|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|
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.
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.
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.
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.
|Subject||Sequoia Sells WAG|
|Entry||03/08/2011 12:06 AM|
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."
|Subject||RE: RE: Sequoia Sells WAG|
|Entry||03/09/2011 02:14 PM|
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.
|Subject||Questions about synergies of merger|
|Entry||03/12/2011 01:11 PM|
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. "
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.
|Subject||RE: RE: Questions about synergies of merger|
|Entry||03/14/2011 02:08 AM|
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?
|Subject||RE: RE: RE: Questions about synergies of merger|
|Entry||03/14/2011 02:30 AM|
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?
|Subject||Question about the generics wave|
|Entry||03/29/2011 01:43 PM|
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:
Part D Revenue per Script = $127.49
Part D Gross Profit per Script = $11.29
Part D Gross Margin per Script = 8.9%
Part D Revenue per Script = $23.92
Part D Gross Profit per Script = $11.48
Part D Gross Margin per Script = 48.0%
Can you quantify roughly how much of an impact, in terms of gross dollars, the upcoming generics wave can have on the dispensing business?
|Subject||RE: Question about the generics wave|
|Entry||03/29/2011 02:15 PM|
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).
|Subject||RE: RE: PBM GP on Generics|
|Entry||07/05/2012 01:49 PM|
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.
|Entry||06/22/2016 08:59 PM|
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?
|Subject||Re: Re: Attractive here?|
|Entry||11/12/2016 03:05 PM|
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.
|Subject||Short to zero?|
|Entry||10/17/2017 09:56 AM|
Just kidding. I re-read their annual report over the weekend and scanned all of the industry's recent presentation transcripts for any discussion of Amazon. Rather than discuss every element of their moat, I'll just say in summary it sure doesn't seem like a business that can easily be disrupted by a newcomer, although I concede that Amazon more than anyone has the staying power to lose money as long as it takes to breach the moat. But even if it's possible, and it doesn't seem like it would be very easy, wouldn't it take a number of years? In the mean time, CVS is trading at 11.4x 2016 consensus EPS and has a buyback in place equal to 20% of the market cap. The multiple isn't that far above many retailers and I would submit this business has a much stronger moat. It's also yielding close to 3% and will probably raise the dividend again next quarter. The CEO owns a ton of stock. Their main competitor is no slouch either.
|Subject||Re: Short to zero?|
|Entry||10/18/2017 04:57 PM|
Snarfy, FWIW I'm a big fan of CVS here. Since Amazon entering pharmacy is the fear de jour, here are a few thoughts on the issue: The key to success in the pharma supply chain is scale. Yet Amazon is getting the benefit of the doubt despite starting from scratch, simply because 1) they are great at logistics, and 2) are willing to endure losses for a long time. Dispensing a rx is very different from selling a book. You have to be "in network" to dispense drugs to people that are covered by insurance. The cash pay market is 7% or so of spend. So sure, Amazon could build a fulfilment center and work out a deal with the PBM to become an in-network mail order pharmacy for maintenance rx. That would hardly be disruptive, as there are plenty of other mail order pharmacies out there. Additionally, it will be hard for them to get to scale because PBMs tend to structure plan design to favor their own mail order pharmacies. Not to mention that mail order utilization has been declining in recent years. Old people use more drugs and prefer to go to pharmacy. History has shown that you actually have to make mail order mandatory to get your members to use it. Could Amazon put retail pharmacies in Whole Foods? Sure. All 400 or so of them (vs. roughly 10k each for WBA and CVS). It wouldn’t make a huge difference. How about if Amazon bought a PBM? I doubt they would do that. I can't see why Amazon would risk their strong consumer brand by becoming a PBM. Everyone hates their PBM - they restrict the drugs you can use, the pharmacies you can use, force you to use generics, and screw up your order every once in a while. Also they are frequent political pinatas). Regardless, the PBM business is all about scale. So if they were to buy a subscale one, they'd be disadvantaged vs. CVS, ESRX, and Optum. That doesn't seem particularly disruptive to me either.
|Subject||Re: Re: Short to zero?|
|Entry||10/18/2017 05:44 PM|
Thanks for your reply. What you have said mirrors my own thinking. I have been buying.
|Entry||10/27/2017 05:35 PM|
Agreed on the surprise and agreed on how cheap the stock is.
Maybe this will sound dumb, but I am trying to figure out if the moat is so easy to breach then why hasn't it happened sooner? And what does Amazon bring to the table besides an ability/willingness to endure losses? Will they ever be able to add value above and beyond simply offering unit costs. Between the importance of "just in time" script fills, the value that seeing a pharmacists adds to adherence, and the fact that such a high percentage of prescriptions are written for seniors who perhaps I naively view as disinterested in switching all their pharmacy business over to a website, I am struggling to see how Amazon will simply waltz in and destroy one of the great moats in American business. Again, when I re-read CVS's annual report and took note of all the different things they are doing to add value, it was hard for me to see how Amazon could replicate all of that.
I would genuinely like to understand how it would be possible, if at all. I don't want to have my head in the sand. So please, any insights would be appreciated.
|Subject||Re: Re: AET|
|Entry||10/27/2017 09:17 PM|
I'm just getting my feet wet in this space so maybe this is just hopelessly naive but I'd look at it a different way:
Are prescriptions something you'd rather buy online w/ 24 hour delivery as opposed to going to the store?
Is Amazon best situated to deliver that experience?
Maybe the answer to one of these questions is "no" but they both seem like "yesses" to me