|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 (in $M):||53,773||TEV/EBIT||8.1x||8.0x|
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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.
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