When one looks at CVS's dividend history, it really is a thing of beauty:
(Chart by Author, data from Morningstar)
This works out to an average annual increase of 23.62%.
Further, they have a low 35% payout ratio which means they have plenty of room to grow the dividend... right?
In this article I argue that payout ratio has nothing to do with a stock's ability to grow their dividend, and that I believe CVS will face persisting headwinds in future years due to their business model lacking a real moat. I'm not including CVS as a dividend growth stock in my portfolio.
CVS is in a slowly declining industry
Wait, what? When we look at their numbers this does not seem to be the case at all.
The problem with slowly declining industries is that the struggles do not show up in the numbers until it is too late, when the stock price already has dropped significantly.
CVS started out as a convenience store in the 1960s but as grocery stores became more prevalent, they added the pharmacy segment which is what they are known for now.
When I grew up, my family would go to CVS primarily to pick up medicine, and purchase snacks/other necessities along the way.
Nowadays, it is the opposite. I would only go to CVS to purchase household things, and this would be the primary reason to have my medicine shipped there (so I can pick the medicine up along the way).
Why is this the case? They have no moat
Times are changing fast. One no longer has to go to CVS to get their medicines as they can go to competitor Walgreens (WBA), or more likely go to their neighborhood grocery store's pharmacy, or even yet, have it shipped directly to their home from an online pharmacy.
Because pharmacies do not really have any way to differentiate themselves directly (do you remember anything special about picking up medicine at the medicine counter?), one would expect that CVS try to use its convenience store items as this differentiator. The problem is that CVS is a convenience store and thus all their products are more expensive than competitors. How have they tried to hide this?
CVS has become known for offering "savings" on already marked-up items but this has come up short as somehow their products are still more expensive than competitors even after these "savings" are applied.
Nowadays it is very easy to check prices of items online (there are even apps for this) and to make things worse, one would only need to go to a close by neighborhood grocery store to purchase the same exact household items for cheaper prices.
One may contend that people do want to purchase the items from CVS for its convenience and do not want to go all the way to the grocery store. However I must point out that most people are going to be driving to these stores, and for the majority of the situations driving an extra minute or two is not a large switching cost to save money.
Their drugs are expensive too: According to Consumer Reports, CVS consistently prices its generic drugs as high as possible to get the most out of insurance companies, whereas Costco (COST) prices its generic drugs as low as possible while still maintaining a profit (Consumer Reports).
If they can not get you through the door with their household products, not their medicines, how are they going to get your business?
Why does this matter? Isn't retail only a small portion of their business? Look at this chart:
We can see that their Retail/LTC segment makes up 70.4% of their total operating profit and 45.7% of total revenues. Their pharmacy services segment is growing quite healthily, but clearly if their largest earnings segment is facing headwinds then this is a big problem.
The deterioration already is starting to show in their results
We can see from their Q1 and Q2 earnings that their Retail/LLC segment is seeing weak same store sales:
Management said that this is due to "an increase in the generic dispensing rate and continued reimbursem*nt pressure" but I believe the problems are much more deeply rooted in their business model overall.
They have managed to keep their numbers steadily increasing over the years due to store openings, but do notice store closures is ticking up in recent years:
(CVS Annual Report)
I'm afraid that I do not see a reason for CVS retail stores to exist. I love my local CVS, but most if not all of their products are available cheaper elsewhere, including even their medicines. Retail stocks already have experienced the consequences of such a predicament, and I believe that we will see CVS see the same fate in the next ten years.
Is CVS a dividend growth stock?
At the beginning of this article I asked if the fact that they had a growing dividend history coupled with a low payout ratio signaled that they were a dividend growth stock.
I argue that the payout ratio has very little to do if a stock is a dividend growth stock, and that only growing earnings (from which dividends come from) matters. For those who believe that the low payout ratio makes CVS a dividend growth stock, let me ask you, if CVS paid all of their earnings out as dividends, would you feel the same way?
Or let me put it another way: Let's say CVS used to be paying out all their earnings as dividends and suddenly announces in an upcoming earnings report that they are slashing their dividend payout ratio to 20% and intend to "grow" it 7% annually until it is back to 100%. Is it now a dividend growth stock?
Bottomline: Because I do not believe in their long-term ability to raise earnings, I do not view CVS as a suitable to be a core dividend growth stock.
What CVS needs to do
They already have done a good job in purchasing Target's (TGT) pharmacy business in 2015, but I believe they need to be more aggressive and purchase the pharmacies of other chains such as grocery stores. Otherwise I believe that their brick and mortar stores (that's really what they are) will drop one by one like dominoes. This is an existential crisis and CVS must act now.
What price would I be interested in buying in?
I would become interested in CVS if it traded at an earnings yield of 15%. This would require them to trade at 33.2/share. Unfortunately, I do not believe we will be able to see them trade at this level until perhaps 10 years down the line, but by then we will not be questioning whether or not they are a dividend growth stock, but instead whether or not they are a distressed retailer.
Conclusion
Low payout ratios and a great history of dividend raises do not make a dividend growth stock. Only the future dividend performance matters, and I am not confident that CVS makes the mark. Stay away from CVS until it drops lower.
Julian Lin
Julian Lin is a financial analyst. He finds undervalued companies with secular growth that appreciate over time. His approach is to look for companies with strong balance sheets and management teams in sectors with long growth runways.
Julian is the leader of the investing group Best Of Breed Growth Stocks where he only shares positions in stocks which have a large probability of delivering large alpha relative to the S&P 500. He also combines growth-oriented principles with strict valuation hurdles to add an additional layer to the conventional margin of safety. Features include: exclusive access to Julian's highest conviction picks, full stock research reports, real-time trade alerts, macro market analysis, individual industry reports, a filtered watchlist, and community chat with access to Julian 24/7. Learn more.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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