On a journey to see how I can use AI to leverage my expertise in finance and economics to quickly develop thesis for short term investments. I have set up a paper trading account and looking to see how much data I can synthesize to uncover potential over valued or undervalued stocks.
I’ve started with CVS Health which has an earning release this week.
Feedback welcomed on the approach as I explore this process.
Thesis: The cost of capital and increased business expenses, coupled with the acquisition of new business lines, have rendered CVS Health’s future growth prospects and current stock value overpriced. This analysis leverages financial metrics and recent performance data to support this thesis.
Current Financial and Valuation Metrics:
- Current Stock Price: $59.32
- Market Capitalization: $77.29 billion
- Shares Outstanding: 1.26 billion
- PE Ratio (Forward): 8.09
- Debt: $81.79 billion
- Cash: $13.09 billion
- Intrinsic Share Price: $71.74 (based on DCF analysis)
Reasons CVS Health Might Miss Earnings:
- Increased Cost of Capital and Business Expenses:
- Rising Interest Expense: CVS Health’s interest expense has increased by $127 million, or 21.6%, year-over-year due to higher debt levels, primarily from acquisitions. This increased burden on the company’s finances limits its ability to reinvest profits into growth opportunities .
- Higher Operational Costs: The company has faced higher operational costs, especially in its Health Care Benefits segment, where increased Medicare utilization and lower Medicare Advantage star ratings have impacted profitability. The segment’s adjusted operating income decreased by 59.9% year-over-year .
- Acquisition of New Business Lines:
- Integration Challenges: The acquisition of new business lines has not yet resulted in expected synergies. The Health Services segment saw a revenue decline of 9.7% year-over-year due to the loss of a major client and continued pressure to reduce prices for pharmacy clients, impacting margins .
- Resource Allocation: Significant resources allocated to integrating these new businesses may not yield the anticipated returns, further straining financials and reducing overall profitability.
- Revised Guidance and Market Sentiment:
- Downward Earnings Guidance: CVS Health has revised its full-year 2024 earnings guidance downward. GAAP diluted EPS guidance was reduced from $7.06 to $5.64, and adjusted EPS guidance was lowered from $8.30 to $7.00. This signals the company’s own lowered expectations for its financial performance .
- Investor Confidence: The downward revision in guidance could negatively impact investor confidence, leading to a decline in stock price.
Scenario: Earnings Miss and Taking a Short Position
Earnings Announcement: If CVS Health reports earnings that miss the revised expectations, the stock is likely to experience significant downside pressure.
Potential Downside Scenario:
- Revenue Miss: Suppose CVS Health reports quarterly revenues below the expected $88.4 billion.
- EPS Miss: GAAP diluted EPS and adjusted EPS come in below the revised guidance of $5.64 and $7.00, respectively.
- Guidance Revision: Further downward revision of full-year guidance signals ongoing challenges.
Short Position Strategy:
Step 1: Entering the Short Position
- Entry Point: Immediately after the earnings miss is announced.
- Position Size: Short 100 shares at the current price of $59.32.
Step 2: Setting Stop Loss and Take Profit Levels
- Stop Loss: Set a stop-loss order at $63.00 (6.2% above the current price) to protect against an unexpected rally.
- Take Profit: Set a take-profit target at $50.00 (15.7% below the current price).
Step 3: Monitoring Technical Indicators
- Relative Strength Index (RSI): Monitor RSI for oversold conditions (<30) as a potential signal to cover the short position.
- ** Moving Averages**: Track the 50-day and 200-day moving averages for potential support levels.
Valuation and Downside Analysis:
- Current Intrinsic Value: $71.74 (calculated using DCF analysis)
- Current Stock Price: $59.32
- Potential Downside: If the stock price drops to $50.00, this would represent a 15.7% decline from the current price.
Detailed Example Calculation:
- Initial Short Position: Short 100 shares at $59.32.
- Immediate Drop: Stock drops to $50.00 after earnings miss.
- Profit Calculation:
- Short sale proceeds: ( 100 \times 59.32 = $5,932 )
- Covering cost: ( 100 \times 50.00 = $5,000 )
- Total Profit: ( $5,932 – $5,000 = $932 )
Risks and Considerations:
- Short Squeeze: Risk of a short squeeze if positive news emerges, driving the stock price up rapidly.
- Unexpected Positive Developments: Positive earnings surprise, strategic acquisitions, or favorable regulatory changes could lead to a price increase.
- Market Sentiment Shifts: Broader market movements or changes in investor sentiment towards the healthcare sector could impact the stock price independently of the earnings miss.
Conclusion
Taking a short position in CVS Health stock following an anticipated earnings miss could be profitable if the stock declines significantly. The combination of increased costs, integration challenges from recent acquisitions, and downward earnings revisions supports the thesis that the current stock price is overpriced. Careful risk management, including setting appropriate stop-loss and take-profit levels, and staying informed about market developments, is crucial to successfully executing this strategy.