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CVS AT A GLANCE

P/E ► 12.1 AVG EV/EBITDA ► 6.99 LOW ROA ► 7% AVG ROE ► 10.4% AVG Debt to Equity ► 0.735 LOW Current Ratio ► 1.37 AVG Interest Coverage Ratio ► 11.8 AVG

 

 

 

 

 

 

CVS Caremark (NYSE: CVS) is a pharmacy services provider in the U.S. Its business includes operations of pharmacies, which sell prescription and over the counter drugs, as well as retail merchandise such as cosmetics, convenience foods, and photo processing services. It also provides mail-order pharmaceutical services like prescription fulfillment.^[1]

Due to an acquisition streak (Longs Drug Stores (LDG), a retail pharmacy chain in 2008 ^[2], Caremark RX, a leading Pharmacy Benefit Manager in 2007^[3] , MinuteClinic, a retail health clinic business in 2006), CVS has expanded its geographic retail footprint across the country. The company benefits from the increased demand for drugs from aging baby boomer population, the general increase in prescription drug coverage over the last decade, and the expansion of government spending on health care through programs like Medicare Part D. It is further relatively shielded from the 2008 economic slowdown because pharmaceutical retail companies have higher profit margins on generic drugs than prescription drugs. ^[4] The company generated $86.5 billion in sales in fiscal 2008, extending its lead over the industry's historical leader, Walgreen Company (WAG) which netted $59 billion in sales. ^[5]

CVS does have a history of legal problems, however. It has been accused of prescription errors and quality problems, illegally dumping confidential patient information, breaches of patient confidentiality and most recently in 2006 of the bribery of former Rhode Island state senator John Celona (D-RI), who was convicted and plead guilty to mail fraud. ^[6]

Company Overview

CVS Caremark Corporation operates the popular retail CVS Pharmacy stores, which number over 6,300 nationwide. They also operate the Pharmacy Benefit Manager (PBM) Pharmacare and new acquisitions: the PBM Caremark, retail health clinic MinuteClinic (mostly located inside CVS/Pharmacy stores), and Longs Drug Stores. ^[7] CVS consists of two major segments: pharmacy services and retail pharmacy.

Retail Pharmacy (53% of revenue, 58% of income

CVS's retail pharmacy business segment consists of all revenue generated from sales of drugs and general merchandise in CVS stores. CVS has the largest network of retail stores in the retail pharmacy industry and generates more than half of its revenue from this segment. The retail pharmacy business also provides health care services through its MinuteClinics, which serve to diagnose and treat minor health issues. By the end of 2008, the retail pharmacy business consisted of 6,923 retail stores, and 560 MinuteClinics.^[8]

In 2008, the retail pharmacy segment earned $3.5 billion in operating profit from $49 billion in sales for an operating margin of 7.1%.^[9]

Pharmacy Services (47% of revenue, 42% of income)

CVS's pharmacy services segment provides "prescription benefit management services, such as mail-order pharmacy services, prescription plan design, and claims processing. CVS's main customers in this segment are businesses and organizations that sponsor health plans for their members. This segment primarily generates its revenue through contracts with these organization.^[10]

In 2008, the pharmacy services segment earned $2.6 billion in operating profit from $43.8 billion in sales for an operating margin of 5.9%. The pharmacy services segment's mail service contributed $14.9 billion in sales in 2008, while the retail network contracts generated $28.5 billion.^[11]

Quarterly Financials

CVS achieved net revenues of $24.9 billion in Q2 2009 (ending 6-30-09), a growth of 18% over the second quarter of 2008. Net earnings increased 8% to $889.1 million in Q2 2009. Revenue from the pharmacy services segment, which accounts for roughly half of CVS's total revenue, grew 22.1%, bringing in $13 billion for the quarter. Much of this growth was due to increased retail network claims, which CVS attributes largely to their RxAmerica program, which CVS acquired in October 2008.^[12] Revenues in the retail pharmacy segment increased 17.2%, bringing in $13.8 billion in Q2. Same-store sales were up 6.1% on the quarter.^[13]

In addition to these results, which generally beat projections, CVS raised its guidance for 2009 from an EPS range of $2.37-$2.45 to $2.41-$2.46.

Trends and Forces

Company Growing through Acquisitions

Longs Drug Stores (LDG)

In November 2008, CVS completed the acquisition of Longs Drug Stores (LDG) for $2.7 billion. Longs Drug Stores (LDG) ran a similar business to CVS and was heavily concentrated in California, Hawaii, Nevada and Arizona, markets with few or no CVS store locations. The transaction brought 521 Longs drug stores under CVS ownership, dramatically increasing its presence in these markets. Profits results are expected to decrease for the remainder of 2008 and 2009 partially due to transition costs. ^[14]

Caremark RX

Caremark RX is a pharmacy benefit management (PBM) company that provides comprehensive disease and prescription benefit management services aimed at convenience, cost reduction, and increased effectiveness. It operates a retail pharmacy network that includes over 60,000 participating pharmacies(including CVS/Pharmacy), 28 mail service pharmacies, and an FDA approved repackaging plant (the only one in the industry).

In March of 2007, CVS and Caremark completed the merger, outbidding Express Scripts, another PBM to create one of the first true mergers between a retailer and a PBM. ^[15] The merger cost was $26.5 billion, paid in stock. ^[16]

• CVS expects to achieve at least $500 million in cost savings through the merger (e.g., through economies of scale) ^[17]

• This acquisition positions CVS to benefit from the increased trend toward mail order prescription drugs, which has grown from 10% in 1990 to 20% in 2006. Through Caremark and Pharmacare, CVS can profit from this trend as well (or at least maintain current accounts that shift away from retail).

• Centralized Prescription Filling: 60% of drug prescriptions filled at retail locations are from recurring prescriptions. ^[18] CVS Caremark can now push customers these customers to get their scripts in the mail instead, which is less costly and more efficient.

• It is likely that Caremark will convince many of its clients to name CVS as a preferred provider, or it will be able to do so itself. Being a preferred provider will allow a PBM to provide discounted products or services to its members through an agreement with insurers or third-party organizations. Most people whose insurance companies have preferred provider networks use those networks almost exclusively, driving more business to CVS/Pharmacies.

• Consolidation of patient data and reminders: The CVS pharmacist will eventually have access to a patient's entire medication regimen, thus allowing the company to build deeper customer relationships through the PBM as well as local pharmacists.

MinuteClinic

In 2006, CVS acquired and expanded MinuteClinic, the first and largest retail health clinic in the US. It now operates as a subsidiary of CVS Caremark, with the majority of its 462 clinics housed within CVS/Pharmacy locations. ^[19] MinuteClinic employs board certified nurse practitioners and physician's assistants trained to diagnose and treat/make prescriptions for common illnesses; common vaccinations are also provided.

The MinuteClinic acquisition has benefited CVS Caremark's bottom line in the following ways:

• MinuteClinic is less costly than a typical doctor visit, which makes it more attractive to insurers and cash payers alike
• CVS is leveraging MinuteClinic to drive new business to the pharmacy - 25% of MinuteClinic patients are new CVS customers
• If Caremark or Pharmacare is already an insurer's PBM, sending patients to MinuteClinic will be cheaper for the insurer, and more profitable for CVS.
• CVS plans to put MinuteClinics in about 2,500 CVS/Pharmacy stores

Osco, Sav-on

In 2006, CVS expanded its geographic footprint to reach the Chicago area and Southern California. It acquired Sav-On and Osco drugstores from Albertsons. The deal included over 700 stores. CVS also acquired 28 Albertsons' Health'n'Home Durable Medical Equipment (DME) stores through the acquisition. The DME stores represented CVS's entrance into the DME market. ^[20]

What Is Lifting All Boats?

Several external trends are currently increasing all pharmacies' revenues across the industry. In addition to increased sales of prescriptions, CVS will benefit as additional foot traffic for the pharmacy naturally leads to increased retail sales in the front end of the store.

• Baby boomers are only getting older, and will be more likely to need prescription medications in the coming years
• There has been an increase for prescription drug coverage in the last 10 years
• The new Democratic federal government will be more likely to enact legislation to increase spending on health care
• Medicare Part D came into effect in January 2006, which expanded coverage to millions of people who were previously uninsured. Medicare Part D makes it more difficult to prescribe more expensive drugs, shifting overall product mix toward generics (which although cheaper, generate higher margins). Now, over 22 million people are enrolled in Medicare Part D. ^[21]
• Over the next five years, around $50 billion in branded drug sales will lose patent protection, opening them to generics and driving profit margins

Legal Troubles

CVS was accused between 2005 and 2008 of prescription errors and quality problems ^{[22] [23]}, illegally dumping confidential patient information, breaches of patient confidentiality and the bribery of former Rhode Island state senator John Celona (D-RI) in 2006, who was convicted and plead guilty to mail fraud. ^[24] Two CVS executives were put on leave of absence for allegedly bribing the Senator to advance CVS's agenda in Rhode Island and in Washington, D.C but were cleared of charges in 2008. ^[25]

The company's subsidiary Caremark also has an ugly legal history. It has been accused of reusing returned mail-order medications, passing off generics and non-preferred brands as preferred brands, serious racial harassment, options backdating and in 1995, Caremark paid the third highest ever criminal settlement of $161 million for paying kickbacks to doctors. ^[26]

The SEC currently has more stringent financial reporting requirements and other regulations for companies that do a significant amount of business with the government, and with increased government spending on Health Care, it's likely to occur eventually for CVS Caremark. Further investigations could generate more bad press, convictions, and high settlements - any of which could decrease consumer and/or investor confidence.

Economic Slowdown

CVS's revenue comes from both pharmacy sales and non-pharmacy, or front store, sales. Though medical costs such as prescriptions are not discretionary expenses and thus less vulnerable to an economic downturn, patients still migrate towards lower cost generic drugs instead of more expensive brand name drugs. CVS actually stands to benefit from this, as they receive higher levels of reimbursement from groups like Medicare for generic drugs. ^[27] Additionally, CVS CVS Chief Executive Tom Ryan says that very little of front store sales comes from "true discretionary sales," so same store sales are expected to continue to grow. Still, CVS lowered their expected profit by 6 to 7 cents per share for FY2009, citing worries about decreased overall spending from consumers. ^[28]

Competition

Market Share: Prescription Drugs and Front Store Sales^[29][30]

CVS's biggest competitor is the Walgreen Company (WAG), which generated $53.7 billion in 2007 sales. ^[31] Walgreens also has its own PBM--Walgreens Health Services--making it the most comparable to CVS Caremark in terms of breadth of offerings. Walgreens had led CVS in terms of sales and operating margin in recent years until 2007 when CVS's merger with Caremark helped the company surpass Walgreens. CVS earned a 6.2% operating margin in 2007, compared to Walgreen's 5.9% figure. ^{[32] [33]} The result has been greater gains in market share in both prescription drugs and front store sales by CVS than by Walgreens.

CVS also competes for market share with discount stores, particularly Wal-Mart. The retail discount giant has smaller presence in the prescription drug market but dwarfs CVS in front store sales. Its large gains in market share for both prescription drugs and front store sales are likely reflective of customers decreasing spending in face of the economic downturn.

CVS Caremark's other competitors include:

• Rite Aid: $17.5 billion in 2007 revenue. Rite Aid recently acquired Brooks/Eckerd on the East coast, but both companies are currently struggling. CVS owns several key markets in this region and may be poised to benefit from Rite Aid's decline.
• MedcoHealth: $43.1 billion in 2007 revenue. MedcoHealth is specifically a Pharmacy Benefit Manager that sells drugs through a network of privately owned retail pharmacies with which it has operating contracts. Its business is therefore limited to prescription and generic drugs, whereas CVS offers over-the-counter drugs and retail products, as well. This leaves CVS poised to benefit from revenue from front store sales, whereas MedcoHealth leaves such revenue to private pharmacy partners.
• Express Scripts: $17.8 billion in 2007 revenue. Express Scripts is also specifically a Pharmacy Benefit Manager. It consequently suffers from the same disadvantage as Medcohealth - no revenue in the front store sales.
• Other discount stores, food/drug combo stores, mail service prescription services, Internet drugstores, PBMs, and other various sellers of retail and prescription merchandise. Supermarkets currently account for about 12% of the retail prescription market, but they are currently losing market share due to increasing cost pressure industry-wide. It is expected that they may even exit the market in the next couple years. If this trend continues as it is expected to do, CVS and others will be in a position to absorb the market share.

Note 2: A fully transparent breakdown of operating margins is conspicuously absent from all retailers' annual reports, though they provide same store sales, revenue, and sometimes gross margins information.

References

1. ↑ CVS Caremark 10-K 2007. Section 1 - Business. pg 4
2. ↑ MSN Money. "CVS says tender offer for Longs is complete." 29 October 2008.
3. ↑ CVS Caremark 10-K 2007. Section 1 - Business. pg 3
4. ↑ Drug Channels. "The Attack on Generic Profits in Drug Channels." 21 November 2001.
5. ↑ [CVS Caremark 10-K 2008. Section 2 - Financial Statements and Supplementary Data. pg 32]
6. ↑ (D) State Senator John Celona resigns and pleads guilty. 21 June 2006.
7. ↑ CVS Caremark 10-K 2007. Section 1 - Business. pg 3
8. ↑ 2008 CVS Caremark 10-K Annual Report, p. 19
9. ↑ 2008 CVS Caremark 10-K Annual Report, p. 23
10. ↑ 2008 CVS Caremark 10-K Annual Report, p. 19
11. ↑ 2008 CVS Caremark 10-K Annual Report, p. 23
12. ↑ CVS Caremark Reports Successful Tender Offer for Longs Drug Stores Shares
13. ↑ CVS Caremark Reports Record Second Quarter 2009 Results; Company Raises 2009 Guidance
14. ↑ Associated Press. "Pharmacy sales boost CVS 3Q profit 7 percent." 30 October, 2008
15. ↑ CVS Caremark 10-K 2007. Section 1 - Business. pg 3
16. ↑ "CVS Completes Caremark Acquisition; To Launch Tender Offer"
17. ↑ CVS Press Release on Caremark Merger.
18. ↑ CVS Caremark 10-K 2007. Section 1 - Business. pg 5
19. ↑ CVS Caremark 10-K 2007. Section 1 - Business. pg 4
20. ↑ Chain Drug Review. "CVS' purchase of Osco, Sav-on seen as strategic coup." 11 September 2006.
21. ↑ HHS Monthly Summary on Medicare Part D Enrollment. November 2008.
22. ↑ The Boston Channel. "State Probing CVS Prescription Problems." 22 June 2005
23. ↑ ConsumerAffairs.com
24. ↑ (D) State Senator John Celona resigns and pleads guilty. 21 June 2006.
25. ↑ Former CVS execs cleared in U.S. bribery trial. 30 May 2008.
26. ↑ US Department of Justice Press Release. 16 June 1995.
27. ↑ Drug Channels. "The Attack on Generic Profits in Drug Channels." 21 November 2001.
28. ↑ Forbes. "Pharmacy sales boost CVS 3Q profit 7 percent." 30 October 2008.
29. ↑ CVS Caremark 10-K 2007. Section 1 - Business. pg 4
30. ↑ Market Wire. "BIGresearch Retail Ratings: CVS Closes Prescription Drug Gap With Walgreens." October 2008.
31. ↑ Walgreen Company (WAG)
32. ↑ CVS Caremark 10-K 2007. Section 2 - Financial Statements and Supplementary Data. pg 32
33. ↑ Walgreen Company (WAG)