How We View CVS' Evolution

Jake Strole: Within our healthcare coverage, CVS Health trades at one of the steepest discounts to our estimate of intrinsic value. With the stock near $60 per share versus our fair value estimate of $92, we think this narrow-moat name represents compelling value for long-term investors.

CVS Health transformed its business with its acquisition of Aetna in late 2018. The addition of a managed-care franchise to CVS' leading presence in retail pharmacy and pharmacy benefits management underpins our positive trend rating on the name, along with our optimistic outlook regarding valuation. The combination sets the stage for CVS to improve its cost position relative to less-integrated peers, while developing a stronger network effect as management looks to better leverage its retail footprint. Management's strategy to develop more clinically relevant stores, or so-called "health hubs," within its network puts the firm in a position to better manage its members' healthcare needs and potentially bend the medical benefits cost curve at Aetna over time. We think management's vision is very much akin to the integrated strategy pursued by UnitedHealth that forms the basis for its wide economic moat, leaving us similarly bullish on the future prospects for CVS. That said, execution over the next several years will remain paramount to generating shareholder value from the transaction and validating our thesis on the future competitive position of the organization.

Shares trade cheaply as investors remain concerned about the political environment for healthcare businesses more generally, management's less-than-perfect track record of capital deployment, and lingering regulatory scrutiny regarding the transaction. As a result, shares are marked at a steep discount to peers, trading at roughly 9 times our 2020 earnings estimate compared with 14 times for the broader managed-care index. We think many of these fears are overblown and think today's valuation sets the stage for CVS to outperform over a multiyear investment horizon.