us trying to stay diversified. With this in mind I considered it good tactical and strategic sense to go back into CVS Caremark (NYSE: CVS). In summary, the stock does have some political risk, but I think it has all the hallmarks of a stock that can do well this year.

An Undervalued Sector?

Analysts love to talk about a stock’s evaluation relative to its peer group, but what if the whole sector is attractively priced? I also hold its rival Walgreen (NYSE: WAG); after all nobody said that you can’t own both stocks. With that said, there are some key differences between the two.

The first point is that Walgreen sold off it Pharmacy Benefits Manager (PBM) business a few years ago while CVS’ PBM operations contributed 32% of operating profits for 2012.

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Secondly, while Walgreen’s challenge is to win back customers lost in the Express Scripts (NASDAQ: ESRX) debacle , CVS is aiming to retain the customers it gained. Indeed, CVS is confidently predicting it will retain 60% of these customers. As for Express Scripts, ultimately it doesn’t matter which route its prescriptions take to market.

Thirdly, CVS’ deal with Aetna (NYSE: AET) gives it good growth opportunities as it expands services to Aetna’s PBM customers. Aetna was reported to have added 1 million customers this season, and this means more potential business for CVS’s specialty benefit management program. Furthermore Aetna has high single digit revenue growth penciled in for the next few years, so there is more to come here.

Lastly, CVS and WAG both have international expansion plans but are pursuing them on vastly different scales. While WAG’s investment in Alliance Boots is significant and is intended to create management synergies, it doesn’t involve direct control from WAG. On the other hand, CVS has been far more direct but piecemeal in its investment in Brazil. The acquisition (44 stores) is small, and I can’t help thinking that this is almost a pilot scheme before the management decides to dip more than its toe in. If all goes well we can surely expect CVS to use some of its substantial cash flow to make acquisitions here.

Favorable Industry Dynamics

What both companies do have in common are favorable demographics, an ongoing trend towards generics usage, increases in own store brands (which come with higher margin) and a focus on personalizing medicine for the community.

The last statement may seem somewhat PR fluffy, but I think there is something in it. Walgreen is actively promoting itself as a local pharmacy capable of servicing urban communities with things like flu-shots and ongoing treatments. This is an important aspect of ensuring customer loyalty and generating recurring income. It also fits into the trend for diseases like diabetes that require constant treatment.

Another angle on this is that medications are becoming increasingly targeted and therefore personalized at the same time as IT is creating ever more opportunity to profile customers and manage inventory accordingly. This is a big plus point for CVS and its specialty offerings.

The Numbers Make Sense

Focusing on CVS, its investment numbers continue to make perfect sense to me. Analysts have CVS on 15% and 11% for the next two years, and company guidance is for 10-15% operating income growth. Free cash flow remains very strong, and gross margins are forecast to increase in both segments.

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For example, the forecast free cash flow for next year represents around 6.9% of its enterprise value. That is cheap for a business with such good long term prospects. There are always political risks as health care is an area where the Government needs to engineer cost savings, but on balance I think there is a significant margin of safety in the stock to justify buying it. So I did.

 


SaintGermain has positions in Walgreen and CVS Caremark. The Motley Fool recommends Express Scripts. The Motley Fool owns shares of Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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