Stick With the Rally in CVS Stock

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Back in mid-July, I wrote on InvestorPlace that it looked like shares of beaten up pharmacy retailer CVS (NYSE:CVS) were ready to breakout higher. The headwinds, which had plunged shares into dirt-cheap territory, were going to ease going forward, meaning that there was no reason for the dirt-cheap valuation to stick around.

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Fast forward four months. CVS stock has risen 25% — to the S&P 500‘s 3% gain over that same stretch — thanks to exactly that. Headwinds have eased and have been replaced by tailwinds. The numbers and narrative have improved. Investors are realizing CVS stock shouldn’t be this cheap. So they are gobbling up shares in bulk, and CVS stock is flying higher.

The most recent update here is that CVS reported very strong third quarter numbers in early November that were much better-than-expected on all fronts. All of the businesses are growing, profitability is improving, and the balance sheet is being cleaned up. The outlook is also getting brighter.

The implication from this earnings report is that at just 10-times forward earnings, CVS stock isn’t priced for the company to be on such a roll. This discrepancy means that CVS stock should continue to outperform for the foreseeable future.

CVS Is Marching Higher

If the third quarter print confirmed anything, it is that CVS is on a roll thanks to new growth initiatives.

Taking a step back, the big picture here is that CVS is a specialty pharmacy retailer that once co-existed with the likes of Walgreens (NASDAQ:WBA), Rite Aid (NYSE:RAD), and others in the specialty pharmacy world. Then, more players moved more aggressively into the space, including Amazon (NASDAQ:AMZN), Walmart (NYSE:WMT), Target (NYSE:TGT), and a slew of online pharmacies. This competition surge created traffic and margin headwinds for CVS, and CVS revenues, profits, and stock price have consequently all sunk over the past few years.

The writing was on the wall. CVS needed to differentiate itself in order to survive the competition surge in the specialty pharmacy retail world.

That’s exactly what they did, and the Q3 numbers imply that these new initiatives are working. CVS acquired Aetna, and has since leveraged that acquisition to launch HealthHUB concept stores, which are focused on personalized and localized healthcare services. These HealthHUB stores performed exceptionally well in Q3.

At the same time, CVS has doubled down on MinuteClinic services, and success of these services is a key reason why the company’s retail business continues to tick higher. New programs like Maintenance Choice are driving materially positive revenue and profit gains in the pharmacy segment as well.

The whole CVS growth narrative is perking up thanks to new growth initiatives, which have successfully differentiated CVS from the pack in the specialty pharma retail world. Importantly, this differentiation paves the path for the CVS growth trajectory to continue to improve over the next few years.

Shares Remain Unreasonably Cheap

Given that the CVS growth trajectory projects to keep improving thanks to successful differentiation, CVS stock is unreasonably cheap at current levels.

Just look at the multiples:

  • Forward P/E: 10
  • 5-Year average forward P/E: 13
  • Sector average forward P/E: 14
  • Market average forward P/E: 17
  • Consumer discretionary sector average forward P/E: 21

In other words, relative to its historical self, CVS stock is trading at a 20%-plus discount today. Relative to peer stocks across various other industries, the stock is trading a discount of anywhere between 30% and 50%.

That’s just too cheap for CVS stock. At one point in time, this discount was warranted given the bleak growth prospects. But, the growth prospects today are starting to perk up thanks to successful differentiation of the business model through HealthHub, MinuteClinics, Maintenance Choice, and more. The balance sheet is also being deleveraged, so there remains little reason why shares should be so cheap.

The implication? Shares won’t remain this cheap for long. So long as CVS stays on a roll, the multiple underlying CVS stock will continue to expand, and this consistent expansion will keep CVS stock on a healthy uptrend.

Bottom Line on CVS Stock

I loved CVS stock back in July when it was down around $50. I still like CVS stock up here around $70. Shares remain too cheap given the company’s improving growth prospects. This favorable discrepancy will keep CVS stock on a solid uptrend for the foreseeable future.

As of this writing, Luke Lango was long CVS and WMT. 

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