Factors Driving CVS Caremark’s $64 Valuation

by Trefis Team
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CVS Caremark
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CVS Caremark (NYSE: CVS) is one of the leading pharmacy services provider in the U.S. that competes with Walgreen (NYSE:WAG), Wal-Mart (NYSE:WMT) and Rite-Aid (NYSE:RAD). It also competes with Express Scripts, Argus, etc., in the pharmacy benefits management segment. With 7,531 stores operating across 42 states, CVS is the second largest drugstore chain in the U.S. after Walgreen.

The aging U.S. population combined with the fact that older people contribute to a larger proportion of expenditure on drugs and the Affordable Care Act expanding insurance to millions of Americans are key trends driving growth in the pharmaceutical industry. Total prescription revenues of U.S. drugstores are expected to reach $350 billion by the end of 2015, growing at 5.3% annually. [1]

With a large national footprint, own pharmacy benefit management arm and in-store clinics to help with basic healthcare needs, we think CVS is well-positioned to leverage the above trends. Our price estimate of $64.42 for CVS Caremark is almost in line with the current market price.

In this article we discuss key segments and drivers that make up CVS Caremark’s business.

View our detailed analysis for CVS Caremark

CVS Caremark’s Key Customers & Business Segments

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. The company also operates an online pharmacy, CVS.com, and offers pharmacy services such as mail-order pharmacy services, prescription plan management and claims processing. Additionally, it operates 31 retail specialty pharmacies that support individuals that require complex and expensive drug therapies.

CVS Caremark’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.

In 2012, CVS earned $123 billion in revenues and earned 18.3% gross profit and 8.9% operating profit on the same. Aided by a large network of stores, it filed 718 million prescriptions which accounted for over 20% of the U.S. retail pharmacy market. [2]. In order to expand its retail pharmacy network, CVS allots a high percentage (~20%) of its operating profits towards capital expenditure.

CVS Caremark’s business can be broken down into the following categories:

1. Pharmacy Benefit Management (PBM): This division includes mail order pharmacy services, specialty pharmacy services, plan design and administration, formulary management and claims processing services. CVS manages the dispensing of pharmaceuticals through its five fully automated mail order pharmacies as well as its national network of approximately 67,000 retail pharmacies (including its own CVS pharmacy and Longs Drugs stores) to eligible members in the benefit plans maintained by its clients.

CVS derives close to 60% of its revenue from PBM services and earns 6.8% operating profits on the same. On average, the company processes 799 million pharmacy network claims annually and earns $63 as revenue per pharmacy network claim processed. The growing number of partnering pharmacies and the expansion of healthcare coverage to more Americans will increase the number of claims processed at partnering pharmacies over CVS’s pharmacy network.

However, as more drugs lose patent protection and become open to low-cost generics, we expect a decline in revenue per pharmacy network claims processed over our review period. Additionally, the Patient Protection and Affordable Care Act and the extension of Medicare Part D can negatively impact reimbursement rates paid by these programs to pharmacies.

CVS processed 82 million mail order pharmacy claims in 2012 at an average revenue of $280. It offers claims processing by delivering prescriptions over mail at a much discounted price compared to sales at the retail pharmacy stores. We expect the discounted pricing to marginally lower revenue earned per mail order pharmacy claim processed in the future.

2. Prescription Drugs: CVS sells prescription drugs through its large network of drugstores, in-store and worksite health centers, home care facilities, specialty pharmacies and mail service facilities. The company earns approximately 28% of its revenues from prescription drug sales, and the same accounted for over 68% of its sales from retail store locations in 2012. This segment also includes revenues earned from CVS Caremark’s health care services through its MinuteClinic health care clinics.

The total number of prescriptions filled annually in the US by drug store (both chain and independent), mass merchant outlets, supermarket pharmacies and mail orders has increased from 3,515 million in 2007 to about 3,760 million in 2012. CVS accounts for 19% of these prescriptions. The company has consistently increased its store count over the past several years, and we expect the trend to continue in the future. The addition of new stores to its network can help expand its market share. Easy accessability of its stores and a more convenient shopping experience gives CVS a competitive edge over the market other players.

CVS earns approximately $48 in revenues per retail prescription. With the rising proportion of lower prices generic drugs in its total portfolio, we expect the revenue to decline marginally in the future. The total generic dispensing rate, which implies the percentage of generic drugs in a consumer’s prescription, grew to 78.5% in 2012, from 74.1% and 71.5% in 2011 and 2010, respectively. We estimate the substitution of generic drugs to continue, albeit at a slightly slower pace.

3. OTC Drugs & General Merchandise Sales Division: CVS also sells general merchandise for household use and over-the-counter drugs through its large network of drugstores. Non-prescription drug sales contribute less than 12% to CVS’s overall revenues and accounted for under 35% of its retail store sales in 2012.

CVS Caremark plans to aggressively expand its retail footprint in the near future. It has a strong presence in all major markets within the US, and we expect its extension in newer markets such as Puerto Rico, Memphis and St Louis to be key growth drivers. On the flip side, though the expansion of stores will help generate a higher revenue stream for CVS, the rising popularity of the comparatively lower-priced private label goods can put pressure on the growth rate.

CVS earns approximately 12% in operating profits from the sale of prescription drugs, OTC drugs and general merchandise. We expect higher generic, private label and front store sales to boost margins. CVS management believes that the proportion of private label products will increase from 18% in 2012 to around 20-25%. Additionally, over the next five years, over $80 billion worth of drugs would lose patent protection, opening them to generics which offer higher margins to the pharmacist. Gross profit dollars are approximately 50% higher on generic drugs than on branded drugs.

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Notes:
  1. New Study Predicts $350 Billion U.S. Pharmacy Industry by 2015, Identifies Risks to Profitability, Pembroke Consulting, July 30, 2013 []
  2. CVS Caremark 10K, 2012 []
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