CVS Caremark Corporation CVS
February 07, 2010 - 10:15am EST by
2010 2011
Price: 31.07 EPS $2.62 $2.78
Shares Out. (in M): 1,411 P/E 11.8x 11.2x
Market Cap (in $M): 43,826 P/FCF 12.0x 11.0x
Net Debt (in $M): 10,825 EBIT 6,461 6,635
TEV ($): 54,640 TEV/EBIT 8.5x 8.2x

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CVS is a leading drug store/PBM company which trades at a large discount to the comparables at 11x 2010 EPS.  The company earns about 2/3 of its profit from the drug store business and 1/3 of profits from the PBM business which they mainly acquired from Caremark in 2007.  Comparables in the drug store business trade for 14x EPS (the best comp is WAG).  Comparables for CVS's PBM business are ESRX and MHS, both trade for 18x 2010 EPS.  CVS is expected to earn about $2.65 in 2010, plus about 15c per share for goodwill amortization or $2.80 in cash earnings. This equates to about $1.93 of cash EPS from the drug store business and 87c from the PBM business. 

If you put a 14x multiple on the drug store business and an 18x multiple on the PBM business you get a sum of the parts of $42.67, about 38% higher than the recent closing price.  This is my target price.

However, I think there could be more upside potential as the profitability of both segments is likely to improve over the years.  Over $100 billion of drugs are expected going to go generic over the coming few years.  Generic drugs are more profitable for intermediaries, as they are compensated to switch users from branded drugs to generics.  Also, with the aging of the baby boomer population, CVS is well positioned as a retailer and intermediary. 

The reason the company is trading at a large discount to the comparables is due to announcement of the loss of $4.5bn in contracts in the PBM business at the last quarterly call, on top of a previously announced $1.7bn in contract losses.  The lost contracts can be ascribed to a confusing marketing message from the company.  This message was recently changed to be more directly comparable to that of MHS and ESRX.   Howard McClure, the former president of the PBM business, retired on November 27, 2009.  In December the company hired Per Lofberg as the new president of the PBM division.  He was formerly Chairman of Merck Medco prior to Medco's spin-off and is highly knowledgeable about the industry and Caremark's potential. Per bought $1.5 million of stock personally in the low 30s.  Conversations with PBM consultants (at Hewitt, for example) suggest that CVS will be able to gain market share over the coming years and recover lost business.  Also, CVS has less exposure to contract renewals in 2010 than its competitors and many believe they will be able to recover market share this year. 

I believe if CVS's PBM business is not repaired, it will be spun-off due to external pressure from shareholders fed up with a botched merger.  On a recent conference call, the CEO of CVS suggested it was premature to consider a spin.  However, the company's valuation is low enough to attract an activist.

There are numerous risks in the investment.  Health care reform is s potential issue.  Also, the PBM business is opaque.  It's very difficult to determine exactly how the PBM's make money and I would not be entirely surprised to see an FTC investigation into this business.  Another concern of mine is that the company has had a significant amount of insider selling over the past couple of years.  (This could strengthen an activists attempt to make changes, however.)

Because the company is large cap, and attractively priced, there is a lot of reasonably good sell side research in the name.  I recommend interested investors turn to these resources to learn more. 

The company releases earnings on Monday morning.



Announcement of contract wins in PBM business in 2010

Earnings growth due to wave of generic drugs coming on market over the next few years

Pressure from activist shareholder - TBD

If all else fails, spin off of PBM business

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