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Investment Overview for CVS Caremark (NYSE:CVS)
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Prescription Drugs
Prescription Drugs EBITDA Margin: We currently forecast CVS Caremark's EBITDA profit margin for prescription drugs to grow from the current levels to 12.5% during the Trefis forecast period. There could be a 5% upside to the Trefis price estimate if margins further improves to 13.5% by the end of our forecast period due to higher margins provided by generic drugs amid the lower reimbursement rates. This has been pressured by the US Medicaid and Medicare Plan D, as well as health insurance providers in line with the rising proportion of generics. Payors and Pharmacy Benefit Managers (PBMs) will attempt to reap the benefits of the windfall from generic drugs, leading to downward pressure on margins.
Pharmacy Benefit Management
PBM EBITDA Margin: We currently forecast EBITDA margins for pharmacy services to grow steadily from the current levels to 7.5%. Margins may be pressured due to the acquisition of new contracts and other contract renewals. There could be a 5% upside to the Trefis price estimate if margins were to increase back to the historical levels of 8.5% by the end of our forecast period.
Capital Expenditure: We currently forecast capital expenditures as a percentage of EBITDA to remain relatively flat at around 18% over the forecast period. There could be a 8% downside to the Trefis price estimate if this figure were to rise to the 2007-08 levels of close to 24% by the end of our forecast period.
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CVS Caremark Corporation (NYSE: CVS) is the largest pharmacy services provider in the US comprising of the largest network of retail pharmacy stores nationwide along with pharmacy services such as mail-order pharmacy services, prescription plan management and claims processing. CVS fills and manages over 1 billion prescriptions per year through its businesses.
CVS Caremark operates over 7500 retail stores. The retail business provides health care services through some 640 retail health clinics and MinuteClinics, which are mostly located inside CVS pharmacies and serve to diagnose and treat minor health issues. The retail pharmacy business also includes an online pharmacy, CVS.com.
CVS retail stores sell prescription drugs and a wide assortment of general merchandise, including over-the-counter (OTC) drugs, beauty products, cosmetics, photo finishing, seasonal merchandise, greeting cards and convenience foods.
In March 2007, CVS completed its merger with Caremark Rx, which brought together the nation’s largest retail pharmacy chain and a leading pharmacy benefit manager. CVS Caremark's Pharmacy Services business provides a full range of pharmacy benefit management (PBM) services including mail order pharmacy services, specialty pharmacy services, plan design and administration, as well as formulary management and claims processing services. The company's customers are primarily employers, insurance companies, unions, government employee groups, managed care organizations and other sponsors of health benefit plans and individuals throughout the US.
As a pharmacy benefits manager, CVS Caremark manages the dispensing of pharmaceuticals through its 28 mail order pharmacies and national network of approximately 64,000 retail pharmacies (which include its own CVS/pharmacy and Longs Drugs® stores) to eligible members in the benefit plans maintained by its clients. It utilizes proprietary information systems to perform safety checks, drug interaction screenings and brand to generic substitutions.
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Prescription drug sales are the biggest source of value for CVS Caremark, accounting for over half of its total value
Accessibility of stores and convenient shopping experience make CVS an attractive destination for consumers.
CVS has a large network of strategically located retail drugstores across the US. It has over 7500 pharmacy locations and around 75% of the US population lives within a three mile radius of a CVS store, lower than any of the other drugstore chains in US (Walgreen claims to have 75% population within five mile radius). This makes CVS stores more accessible to a larger number of consumers than other pharmacies.
CVS employs over 26,000 pharmacists, nurse practitioners and physician assistants (more than Walgreen's number of 17000) who are responsible for interfacing with patients, advising customers and providing them more personalized attention as compared to other retail pharmacy chains.
CVS has over 640 in-store MinuteClinics across 25 states, making it easy to get treatment for common ailments, receiving vaccinations or obtaining health screenings. More than 70 percent of CVS stores are either open round-the-clock or offer extended hours, and over 60 percent have drive-thru windows, offering greater convenience to customers.
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Increasing demand and utilization of prescription drugs in US
An aging population combined with the fact that older people contribute to a larger proportion of expenditures on drugs will lead to an increase in the prescription drugs market size. An observation from CVS Caremark's 2009 annual report supports our view:
"Looking at demographics, the number of people in the United States who are 65 or older will jump to roughly 47 million by 2015 and to 55 million by 2020. This age group fills an average of more than 25 prescriptions per person annually – 30 percent more than people between the ages of 55 and 64. That will increase utilization dramatically for years to come and will help drive the growth of both our PBM and retail businesses."
The 2010 US health reform legislation is expected to increase prescription drug sales
Over 30 million uninsured Americans will gain coverage under the reform legislation and the US government will increase outlay on prescription drugs driven by an expansion of Medicaid and Medicare Part D plans. This will help drive prescription sales going forward.
Accelerating sales of generic drugs and private label goods to positively impact gross profit margins of retail stores.
Sales of lower priced generic drugs are expected to increase faster than those of branded drugs. Expansion of generic drugs in the US market will impact retail pharmacy gross margins as they have a lower cost compared to branded drugs. The observation from CVS Caremark's 2009 annual report supports our view:
"Nearly $100 billion in branded drug sales will lose patent protection over the next six years. As a result, our GDR could eventually approach 80 percent. That is expected to further reduce costs for health plans, plan sponsors, and their members while expanding our pharmacy margins. We are also hopeful that Congress will pass legislation that finally paves the way for a biogeneric approval process."
Private labels have grown increasingly popular among US consumers as they offer the same quality as established brands and are priced lower. This offers customers value while providing CVS with significantly higher margins.
Private label products accounted for close to 17 percent of front-store sales in 2009 and CVS management believes that it can grow further and reach 20 to 25 percent, thereby lending room for increasing gross profit margins.
Turnaround of the PBM segment
CVS has been aggressively trying to grow its Pharmacy Benefits Management (PBM) after suffering from some major setbacks in 2009-2010. It has witnessed a dramatic turnaround by winning high profile contracts from CalPERS, Medco Health and Aetna in the past year.
In July 2010, CVS Caremark concluded a $9 billion 12-year agreement to provide health insurance carrier Aetna with a broad range of PBM services. In May 2011, CVS Caremark won a 3-year contract worth $3 billion to provide integrated pharmacy services for the Blue Cross and Blue Shield Government Service Benefit Plan or Federal Employee Program (FEP). Contracts with Aetna and FEP have helped arrest the decline in the number of pharmacy claims and provided a much needed upside to CVS Caremark’s pharmacy benefit management business. As a result, the Pharmacy Services revenues grew by 24% and 25% in 2011 and 2012 respectively.
Trefis Forecast Rationale for Average Front-end Revenue per Square Foot
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This represents CVS Caremark's revenue from selling goods and merchandise (apart from prescription drugs), per square foot of CVS Caremark's overall sales area.
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${forecast} declined from $257 in 2007 to $240 in 2008. The decline was primarily as a result of the recessionary macroeconomic outlook over 2008, which led to a decline in the sale of general merchandise. The ${forecast} increased to around $265 in 2009 driven by higher sales of private and exclusive CVS brands. It improved to $272 in 2012. We expect CVS Caremark's ${forecast} to slowly improve over our forecast period.
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Trefis considered the following factors for its forecast
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- Stagnation of front-end comps/same-store sales
- CVS has chosen to focus on driving gross margins rather than maximizing same store sales or comps in the near term. Its front-end comps are expected to stagnate over the current levels in 2012-13.
- Increasing popularity of private label goods
- As a large number of US households decided to cut spending during the recession in 2009, they traded higher priced branded goods for private label goods which offered them reasonable quality at a lower price. As the economy recovers, consumers are expected to stick with private label brands as they realize there is little difference between private label products and their branded counterparts. Since these private label goods are priced lower than their branded counterparts it will suppress revenues. The following management discussion item from CVS Caremark's annual report 2009 supports our view
- "These products (private labels and CVS exclusive brands) accounted for close to 17 percent of front-store sales in 2009, but we believe that this figure can climb to as high as 20 to 25 percent."
- During 2010, CVS sold more private label goods that also positively impacted front-store gross profit rate. The trend is likely to continue.
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- CVS's convenient store locations to help increase market share of front-end sales
- CVS has a large network of strategically located retail drugstores across US. About 75% of the US population lives within a three mile radius of CVS stores, which is lower than any of the other drugstore chains in the US (Walgreen claims to have 75% population within five mile radius). Thus, front end sales for CVS Caremark are poised to grow as a result of increasing household consumption in the US.
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