CVS CAREMARK CORP CVS W
February 27, 2011 - 10:39pm EST by
natey1015
2011 2012
Price: 32.94 EPS $2.66 $2.78
Shares Out. (in M): 1,372 P/E 12.4x 11.9x
Market Cap (in $M): 45,194 P/FCF 13.8x 11.0x
Net Debt (in $M): 8,579 EBIT 6,615 6,731
TEV ($): 53,773 TEV/EBIT 8.1x 8.0x

Sign up for free guest access to view investment idea with a 45 days delay.

  • pharm
 

Description

I think CVS Caremark is currently one of the most attractive risk-adjusted (factoring in liquidity and downside protection) investment opportunities on an absolute basis, but especially in comparison to the investment alternatives that exist today. I'm going to attempt to keep this write-up as short and simple as possible. Thus I am purposely not going to dive into too many details regarding Caremark, the prescription benefit manager because it would make this investment write-up too long and over complicate things, in my humble opinion. Please feel free to ask questions regarding Caremark and the PBM industry as I'll be happy to answer them in the Q&A.
 
CVS Caremark is made up of 2 businesses: CVS drugstore chain (~2/3 of profits) and Caremark (~1/3 of profits). To begin to highlight the value, here is how CVS would theoretically be valued today using a sum-of-the-parts based on comp multiples (WAG FIFO adjusted for CVS drugstores and MHS/ESRX for Caremark) using calendar 2011 consensus estimates:
 
CVS drugstore chain: $26.08 (based on 7.5x EBITDA or 14.3x cash EPS--excludes amortization of intangibles related to acquisitions)
Caremark: $14.31 (based on 10.2x EBITDA or 15.3x cash EPS--excludes amortization of intangibles related to the acquisition of Caremark)
CVS Caremark: $40.39 (upside of 22.7%)
Looking out 2 years I believe CVS is worth at least $48 per share (details shown later) or upside of 50%+ including dividends.
 
 
Investment Thesis
 
The focus of this write-up will be on CVS' drugstore business because that is where I am most confident there is tremendous value given a very strong economic moat due to its unmatched scale (the largest purchaser of prescription drugs in the U.S.) and solid earnings growth opportunities (generic wave, growing 65+ year old population, etc.) over the next 5 years that are as close to guaranteed as I've ever seen. I do believe that CVS Caremark has a unique, integrated retail/PBM model that will ultimately prove itself successful (more on that later). Also, one gets 2 "free call options" that could hit in ~2014 and be quite material to CVS' earnings power.
 
The CVS drugstore business is a compounder. Since half of all retail prescriptions administered are unplanned, physical pharmacies are required for just-in-time dispensing. It would be extremely difficult for most large organizations to have a prescription drug plan that excludes either Walgreens or CVS for dispensing prescriptions. Because CVS (as well as WAG) has such a large footprint that would be near impossible (and take many years) to replicate, it is an essential part of drug distribution and as a result will continue to have a relatively dominant negotiating position vis-à-vis other players in the supply chain. Also, the shift of scripts to the PBM mail channel has barely increased over the past 5 years, which strongly suggests bricks & mortar will continue to be the main end-point of delivery.
 
One of the best parts about an investment in CVS at the current price is that your downside is well protected. Even if you believe Caremark's business is worthless (hardly the case) and you want to assign a 10% discount to CVS drugstores (compared to WAG because one believes there is more margin expansion opportunity there due to a more immature store base) then CVS is worth $23.50 or immediate downside of -28.7%. To me this is a very extreme downside case as CVS would be trading at 8.5x 2011E EPS, but nonetheless one can use this as a worst case scenario.
 
In fact, if one were to hedge out the PBM exposure by shorting MHS and/or ESRX at their current valuations, one would theoretically be creating the CVS drugstore business at 10x 2011 earnings. Clearly, there are risks to doing this--mainly that Caremark loses customers to MHS and/or ESRX. But on the flip side one would get a hedge against the PBM multiples contracting as well as protect against industry pricing/margins from contracting. I'm not necessarily advocating one short part or all of the PBM exposure, but am simply highlighting the implied valuation of the CVS drugstore business. Market leading businesses with industry growth tailwinds don't normally trade for 10x earnings.
 
Without a hedge, CVS trades at 12x 2011E EPS and 10x 2012E EPS.
 
 
Drugstore Chain Economics
 
Drugstores are a very good, recurring revenue business. They are necessary because about half of all prescriptions are prescribed on an as needed basis. Thus enough inventories, which take up little room, must be kept at the local store to be able to execute fills with little notice. Also, since many people still prefer to pick-up their chronic prescriptions at a local retail pharmacy, this allows the drugstore at least 4-12+ (depending on monthly or 90+ day fill) opportunities per year to sell the customer front-end merchandise.

About 2/3 of the CVS drugstore chain's sales and operating profits are made from filling customers’ prescriptions. All prescription drugs are sold to individuals who (or their guardians) make the choice of where to get their prescriptions filled. But certain insurance plans or companies can restrict which pharmacies one can go to. The payer mix by customer type is 66.9% insurance, 16.7% Medicare, 6.9% Medicaid, 6.5% other government and 3.0% self. However, mainly due to co-pays, the sales based on dollars paid are: 53.4% insurance, 21.4% out-of-pocket, 13.4% Medicare, 6.6% Medicaid and 5.2% other government.

CVS buys branded drugs from one of the 3 large distributors where it has enough negotiating leverage given its respective market share to garner a better price than independent pharmacies. It buys most generic drugs directly from manufacturers because it has enough scale in its end markets to self-distribute and because its purchasing power allows it to negotiate directly with generic manufacturers to get the best price possible. In contrast, independent pharmacies don’t have that ability and thus buy their generic drugs from a distributor. Distributors claim that their average contribution margin per generic prescription is well over $3—a margin that only large chains are able to keep for themselves.

While just over 70% of prescription unit volume is made up of generic drugs it represents about 3/4 of pharmacy profits, but just 1/3 of prescription sales since the average generic drug price is about 40% of the price of a branded equivalent. Retail pharmacy chains make on average about 40% higher gross profit dollars per generic prescription compared to the average branded drug. This is because regarding branded drugs the retailer is generally a price taker since there is usually only one or two manufacturers. However, most generic drugs have multiple manufacturers, which allow a large retailer such as WAG/CVS/RAD/WMT that self-distributes generic drugs the ability to work with the insurance company/PBM to set a formulary, which can steer customers to a particular generic drug that has equal efficacy as the branded or other generic counterpart.

Since 97% of prescriptions are paid via insurance/PBM/Medicare/Medicaid plans, pharmacies typically receive the same price per prescription. The only exception is that large chains have the ability to get rebates on branded drugs (when there are at least 2 equal efficacy drugs) and discounts on generic multi-manufactured (equal efficacy) drugs since they have the ability to move market share. Independents cannot do this. Thus independent pharmacies in general have lower operating margins because their drug acquisition costs are higher along with pricing (net of rebates and discounts) that is lower than a large pharmacy chain. If the government forces drug prices to get cut across the supply chain, independent pharmacies will be hurt the most and likely accelerate their market share losses.

Despite ~90% of an average CVS store’s square footage is dedicated to front-end merchandise, only 1/3 of its sales and operating profits come from this. While the front-end contributes ~40% of gross profit, it is less on an operating profit basis because a greater portion of indirect costs such as rent are allocated to this segment. Both chains have tried a much smaller format in the past, but customers like the convenience of being able to buy consumer staples from drugstores. CVS' prices are generally in-line with supermarkets’ prices, but are about 20% more expensive than Wal-Mart’s prices. Independent pharmacies typically have much smaller front-end areas as they don’t have the systems and distribution infrastructure to manage the thousands of SKUs CVS stores sell to its customers.

WAG and CVS have the best return on capital in the industry for a few main reasons: 1) Size and scale allow them to buy drugs at the best price possible from distributors and generic manufacturers; 2) Size and scale allow each to leverage its distribution network as effectively as possible; 3) Size and scale allow it to buy general merchandise at relatively favorable prices and have an effective private label strategy; 4) Sales per square foot is significantly higher than the competition, which allows it to leverage its fixed costs better.


 

Competitive Analysis

CVS has a sustainable and growing cost advantage due to its large scale/market share, self-distribution of generic drugs (costs itself at least ~$3 less per generic vs. the avg. branded script) and being the 2nd largest purchaser/seller of drugs in the U.S. behind CVS Caremark. There are still independent pharmacies and other weaker competitors such as Rite Aid, but they are continuously losing share to CVS & WAG due to inferior merchandising/size of stores, inferior locations, lack of capital to refresh stores and a lack of scale on drug purchases along with no self-distribution of generics.

Independent pharmacies must compete with better service because they cannot win on price since they are price takers. The large retail chains have better negotiating leverage with the major drug distributors than do independent pharmacies. Over time the large chains such as CVS, WAG and WMT continuously gain a little bit more of a negotiating advantage since they continue to gain market share. But at the end of the day the retailers with large market share are negotiating against three distributors that each has 25% - 35% share that make up 95% of the market. Thus a large retailer and distributor have approximately equal negotiating leverage.

There are two types of customers—direct and indirect. The direct customers are the individuals that consume the prescription and thus make the ultimate decision as to where to fill it. They make their choice based on service, convenience as well as selection and price of front-end merchandise. The indirect customer is the payer (companies using PBMs/insurance plans, Medicare and Medicaid) that is responsible for a majority of the dollars spent on prescriptions. The larger the payer is compared to the retail pharmacy, the more negotiating leverage it has with the retail pharmacy to get a better split of the revenue since it can threaten to exclude it from the network. Since most payers cannot pose that threat to a large retailer, CVS has the ability to get the best split possible. The only example of a payer having exerted influence over a retailer on price was Caterpillar’s decision to set its own retail network made up of just WMT and WAG. In exchange for guaranteeing each a certain level of volume CAT believes this (along with setting its own formulary) allows it to garner better drug prices than it would through using a PBM. If more large U.S. companies do this, then the largest chains would benefit at the expense of independent pharmacies.

While WMT is a major threat to many traditional retailers, drug distribution is not one of them as it stands today. First, WMT (including Sam’s Clubs & Neighborhood Markets) has less than 4,500 stores. Thus it does not have as large of a footprint as WAG or CVS, which each has over 7,000 stores. At the same time, WAG & CVS have locations in various urban markets where WMT does not have a presence and in markets where it does, WAG & CVS typically have more convenient, often premium “corner” locations—not to mention smaller stores that are easier to get in and out of. Second, as a result of having significantly fewer locations and less than half the prescription volume of WAG or CVS, it cannot command a better price from generic manufacturers than WAG or CVS since it buys much less drugs. Third, about 75% of drug spend mix is on branded drugs. WMT has no cost advantage on buying branded drugs from a distributor since a majority of the acquisition cost is set by the branded drug manufacturer, which typically has a monopoly/duopoly position. So while WMT made a big splash with its entry into the pharmacy industry in October, 2006 with $4 generics on 300+ drugs, this did not impact WAG’s or CVS’ business in a material way. If anything, it likely expanded the market by making generic drugs more affordable to those who do not have health insurance—many of whom are likely WMT customers.

The only major threat of substitution is the shift of chronic scripts being ordered from mail instead of picked up at retail. Both CVS and WAG have their own mail facilities. So long as each retains its customer’s orders, it does not make a major difference from which channel the script is filled. The reason is because while mail pharmacy charges a lower price for a 90-day equivalent of 3 monthly fills, there are lower costs from two fewer dispensing fees and a portion of labor being replaced by machine automation. If the U.S. moved this way in a material manner the drugstore industry could rationalize its base over time to keep its store overhead in-line with retail sales volumes. The other potential negative would be that it could lose some front-end sales that occur when people come into the drugstore to pick up these prescriptions. Mail pharmacy penetration currently stands at ~18% on 30-day equivalent supplies. Mail pharmacy is mainly used for chronic prescriptions (i.e. Lipitor) so mail pharmacy has ~36% share of the U.S. chronic prescriptions. Nevertheless, mail penetration has barely grown over the past 6 years. This is because many 65+ year-olds (who consume the most chronic Rx) prefer to pick-up their prescriptions from a retail pharmacy.

One potential threat to WAG's (and other pharmacies’) business is CVS Caremark’s maintenance choice offering to its PBM customers. This allows its customers to pick up 90-day scripts at its stores for the same price (due to lower co-pays) as getting it through the mail since there are two fewer dispensing fees. However, WAG offers its customers 90-day scripts as well, but not at mail pricing since it does not own a PBM and thus must allow this middleman to make a fee for processing the claim. Mail pricing for a 90-day fill is typically $5-$10 less than the equivalent 3-month supply at retail—not enough of an incentive for most to change their buying habits.

 

 

 

Industry Outlook

The drugstore industry continues to consolidate—a trend that has been going on for over a decade. CVS has been a continual acquirer of regional pharmacies—most recently buying Longs and prior to that, Sav-on/Osco. Walgreens bought Duane Reade on 2/17/10. Rite Aid’s most recent purchase was Brooks/Eckerd and prior to that, Thrifty PayLess. At the same time WMT along with other strong retailers such as Target continue to take market share as they open up more pharmacies within new and existing stores. As time goes on this continual consolidation should incrementally shift power within the supply chain to the largest pharmacies.

Over the past 17 years drugstore chains have taken 22% market share from independent pharmacies—averaging about 1.3% per year. This coincides with the strong same store sales increases from WAG and CVS over that time. While share gains slowed to 0.5% per year in 2004-2008, it reaccelerated in 2009 with a 3.0% gain. The recession put pressure on pharmacies’ front-end, which likely forced more independents out of business when that profit center diminished.

 

Tailwinds: The significant number of branded drugs coming off patent into 2015 should help provide a boost to profitability for large drugstore chains since the avg. generic drug carries ~40% higher gross profit dollars per prescription vs. its branded counterpart.

 

By 2020 there should be almost 55 million people over the age of 65 in the U.S. compared to ~40 million today. The 3.1% CAGR of the 65+ U.S. population over the next 10 years should translate into about a 1% per annum growth in drug consumption since the average 75-year old living independently consumes 4.2 scripts (and 8.1 scripts living in an assisted living/skilled nursing facility) vs. 1.1 for the average American. It is worth noting that from 2000 to 2010 the 65+ year-old population increase from ~35 million to ~40 million or cumulative growth of just 15% vs. 36% expected growth for this decade.

 

In Context of Economy: One of the most cost effective ways to keep healthcare spending as a % of GDP in check is the increased and proper usage of prescription drugs (substituting branded for generic when possible) to combat rising medical costs. Only ~12% of total healthcare costs are prescription drugs, which from 2007-2009 grew at a slower rate than overall healthcare costs due to the increased penetration of generic drug volumes. The generic wave coming over the next 5 years will help keep prescription drug spending in check. Beginning in 2014, healthcare reform as is stands today will help provide access to expensive prescription drugs that up to 32 million people cannot currently afford. While this will increase prescription drug spending, this should help combat rising total healthcare costs.


CVS Drugstores

History: CVS built itself into the 2nd largest drugstore chain over the past two decades mainly through acquisition, which accounts for ~73% of its store base. It bought Revco in 1997, Arbor in 1998, Eckerd in 2004, Albertson's Sav-On/Osco in 2006 and Longs in 2008. What it was really buying was a built-in customer base because people tend to be very loyal to their pharmacist/pharmacy. In fact, what CVS did was mainly close down its acquired stores and open up a brand new ones nearby over time. So while it could have grown organically (like WAG mainly did), CEO Tom Ryan figured it would get a better ROIC this way. Ryan was wrong, but he wasn't too far off because from 1996-2010 CVS retail's pre-tax ROIC [defined as growth in EBIT/(acquisitions + capital expenditures - D&A + increase in working capital)] was 14.1% compared to WAG's 16.3%. The only main thing keeping the ROICs from being at parity is that WAG has done a much better job managing its inventory due to its homegrown system. While CVS did a very good job integrating its acquired stores, it did a horrible job integrating the distribution platforms. Until recently CVS was on 7 different inventory management systems. It recently brought it down to 2 and expects to be down to 1 system this year. These additional systems has resulted in there being excess pharmaceutical safety stock held at its drugstores. WAG's inventory net of A/P (FIFO adjusted) is just 6.4% of TTM revenue. CVS retail's inventory net of A/P (based on my estimates by disaggregating Caremark's balance sheet by looking at MHS, ESRX and Caremark's historical filings) is at 13.2%. Thus there's ~$3.9 billion of working capital CVS could potentially take out of the business. Management said it would take $1 billion out in 2011 and another $1 billion out by 2013. About a year ago CVS hired a high-level supply chain executive from WMT to head up this effort.

With ~18% market share, it fills the second most (behind WAG) retail based prescriptions in the U.S.--636 million in 2010. The rest of the retail industry market share roughly breaks down as follows: 21% WAG, 7-8% WMT, 7-8% RAD, 18% independents, 28% other regional chains (including COST and supermarkets such as KR, SWY, SVU). More than half of its store base is new or has been significantly remodeled in the past 5 years.

However, when CVS drugstores are combined with Caremark's mail pharmacy, it is the largest purchaser of generic drugs in the U.S.--and it takes advantage of this scale by buying as one single entity. This is very important. The only drugstore chains in the U.S. that purchase generic drugs directly from the manufacturer (and thus have the distribution infrastructure to do that) are CVS, WAG, WMT and RAD. So ~55% of the industry self-distributes generics while ~45% of the industry buys their generic drugs through a distributor (namely ABC, MCK, CAH). The entire drugstore industry buys its branded drugs through a distributor because there isn't enough volume to justify sourcing them directly. Today 2/3 - 3/4 of all prescriptions dispensed in the U.S. are generic. Why is this so important? Let's look at the economics of the supply chain for branded vs. generic drugs:
 
In an effort to keep things simple I displayed the economics (using rough numbers) the following way because it is important to keep in mind this is a spread business for the distributor, PBM and drugstore.
 
Branded Drug (based on a ~$117.00 30-day supply sold at retail):
 
Drugstore: Makes $11.50 of gross profit
Distributor: Makes $2.50 gross profit
PBM: Makes $2.00 gross profit for adjudicating the claim
Manufacturer: $101.00 revenue (with 80%+ gross margins)
The economics work out this way because the manufacturer captures a majority of the gross profit dollars since it is a price setter (due to a patent protected product). 
 
Here are the economics for the drug when it becomes generic after the 180-day exclusivity window (based on a ~$51 30-day supply sold at retail):
 
Drugstore (that self-distributes--namely CVS & WAG): Makes $16.00 of gross profit (captures the distributor's margin and and is able to garner additional margin from the manufacturer since it has the ability to move market share, which affects the success of a generic manufacturer's drug)
Distributor: Makes $0 of gross profit (no longer part of the equation)
PBM: Makes $7 of gross profit (because it sets the formulary for the payers and there is more money to go around for all of the players in the supply chain)
Manufacturer: $21 of revenue (with 30%+ gross margins)
 
The large market share and footprint CVS has allows it to have a strong negotiating stance with PBMs. Witness the spat WAG had with Caremark this past summer. WAG got an increase in its reimbursement rates--how much wasn't disclosed. The bottom line is that the CVS drugstore chain could always threaten a PBM that it would leave its network if reimbursement rates were too low. This would be very disruptive for many large commercial/government payers, which is why both CVS and WAG drugstore chains have enough negotiating leverage to get a fair rate. The same can't be said for the other 60% of the market--especially the independents.
 
Of the 636 million Rx filled by CVS drugstores in 2010, 464 million were generic and 172 million were branded. The 2010 generic dispensing rate of 73.0% (which was 73.8% in Q4'10) should increase to 86.0% by 2015. Using a 2.5% CAGR of total Rx growth for the CVS drugstore chain over the next 5 years along with consistent rates of branded drug price inflation of 7-8% (in-line with historical rates) should translate into an increase in pharmacy EBITA (excluding the front-end) of ~40% or a CAGR of 6.7%.
 
For the front-end I assume constant operating margins. I assume same store sales for the front-end of 0-1%. In total I assume front-end sales grow in-line with modest inflation and its 2-3% annual square footage increase. This translates into 16% cumulative growth over 5 years or a 3% CAGR for EBITA.
 
In total I expect CVS' drugstore EBITA to conservatively grow a cumulative 31.1% over the next 5 years or a CAGR of 5.6%. Why is this conservative? Management guidance for the CVS drugstores in 2011 is 6-8% operating profit growth in a year that is a lull for generic conversions. 2012 and 2013 will be the biggest years for generic conversions. See pilot72's good write-up on WAG for more information on the future generic drug conversions.
 
Larry Merlo who has managed CVS' operations for the past 13 years is the new CEO. He has $65+ million (his total equity exposure) reasons to make sure CVS reaches its full potential.
 
 
Caremark
 
Caremark is one of the three largest prescription benefit managers (PBMs) in the U.S. along with Medco (MHS) and Express Scripts (ESRX). Each control 15%+ of the market and combined have over half of the U.S. market. A PBM adjudicates Rx claims, sets the formulary (i.e. what prices pharmacies get reimbursed for each drug), garners rebates from branded manufacturers (which it shares with the payers) and fills chronic Rx through its mail pharmacy. A PBM will work with the client to develop a prescription drug coverage plan that works best for the client (payer) and its members (employees). If a client wants to save the most amount of money it can implement incentives to its members to as much mail pharmacy as possible. In some cases a PBM will create a restricted retail network and require mail use on all chronic prescriptions. Simply put a PBM is in essence an insurance company for prescription drug coverage. Many insurance companies have sold (Wellpoint to ESRX) or outsourced (AET to Caremark, UNH to MHS) their PBM because it is a relatively small part of their overall business and they have historically done a poor job managing it due to a lack of attention.
 
CVS bought Caremark in 2006 as part of the now retired CEO Tom Ryan's vision. His view was by combining the two pieces there would be two main synergies. The first is from increased drug purchasing scale of generics for both CVS retail and Caremark. The second is an ability to offer increased savings to its own Caremark clients and members by offering (lower) mail pricing on chronic Rx through its own CVS stores--an offering formally known as Maintenance Choice. It launched this program in Q4'08 and has since seen a nice uptake over the past 2 years. In Q4'08 CVS drugstores had a 19.2% market share of Caremark clients, but now has a 27.7% share and averaged a 26.8% share in 2010. This Maintenance Choice program helps drive comps at CVS retail, which is one main reason why CVS has out comped WAG over the past 2 years. I would expect that CVS can continue to get more Caremark members to switch to a CVS pharmacy given the economic incentives to clients (more savings) and their members (lower co-pays).
 
To highlight the opportunity only 27.3% of its clients are signed up for Maintenance Choice while just 14.0% of its members actually use the service. Management believes it can get the 14% up to 50%+ over time. If you use a 7% incremental penetration rate per year it would take 5-6 years to reach the 50%+ penetration. Currently there are ~210 million chronic Rx it doesn't fill for Caremark members plus another ~210 million acute prescriptions. Thus if a member signs up for Maintenance Choice and decides to pick up their chronic Rx at a CVS drugstore there is an opportunity to gain share in both chronic and acute prescriptions. Also, its recent deal with Aetna gives Caremark another ~50 million of chronic claims (and another ~50 million acute) it can try to convert members to fill through Caremark mail or a CVS retail pharmacy. Thus it's trying to convert a 500+ million pool of Rx that it doesn't currently fill through Caremark mail or a CVS drugstore. Every additional 10 million of Rx filled through Maintenance Choice (via mail or retail pharmacy) represents ~$65 million of incremental profit or a ~1% boost to 2010 company EBITA.
 
A little over one year ago at age 62, Per Lofberg took over Caremark. He came back to the PBM business after leaving it 6 years ago when he was Chairman of Merck-Medco before Medco was spun off. Lofberg was hired two months after the disappointing news that Caremark would lose an additional $2B of contracts on top of $2.5B that had been announced earlier in 2009. Most recently Per was President and CEO of Generation Health. Prior to working at Merck he spent 15 years with BCG in Boston, New York and Munich. Since Per took over he struck a large deal with Aetna to get it to outsource its PBM business to Caremark. The consensus view is that Per is a good operator and will turn around Caremark--we shall see. Per bought $7 million of  stock over the past year at an avg. price of ~$33.60.
 
 
Base Case EPS Estimates
2010: $2.66--excluding a $0.03 tax benefit
2011: $2.78 (11.9x)
2012: $3.25 (10.1x)
2013: $3.70 (8.9x)
2014: $4.21 (7.8x)
2015: $4.68 (7.0x)
 
Base Case Upside (over 2 years): In 2 years the market will be looking at 2013 EPS estimates. If I apply a 13x P/E (~10% discount to WAG's P/E) to my base case $3.70 then CVS would be trading at $48.10. Add in another $1.00+ for 2 years of dividends and one gets a total return of ~50% over 2 years.
 
Free Cash Flow: CVS should generate $4.0+ billion of free cash flow this year, growing to ~$5 billion in 2015. Of that $700+ million will be paid out in dividends per year. At least $2 billion per year will be used to repurchase shares per management's guidance. At analyst day in October, 2010 management said it expected to generate 50%+ of its market cap (currently at the same level) in cash by 2015. I expect 4-5% annual share count reductions per year so long as the share price remains attractive enough for the company to repurchase.
 
 
"Free Call Options"
 
1) In 2014 an additional ~32 million people could gain healthcare (including prescription drugs) coverage. Applying CVS' 18% market share would result in the following: 32 million x 18% x 2 Rx per person x 12 months = 138.2 million prescriptions x $15 gross profit = ~$2.1 billion of incremental pre-tax profit.
 
2) In 2014 Rite Aid has 26% of its debt come due--namely its secured credit facilities. RAD is barely profitable on an EBITA basis and unprofitable on a pre-tax basis. To be able to pay its interest expense it spends less than 1/3 of its D&A on capital expenditures--a very short-term solution as it continues to lose customers to nicer looking CVS and WAG stores. It is a sub-scale operator (~$535 in sales per sq. ft. vs. ~$830 for CVS & WAG) with 7-8% market share, dilapidated stores, a debt laden balance sheet that keeps it from investing in its stores, temp pharmacists and a unionized workforce. It is estimated that it spends half of what CVS and WAG do on labor to run its stores in order to stay afloat. Despite the rumors that WMT might buy RAD, if anything it would make sense to take a run at it in bankruptcy so it can close down poor performing stores with bad locations. Plus WMT stays away from unionized labor, which would appear to be a deal breaker. So if RAD goes bankrupt, CVS stands to gain twice as much as WAG based on their real estate footprint overlap.
 
RAD has ~$25.5 billion in sales. If it were to go bankrupt CVS would at least take its 18% share, but more likely 1/3 given the overlapping footprint. Plus I wouldn't be surprised to see CVS and WAG jointly carve up the carcass of RAD in terms of which stores each would want to acquire as this would help both get around anti-trust.
 
So 1/3 of $25.5 billion in sales = $8.5 billion in sales at say an incremental margin of ~20% (2010 retail pharmacy gross margin was 29.5%). This would equate to ~$1.7 billion of incremental pre-tax profit.
 
Considering 2010 pre-tax income was $5.6 billion, if either one of these options comes through it would certainly move the needle.
 
 
January, 2013 Call Options
 
If you share my view on CVS then an appropriate question to ask is why buy the stock when you can buy in-the-money leaps for barely any premium (including the foregone dividends)? The 1/18/13 call options with a strike price of $25.00 have a bid/ask of $9.05/$9.90. Even if one were to pay the ask the implied annualized premium (including foregone dividends) is just 4.6%! That's because CVS has historically been a low volatile stock with a beta of 0.78. The options maker out of Chicago isn't thinking about the coming generic wave, etc.--he has a computerized formula that spits out what the premium should be. For paying that 4.6% annual premium one gets 3.3x leverage. So if you believe the downside is well protected and you think my ~50% return over 2 years is reasonable then you're much better off buying the leaps as your return would be 133%.

Catalyst

The generic wave, continued market share gains for CVS retail pharmacy and Caremark retaining most of its clients during this year's selling season at normal pricing.
    sort by    

    Description

    I think CVS Caremark is currently one of the most attractive risk-adjusted (factoring in liquidity and downside protection) investment opportunities on an absolute basis, but especially in comparison to the investment alternatives that exist today. I'm going to attempt to keep this write-up as short and simple as possible. Thus I am purposely not going to dive into too many details regarding Caremark, the prescription benefit manager because it would make this investment write-up too long and over complicate things, in my humble opinion. Please feel free to ask questions regarding Caremark and the PBM industry as I'll be happy to answer them in the Q&A.
     
    CVS Caremark is made up of 2 businesses: CVS drugstore chain (~2/3 of profits) and Caremark (~1/3 of profits). To begin to highlight the value, here is how CVS would theoretically be valued today using a sum-of-the-parts based on comp multiples (WAG FIFO adjusted for CVS drugstores and MHS/ESRX for Caremark) using calendar 2011 consensus estimates:
     
    CVS drugstore chain: $26.08 (based on 7.5x EBITDA or 14.3x cash EPS--excludes amortization of intangibles related to acquisitions)
    Caremark: $14.31 (based on 10.2x EBITDA or 15.3x cash EPS--excludes amortization of intangibles related to the acquisition of Caremark)
    CVS Caremark: $40.39 (upside of 22.7%)
    Looking out 2 years I believe CVS is worth at least $48 per share (details shown later) or upside of 50%+ including dividends.
     
     
    Investment Thesis
     
    The focus of this write-up will be on CVS' drugstore business because that is where I am most confident there is tremendous value given a very strong economic moat due to its unmatched scale (the largest purchaser of prescription drugs in the U.S.) and solid earnings growth opportunities (generic wave, growing 65+ year old population, etc.) over the next 5 years that are as close to guaranteed as I've ever seen. I do believe that CVS Caremark has a unique, integrated retail/PBM model that will ultimately prove itself successful (more on that later). Also, one gets 2 "free call options" that could hit in ~2014 and be quite material to CVS' earnings power.
     
    The CVS drugstore business is a compounder. Since half of all retail prescriptions administered are unplanned, physical pharmacies are required for just-in-time dispensing. It would be extremely difficult for most large organizations to have a prescription drug plan that excludes either Walgreens or CVS for dispensing prescriptions. Because CVS (as well as WAG) has such a large footprint that would be near impossible (and take many years) to replicate, it is an essential part of drug distribution and as a result will continue to have a relatively dominant negotiating position vis-à-vis other players in the supply chain. Also, the shift of scripts to the PBM mail channel has barely increased over the past 5 years, which strongly suggests bricks & mortar will continue to be the main end-point of delivery.
     
    One of the best parts about an investment in CVS at the current price is that your downside is well protected. Even if you believe Caremark's business is worthless (hardly the case) and you want to assign a 10% discount to CVS drugstores (compared to WAG because one believes there is more margin expansion opportunity there due to a more immature store base) then CVS is worth $23.50 or immediate downside of -28.7%. To me this is a very extreme downside case as CVS would be trading at 8.5x 2011E EPS, but nonetheless one can use this as a worst case scenario.
     
    In fact, if one were to hedge out the PBM exposure by shorting MHS and/or ESRX at their current valuations, one would theoretically be creating the CVS drugstore business at 10x 2011 earnings. Clearly, there are risks to doing this--mainly that Caremark loses customers to MHS and/or ESRX. But on the flip side one would get a hedge against the PBM multiples contracting as well as protect against industry pricing/margins from contracting. I'm not necessarily advocating one short part or all of the PBM exposure, but am simply highlighting the implied valuation of the CVS drugstore business. Market leading businesses with industry growth tailwinds don't normally trade for 10x earnings.
     
    Without a hedge, CVS trades at 12x 2011E EPS and 10x 2012E EPS.
     
     
    Drugstore Chain Economics
     
    Drugstores are a very good, recurring revenue business. They are necessary because about half of all prescriptions are prescribed on an as needed basis. Thus enough inventories, which take up little room, must be kept at the local store to be able to execute fills with little notice. Also, since many people still prefer to pick-up their chronic prescriptions at a local retail pharmacy, this allows the drugstore at least 4-12+ (depending on monthly or 90+ day fill) opportunities per year to sell the customer front-end merchandise.

    About 2/3 of the CVS drugstore chain's sales and operating profits are made from filling customers’ prescriptions. All prescription drugs are sold to individuals who (or their guardians) make the choice of where to get their prescriptions filled. But certain insurance plans or companies can restrict which pharmacies one can go to. The payer mix by customer type is 66.9% insurance, 16.7% Medicare, 6.9% Medicaid, 6.5% other government and 3.0% self. However, mainly due to co-pays, the sales based on dollars paid are: 53.4% insurance, 21.4% out-of-pocket, 13.4% Medicare, 6.6% Medicaid and 5.2% other government.

    CVS buys branded drugs from one of the 3 large distributors where it has enough negotiating leverage given its respective market share to garner a better price than independent pharmacies. It buys most generic drugs directly from manufacturers because it has enough scale in its end markets to self-distribute and because its purchasing power allows it to negotiate directly with generic manufacturers to get the best price possible. In contrast, independent pharmacies don’t have that ability and thus buy their generic drugs from a distributor. Distributors claim that their average contribution margin per generic prescription is well over $3—a margin that only large chains are able to keep for themselves.

    While just over 70% of prescription unit volume is made up of generic drugs it represents about 3/4 of pharmacy profits, but just 1/3 of prescription sales since the average generic drug price is about 40% of the price of a branded equivalent. Retail pharmacy chains make on average about 40% higher gross profit dollars per generic prescription compared to the average branded drug. This is because regarding branded drugs the retailer is generally a price taker since there is usually only one or two manufacturers. However, most generic drugs have multiple manufacturers, which allow a large retailer such as WAG/CVS/RAD/WMT that self-distributes generic drugs the ability to work with the insurance company/PBM to set a formulary, which can steer customers to a particular generic drug that has equal efficacy as the branded or other generic counterpart.

    Since 97% of prescriptions are paid via insurance/PBM/Medicare/Medicaid plans, pharmacies typically receive the same price per prescription. The only exception is that large chains have the ability to get rebates on branded drugs (when there are at least 2 equal efficacy drugs) and discounts on generic multi-manufactured (equal efficacy) drugs since they have the ability to move market share. Independents cannot do this. Thus independent pharmacies in general have lower operating margins because their drug acquisition costs are higher along with pricing (net of rebates and discounts) that is lower than a large pharmacy chain. If the government forces drug prices to get cut across the supply chain, independent pharmacies will be hurt the most and likely accelerate their market share losses.

    Despite ~90% of an average CVS store’s square footage is dedicated to front-end merchandise, only 1/3 of its sales and operating profits come from this. While the front-end contributes ~40% of gross profit, it is less on an operating profit basis because a greater portion of indirect costs such as rent are allocated to this segment. Both chains have tried a much smaller format in the past, but customers like the convenience of being able to buy consumer staples from drugstores. CVS' prices are generally in-line with supermarkets’ prices, but are about 20% more expensive than Wal-Mart’s prices. Independent pharmacies typically have much smaller front-end areas as they don’t have the systems and distribution infrastructure to manage the thousands of SKUs CVS stores sell to its customers.

    WAG and CVS have the best return on capital in the industry for a few main reasons: 1) Size and scale allow them to buy drugs at the best price possible from distributors and generic manufacturers; 2) Size and scale allow each to leverage its distribution network as effectively as possible; 3) Size and scale allow it to buy general merchandise at relatively favorable prices and have an effective private label strategy; 4) Sales per square foot is significantly higher than the competition, which allows it to leverage its fixed costs better.


     

    Competitive Analysis

    CVS has a sustainable and growing cost advantage due to its large scale/market share, self-distribution of generic drugs (costs itself at least ~$3 less per generic vs. the avg. branded script) and being the 2nd largest purchaser/seller of drugs in the U.S. behind CVS Caremark. There are still independent pharmacies and other weaker competitors such as Rite Aid, but they are continuously losing share to CVS & WAG due to inferior merchandising/size of stores, inferior locations, lack of capital to refresh stores and a lack of scale on drug purchases along with no self-distribution of generics.

    Independent pharmacies must compete with better service because they cannot win on price since they are price takers. The large retail chains have better negotiating leverage with the major drug distributors than do independent pharmacies. Over time the large chains such as CVS, WAG and WMT continuously gain a little bit more of a negotiating advantage since they continue to gain market share. But at the end of the day the retailers with large market share are negotiating against three distributors that each has 25% - 35% share that make up 95% of the market. Thus a large retailer and distributor have approximately equal negotiating leverage.

    There are two types of customers—direct and indirect. The direct customers are the individuals that consume the prescription and thus make the ultimate decision as to where to fill it. They make their choice based on service, convenience as well as selection and price of front-end merchandise. The indirect customer is the payer (companies using PBMs/insurance plans, Medicare and Medicaid) that is responsible for a majority of the dollars spent on prescriptions. The larger the payer is compared to the retail pharmacy, the more negotiating leverage it has with the retail pharmacy to get a better split of the revenue since it can threaten to exclude it from the network. Since most payers cannot pose that threat to a large retailer, CVS has the ability to get the best split possible. The only example of a payer having exerted influence over a retailer on price was Caterpillar’s decision to set its own retail network made up of just WMT and WAG. In exchange for guaranteeing each a certain level of volume CAT believes this (along with setting its own formulary) allows it to garner better drug prices than it would through using a PBM. If more large U.S. companies do this, then the largest chains would benefit at the expense of independent pharmacies.

    While WMT is a major threat to many traditional retailers, drug distribution is not one of them as it stands today. First, WMT (including Sam’s Clubs & Neighborhood Markets) has less than 4,500 stores. Thus it does not have as large of a footprint as WAG or CVS, which each has over 7,000 stores. At the same time, WAG & CVS have locations in various urban markets where WMT does not have a presence and in markets where it does, WAG & CVS typically have more convenient, often premium “corner” locations—not to mention smaller stores that are easier to get in and out of. Second, as a result of having significantly fewer locations and less than half the prescription volume of WAG or CVS, it cannot command a better price from generic manufacturers than WAG or CVS since it buys much less drugs. Third, about 75% of drug spend mix is on branded drugs. WMT has no cost advantage on buying branded drugs from a distributor since a majority of the acquisition cost is set by the branded drug manufacturer, which typically has a monopoly/duopoly position. So while WMT made a big splash with its entry into the pharmacy industry in October, 2006 with $4 generics on 300+ drugs, this did not impact WAG’s or CVS’ business in a material way. If anything, it likely expanded the market by making generic drugs more affordable to those who do not have health insurance—many of whom are likely WMT customers.

    The only major threat of substitution is the shift of chronic scripts being ordered from mail instead of picked up at retail. Both CVS and WAG have their own mail facilities. So long as each retains its customer’s orders, it does not make a major difference from which channel the script is filled. The reason is because while mail pharmacy charges a lower price for a 90-day equivalent of 3 monthly fills, there are lower costs from two fewer dispensing fees and a portion of labor being replaced by machine automation. If the U.S. moved this way in a material manner the drugstore industry could rationalize its base over time to keep its store overhead in-line with retail sales volumes. The other potential negative would be that it could lose some front-end sales that occur when people come into the drugstore to pick up these prescriptions. Mail pharmacy penetration currently stands at ~18% on 30-day equivalent supplies. Mail pharmacy is mainly used for chronic prescriptions (i.e. Lipitor) so mail pharmacy has ~36% share of the U.S. chronic prescriptions. Nevertheless, mail penetration has barely grown over the past 6 years. This is because many 65+ year-olds (who consume the most chronic Rx) prefer to pick-up their prescriptions from a retail pharmacy.

    One potential threat to WAG's (and other pharmacies’) business is CVS Caremark’s maintenance choice offering to its PBM customers. This allows its customers to pick up 90-day scripts at its stores for the same price (due to lower co-pays) as getting it through the mail since there are two fewer dispensing fees. However, WAG offers its customers 90-day scripts as well, but not at mail pricing since it does not own a PBM and thus must allow this middleman to make a fee for processing the claim. Mail pricing for a 90-day fill is typically $5-$10 less than the equivalent 3-month supply at retail—not enough of an incentive for most to change their buying habits.

     

     

     

    Industry Outlook

    The drugstore industry continues to consolidate—a trend that has been going on for over a decade. CVS has been a continual acquirer of regional pharmacies—most recently buying Longs and prior to that, Sav-on/Osco. Walgreens bought Duane Reade on 2/17/10. Rite Aid’s most recent purchase was Brooks/Eckerd and prior to that, Thrifty PayLess. At the same time WMT along with other strong retailers such as Target continue to take market share as they open up more pharmacies within new and existing stores. As time goes on this continual consolidation should incrementally shift power within the supply chain to the largest pharmacies.

    Over the past 17 years drugstore chains have taken 22% market share from independent pharmacies—averaging about 1.3% per year. This coincides with the strong same store sales increases from WAG and CVS over that time. While share gains slowed to 0.5% per year in 2004-2008, it reaccelerated in 2009 with a 3.0% gain. The recession put pressure on pharmacies’ front-end, which likely forced more independents out of business when that profit center diminished.

     

    Tailwinds: The significant number of branded drugs coming off patent into 2015 should help provide a boost to profitability for large drugstore chains since the avg. generic drug carries ~40% higher gross profit dollars per prescription vs. its branded counterpart.

     

    By 2020 there should be almost 55 million people over the age of 65 in the U.S. compared to ~40 million today. The 3.1% CAGR of the 65+ U.S. population over the next 10 years should translate into about a 1% per annum growth in drug consumption since the average 75-year old living independently consumes 4.2 scripts (and 8.1 scripts living in an assisted living/skilled nursing facility) vs. 1.1 for the average American. It is worth noting that from 2000 to 2010 the 65+ year-old population increase from ~35 million to ~40 million or cumulative growth of just 15% vs. 36% expected growth for this decade.

     

    In Context of Economy: One of the most cost effective ways to keep healthcare spending as a % of GDP in check is the increased and proper usage of prescription drugs (substituting branded for generic when possible) to combat rising medical costs. Only ~12% of total healthcare costs are prescription drugs, which from 2007-2009 grew at a slower rate than overall healthcare costs due to the increased penetration of generic drug volumes. The generic wave coming over the next 5 years will help keep prescription drug spending in check. Beginning in 2014, healthcare reform as is stands today will help provide access to expensive prescription drugs that up to 32 million people cannot currently afford. While this will increase prescription drug spending, this should help combat rising total healthcare costs.


    CVS Drugstores

    History: CVS built itself into the 2nd largest drugstore chain over the past two decades mainly through acquisition, which accounts for ~73% of its store base. It bought Revco in 1997, Arbor in 1998, Eckerd in 2004, Albertson's Sav-On/Osco in 2006 and Longs in 2008. What it was really buying was a built-in customer base because people tend to be very loyal to their pharmacist/pharmacy. In fact, what CVS did was mainly close down its acquired stores and open up a brand new ones nearby over time. So while it could have grown organically (like WAG mainly did), CEO Tom Ryan figured it would get a better ROIC this way. Ryan was wrong, but he wasn't too far off because from 1996-2010 CVS retail's pre-tax ROIC [defined as growth in EBIT/(acquisitions + capital expenditures - D&A + increase in working capital)] was 14.1% compared to WAG's 16.3%. The only main thing keeping the ROICs from being at parity is that WAG has done a much better job managing its inventory due to its homegrown system. While CVS did a very good job integrating its acquired stores, it did a horrible job integrating the distribution platforms. Until recently CVS was on 7 different inventory management systems. It recently brought it down to 2 and expects to be down to 1 system this year. These additional systems has resulted in there being excess pharmaceutical safety stock held at its drugstores. WAG's inventory net of A/P (FIFO adjusted) is just 6.4% of TTM revenue. CVS retail's inventory net of A/P (based on my estimates by disaggregating Caremark's balance sheet by looking at MHS, ESRX and Caremark's historical filings) is at 13.2%. Thus there's ~$3.9 billion of working capital CVS could potentially take out of the business. Management said it would take $1 billion out in 2011 and another $1 billion out by 2013. About a year ago CVS hired a high-level supply chain executive from WMT to head up this effort.

    With ~18% market share, it fills the second most (behind WAG) retail based prescriptions in the U.S.--636 million in 2010. The rest of the retail industry market share roughly breaks down as follows: 21% WAG, 7-8% WMT, 7-8% RAD, 18% independents, 28% other regional chains (including COST and supermarkets such as KR, SWY, SVU). More than half of its store base is new or has been significantly remodeled in the past 5 years.

    However, when CVS drugstores are combined with Caremark's mail pharmacy, it is the largest purchaser of generic drugs in the U.S.--and it takes advantage of this scale by buying as one single entity. This is very important. The only drugstore chains in the U.S. that purchase generic drugs directly from the manufacturer (and thus have the distribution infrastructure to do that) are CVS, WAG, WMT and RAD. So ~55% of the industry self-distributes generics while ~45% of the industry buys their generic drugs through a distributor (namely ABC, MCK, CAH). The entire drugstore industry buys its branded drugs through a distributor because there isn't enough volume to justify sourcing them directly. Today 2/3 - 3/4 of all prescriptions dispensed in the U.S. are generic. Why is this so important? Let's look at the economics of the supply chain for branded vs. generic drugs:
     
    In an effort to keep things simple I displayed the economics (using rough numbers) the following way because it is important to keep in mind this is a spread business for the distributor, PBM and drugstore.
     
    Branded Drug (based on a ~$117.00 30-day supply sold at retail):
     
    Drugstore: Makes $11.50 of gross profit
    Distributor: Makes $2.50 gross profit
    PBM: Makes $2.00 gross profit for adjudicating the claim
    Manufacturer: $101.00 revenue (with 80%+ gross margins)
    The economics work out this way because the manufacturer captures a majority of the gross profit dollars since it is a price setter (due to a patent protected product). 
     
    Here are the economics for the drug when it becomes generic after the 180-day exclusivity window (based on a ~$51 30-day supply sold at retail):
     
    Drugstore (that self-distributes--namely CVS & WAG): Makes $16.00 of gross profit (captures the distributor's margin and and is able to garner additional margin from the manufacturer since it has the ability to move market share, which affects the success of a generic manufacturer's drug)
    Distributor: Makes $0 of gross profit (no longer part of the equation)
    PBM: Makes $7 of gross profit (because it sets the formulary for the payers and there is more money to go around for all of the players in the supply chain)
    Manufacturer: $21 of revenue (with 30%+ gross margins)
     
    The large market share and footprint CVS has allows it to have a strong negotiating stance with PBMs. Witness the spat WAG had with Caremark this past summer. WAG got an increase in its reimbursement rates--how much wasn't disclosed. The bottom line is that the CVS drugstore chain could always threaten a PBM that it would leave its network if reimbursement rates were too low. This would be very disruptive for many large commercial/government payers, which is why both CVS and WAG drugstore chains have enough negotiating leverage to get a fair rate. The same can't be said for the other 60% of the market--especially the independents.
     
    Of the 636 million Rx filled by CVS drugstores in 2010, 464 million were generic and 172 million were branded. The 2010 generic dispensing rate of 73.0% (which was 73.8% in Q4'10) should increase to 86.0% by 2015. Using a 2.5% CAGR of total Rx growth for the CVS drugstore chain over the next 5 years along with consistent rates of branded drug price inflation of 7-8% (in-line with historical rates) should translate into an increase in pharmacy EBITA (excluding the front-end) of ~40% or a CAGR of 6.7%.
     
    For the front-end I assume constant operating margins. I assume same store sales for the front-end of 0-1%. In total I assume front-end sales grow in-line with modest inflation and its 2-3% annual square footage increase. This translates into 16% cumulative growth over 5 years or a 3% CAGR for EBITA.
     
    In total I expect CVS' drugstore EBITA to conservatively grow a cumulative 31.1% over the next 5 years or a CAGR of 5.6%. Why is this conservative? Management guidance for the CVS drugstores in 2011 is 6-8% operating profit growth in a year that is a lull for generic conversions. 2012 and 2013 will be the biggest years for generic conversions. See pilot72's good write-up on WAG for more information on the future generic drug conversions.
     
    Larry Merlo who has managed CVS' operations for the past 13 years is the new CEO. He has $65+ million (his total equity exposure) reasons to make sure CVS reaches its full potential.
     
     
    Caremark
     
    Caremark is one of the three largest prescription benefit managers (PBMs) in the U.S. along with Medco (MHS) and Express Scripts (ESRX). Each control 15%+ of the market and combined have over half of the U.S. market. A PBM adjudicates Rx claims, sets the formulary (i.e. what prices pharmacies get reimbursed for each drug), garners rebates from branded manufacturers (which it shares with the payers) and fills chronic Rx through its mail pharmacy. A PBM will work with the client to develop a prescription drug coverage plan that works best for the client (payer) and its members (employees). If a client wants to save the most amount of money it can implement incentives to its members to as much mail pharmacy as possible. In some cases a PBM will create a restricted retail network and require mail use on all chronic prescriptions. Simply put a PBM is in essence an insurance company for prescription drug coverage. Many insurance companies have sold (Wellpoint to ESRX) or outsourced (AET to Caremark, UNH to MHS) their PBM because it is a relatively small part of their overall business and they have historically done a poor job managing it due to a lack of attention.
     
    CVS bought Caremark in 2006 as part of the now retired CEO Tom Ryan's vision. His view was by combining the two pieces there would be two main synergies. The first is from increased drug purchasing scale of generics for both CVS retail and Caremark. The second is an ability to offer increased savings to its own Caremark clients and members by offering (lower) mail pricing on chronic Rx through its own CVS stores--an offering formally known as Maintenance Choice. It launched this program in Q4'08 and has since seen a nice uptake over the past 2 years. In Q4'08 CVS drugstores had a 19.2% market share of Caremark clients, but now has a 27.7% share and averaged a 26.8% share in 2010. This Maintenance Choice program helps drive comps at CVS retail, which is one main reason why CVS has out comped WAG over the past 2 years. I would expect that CVS can continue to get more Caremark members to switch to a CVS pharmacy given the economic incentives to clients (more savings) and their members (lower co-pays).
     
    To highlight the opportunity only 27.3% of its clients are signed up for Maintenance Choice while just 14.0% of its members actually use the service. Management believes it can get the 14% up to 50%+ over time. If you use a 7% incremental penetration rate per year it would take 5-6 years to reach the 50%+ penetration. Currently there are ~210 million chronic Rx it doesn't fill for Caremark members plus another ~210 million acute prescriptions. Thus if a member signs up for Maintenance Choice and decides to pick up their chronic Rx at a CVS drugstore there is an opportunity to gain share in both chronic and acute prescriptions. Also, its recent deal with Aetna gives Caremark another ~50 million of chronic claims (and another ~50 million acute) it can try to convert members to fill through Caremark mail or a CVS retail pharmacy. Thus it's trying to convert a 500+ million pool of Rx that it doesn't currently fill through Caremark mail or a CVS drugstore. Every additional 10 million of Rx filled through Maintenance Choice (via mail or retail pharmacy) represents ~$65 million of incremental profit or a ~1% boost to 2010 company EBITA.
     
    A little over one year ago at age 62, Per Lofberg took over Caremark. He came back to the PBM business after leaving it 6 years ago when he was Chairman of Merck-Medco before Medco was spun off. Lofberg was hired two months after the disappointing news that Caremark would lose an additional $2B of contracts on top of $2.5B that had been announced earlier in 2009. Most recently Per was President and CEO of Generation Health. Prior to working at Merck he spent 15 years with BCG in Boston, New York and Munich. Since Per took over he struck a large deal with Aetna to get it to outsource its PBM business to Caremark. The consensus view is that Per is a good operator and will turn around Caremark--we shall see. Per bought $7 million of  stock over the past year at an avg. price of ~$33.60.
     
     
    Base Case EPS Estimates
    2010: $2.66--excluding a $0.03 tax benefit
    2011: $2.78 (11.9x)
    2012: $3.25 (10.1x)
    2013: $3.70 (8.9x)
    2014: $4.21 (7.8x)
    2015: $4.68 (7.0x)
     
    Base Case Upside (over 2 years): In 2 years the market will be looking at 2013 EPS estimates. If I apply a 13x P/E (~10% discount to WAG's P/E) to my base case $3.70 then CVS would be trading at $48.10. Add in another $1.00+ for 2 years of dividends and one gets a total return of ~50% over 2 years.
     
    Free Cash Flow: CVS should generate $4.0+ billion of free cash flow this year, growing to ~$5 billion in 2015. Of that $700+ million will be paid out in dividends per year. At least $2 billion per year will be used to repurchase shares per management's guidance. At analyst day in October, 2010 management said it expected to generate 50%+ of its market cap (currently at the same level) in cash by 2015. I expect 4-5% annual share count reductions per year so long as the share price remains attractive enough for the company to repurchase.
     
     
    "Free Call Options"
     
    1) In 2014 an additional ~32 million people could gain healthcare (including prescription drugs) coverage. Applying CVS' 18% market share would result in the following: 32 million x 18% x 2 Rx per person x 12 months = 138.2 million prescriptions x $15 gross profit = ~$2.1 billion of incremental pre-tax profit.
     
    2) In 2014 Rite Aid has 26% of its debt come due--namely its secured credit facilities. RAD is barely profitable on an EBITA basis and unprofitable on a pre-tax basis. To be able to pay its interest expense it spends less than 1/3 of its D&A on capital expenditures--a very short-term solution as it continues to lose customers to nicer looking CVS and WAG stores. It is a sub-scale operator (~$535 in sales per sq. ft. vs. ~$830 for CVS & WAG) with 7-8% market share, dilapidated stores, a debt laden balance sheet that keeps it from investing in its stores, temp pharmacists and a unionized workforce. It is estimated that it spends half of what CVS and WAG do on labor to run its stores in order to stay afloat. Despite the rumors that WMT might buy RAD, if anything it would make sense to take a run at it in bankruptcy so it can close down poor performing stores with bad locations. Plus WMT stays away from unionized labor, which would appear to be a deal breaker. So if RAD goes bankrupt, CVS stands to gain twice as much as WAG based on their real estate footprint overlap.
     
    RAD has ~$25.5 billion in sales. If it were to go bankrupt CVS would at least take its 18% share, but more likely 1/3 given the overlapping footprint. Plus I wouldn't be surprised to see CVS and WAG jointly carve up the carcass of RAD in terms of which stores each would want to acquire as this would help both get around anti-trust.
     
    So 1/3 of $25.5 billion in sales = $8.5 billion in sales at say an incremental margin of ~20% (2010 retail pharmacy gross margin was 29.5%). This would equate to ~$1.7 billion of incremental pre-tax profit.
     
    Considering 2010 pre-tax income was $5.6 billion, if either one of these options comes through it would certainly move the needle.
     
     
    January, 2013 Call Options
     
    If you share my view on CVS then an appropriate question to ask is why buy the stock when you can buy in-the-money leaps for barely any premium (including the foregone dividends)? The 1/18/13 call options with a strike price of $25.00 have a bid/ask of $9.05/$9.90. Even if one were to pay the ask the implied annualized premium (including foregone dividends) is just 4.6%! That's because CVS has historically been a low volatile stock with a beta of 0.78. The options maker out of Chicago isn't thinking about the coming generic wave, etc.--he has a computerized formula that spits out what the premium should be. For paying that 4.6% annual premium one gets 3.3x leverage. So if you believe the downside is well protected and you think my ~50% return over 2 years is reasonable then you're much better off buying the leaps as your return would be 133%.

    Catalyst

    The generic wave, continued market share gains for CVS retail pharmacy and Caremark retaining most of its clients during this year's selling season at normal pricing.

    Messages


    SubjectSequoia Sells WAG
    Entry03/08/2011 12:06 AM
    Memberrhg
    Sequoia Fund had been a long time shareholder of WAG but they sold in the last quarter. In their quarterly report, they comment the following:
     
    "We also sold our long-time holding in Walgreen during 2010. Simply put, we believe the economics of the drug store business have deteriorated in recent years as the pharmacy benefit managers, or PBMs, have been successful at reducing the reimbursement paid to pharmacies for dispensing prescriptions, and at enticing patients to fill long-term prescriptions via mail order services operated by the PBMs. Despite consistent sales growth in recent years, Walgreen's operating margin has steadily receded since 2007 and its earnings have barely grown. The company should benefit in the short-term from a wave of new generic drug introductions. New generic drugs are initially quite profitable for pharmacies as payers offer incentives to convert patients from branded medicines. In the longer-term, however, it must find a way to stop the slide in its operating margin."
     
    Any thoughts? 

    SubjectRE: RE: Sequoia Sells WAG
    Entry03/09/2011 02:14 PM
    Memberrhg
    I agree with your analysis. I see how WAG/CVS are in better negotiating position with the PBMs and manufacturers with the oncoming wave of generics.
     
    It makes me think, based on the recent event of WAG with Caremark, that Caremark's business will probably continue to see these kinds of pressures from WAG/WMT going forward. It also seems that your thesis about CVS should be applicable to WAG. Why not invest in WAG instead of CVS? I have not looked at the latest numbers from WAG. Is it not as attractive as CVS?
     
    Thanks for the write up.

    SubjectQuestions about synergies of merger
    Entry03/12/2011 01:11 PM
    Memberrhg

    natey1015,

    As you may know, FTC has launched an investigation on the business practices of Caremark. Through Caremark, CVS potentially has access to the most competitively sensitive information of rival pharmacies including the identity of their customers and prescribers, the drugs prescribed, the cost of the drugs, the amount of drugs acquired, the drug acquisition cost, and the reimbursement amount. By owning Caremark, CVS controls reimbursement for a substantial segment of reimbursement for its rivals. In no other industry does a rival have this type of control or access to this type of information of its rivals. A similar vertical integration in the 90s happened when the manufacturers acquired PBMs - the most notable one being Merck/Medco. FTC eventually raised walls between the two units, and then Merck eventually spun-off Medco.

    (1) Did Caremark's clients decide to switch to other PBMs because they perceived the merger as representing a conflict of interest? Is this one reason why Caremark has had difficulty to win business over? Maybe their potential clients think - "How could a PBM successfully negotiate with the other pharmacies in the network if its primary goal is drive customers to its CVS stores. I want to ensure that we have cost savings but also an open network with more choices than just CVS. The other PBMs can offer similar savings, so why go with someone that represents a conflict of interest". What do you think?

    (2) The management has been very promotional in its conference calls touting the merger and its benefits. It's not very clear to me how the PBM business benefits in any way from the merger. The numbers clearly show that the business has been struggling for more than 3 years since the merger. Because of its integration issues, its not focusing on growth areas that Medco is - like international growth. So, it almost seems like CVS is benefiting from the merger through improved SSS relative to the rest of the industry but at the cost of cannibalizing PBM's mail order transactions and the merger is taking away focus of PBM's management from growth initiatives to integration issues. In Per Lofberg's words: "given all of the challenges we have to work on here domestically." At the same time, Medco is going international.

    (2) Looking at SSS numbers, CVS outperformed WAG possibly because of the maintenance choice program driving customers to its stores. Do you know what SSS numbers would look like had it not been for Caremark. I am trying to understand if there are key drivers on the retail side that are different from those of WAG other than the maintenance choice. If FTC uses the Merck/Medco case to raise walls by may be forcing it to discontinue the maintenance choice program or even breaking the merger , what would it do the CVS SSS. Why would CVS's business perform better than that of WAG in such a case?

    (3) In your post, you say that the older generation prefers to go to the pharmacy instead of receiving their chronic medications through the mail-order channel. But, one could also look at this way. Older people prefer to stay at home rather than wait in lines at pharmacy. I guess do you have data that shows this assumption to be true. Also, I read a study that showed that this your assumption is not quite true. "Revealed preference for community and mail service pharmacy", JAPha, Jan-Feb 2011.

    I understand that the you may agree with all of the above, and say that CVS at today's price is very attractive. I don't question that. I am just trying to understand the business economics. Also, I am new to this industry and reading up on it, so this may all sound obviously incorrect to someone experienced in this industry, but it isn't to me. So, excuse me if I am not understanding something that is basic/obvious to an experienced individual in this industry. 

    Thanks -rhg


    SubjectRE: RE: Questions about synergies of merger
    Entry03/14/2011 02:08 AM
    Memberrhg
    natey1015,
     
    Your responses make sense.
     
    I have one follow-up question. I look at the top-line data at IMS Health for US Channel Distribution by $ and it shows that mail service has grown from 38.3$ billion to 51.5$ billion from 2005 to 2009 i.e 34% growth i.e. 6.1% CAGR growth, but chain store $ have grown from 83.6$ billion in 2005 to 105.5$ billion in 2009 i.e 4.75% CAGR growth.  
     
    Can you clarify "mail penetration has not grown in the past 5-6 years"? Am I not interpreting the information published at IMS Health correctly in the context that you are talking about?
     
    Thanks
    rhg

    SubjectRE: RE: RE: Questions about synergies of merger
    Entry03/14/2011 02:30 AM
    Memberrhg

    I think I have the answer to my question. Correct me if I am wrong here.

    Is it that I am supposed to look at prescription dispensed numbers instead of $s because $ can be skewed by specialty drugs that expensive. Also, when I look at numbers for prescriptions dispensed, should I be adjusting it by 3 to compare to those at chain stores?

    http://www.imshealth.com/deployedfiles/imshealth/Global/Content/StaticFile/Top_Line_Data/Channel%20Distribution%20by%20U.S.%20RXs.pdf


    SubjectQuestion about the generics wave
    Entry03/29/2011 01:43 PM
    Memberrhg
    I am strugging to understand how the upcoming generics wave helps in terms of growth in gross dollars. I know that generics are very profitable for the chains but in terms of dollars aren't the generics only replacing the lost gross dollars from the busted branded drugs? I can see how the it probably leads to increased utilization through higher GDR, but if we don't account for it, where does the growth in gross dollars come from?
     
    Here is data from OIG's report for payments made by Medicare Part D to independent pharmacies:
     
    Brand-name drugs
    Part D Revenue per Script = $127.49
    Part D Gross Profit per Script = $11.29
    Part D Gross Margin per Script = 8.9%

    Generic Drugs
    Part D Revenue per Script = $23.92
    Part D Gross Profit per Script = $11.48
    Part D Gross Margin per Script = 48.0%
     
    Source: http://www.drugchannels.net/2008/01/pharmacy-profits-part-d.html
     
    Can you quantify roughly how much of an impact, in terms of gross dollars, the upcoming generics wave can have on the dispensing business?
     
     

    SubjectRE: Question about the generics wave
    Entry03/29/2011 02:15 PM
    Memberrhg
    I forgot to mention that I do understand how pharmacies benefit in the exclusitivity period. My question is more about the profitability after the period ends as compared to the branded drugs before the patent loss (in actual dollar terms).
     
    Thanks

    SubjectRE: RE: PBM GP on Generics
    Entry07/05/2012 01:49 PM
    Membertyler939
    Just in general, does it make sense to anyone that the new SXC is trading at around twice the PE (to analyst 2013 combined earnings estimates) as ESRX is?  I understand that SXC has some potential for growth from its IT platform, but I think ESRX has a huge economy of scale advantage at around 30% of all PBM scripts versus less than 10% for SXC/Catalyst.

    SubjectAttractive here?
    Entry06/22/2016 08:59 PM
    MemberBluegrass

    Trading at 14x forward earnings after declining 15% over the prior year, is this an attractive entry point? Good mgmt, best business model in ecosytem, balanced and focused capital allocation, supporting secular trends (aging population, higher % of population gaining insurance coverage, shortage of MDs + higher costs driving patients away from traditional care setting, ongoing focus on system wide cost reduction) continue unabated. Meanwhile you have Walgreens and McKesson tied up with their own acquisition integrations, ESRX distracted and not likely a merger partner (at least near term) for anyone, and Congress threatening to block proposed managed care consolidation. The co has also fully lapped its SSS pressure from independently choosing to remove nicotine products from retail.

    What has changed, for better or worse, re the CVS investment thesis since the original writeup? 


    SubjectRe: Re: Attractive here?
    Entry11/12/2016 03:05 PM
    Memberxds68

    Natey, after 3q cvs results, do you still think chain is agnostic on mail vs. in store fills? My sense is in store gross margins are substantially higher - is your thought that EBITDA margins are similar given lower sg&a on mail?

    If that's your thinking, i think the in store fixed cost leverage was under appreciated pre-3q. Does 3q result change your view on cvs' ability to absorb a large share shift to mail? 

    Also, any thoughts on the restricted network news? My thought is that with 2 major nationals and a much weaker number 3, this industry is better positioned than most to hold pricing. I'm more concerned by the mail risk though, long term.

      Back to top