CVS Caremark (NYSE: CVS), the largest U.S. pharmacy based on total prescription revenue will release its Q2 2013 earnings on August 6, 2013. The company reported strong results in 2012 with a 15% and 12% increase in revenues and net income, respectively. Though net revenues declined marginally (y-o-y) in Q1 2013 on account of higher generic sales and dispensing rates for both the pharmacy services and retail pharmacy segments, CVS marked a 12.5% y-o-y rise in gross profits.
The rising proportion of generic and private labels can negatively impact revenue growth as these products are comparatively lower priced than branded drugs. However, both generic and private label drugs can have a positive impact on CVS Caremark’s bottom line as they offer higher margins.
With 7,531 stores operating across 42 states, CVS is the second largest drugstore chain in the U.S. The aging U.S. population is leading older people to become a larger share of the total spending on drugs. Also the Affordable Care Act expanding insurance to millions of Americans is another key trend driving growth in the pharmaceutical industry. With a large national footprint, its 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.
Expanding Footprint To Help Drive Growth
From 17 stores in 1964, CVS has expanded its operations rapidly and currently operated over 7,500 stores in the U.S., second only to Walgreen (NYSE:WAG). It has consistently increased its store count over the past several years, and we expect the trend to continue in the future. Aided by a large network of stores, CVS filed 718 million prescriptions last year which accounted for over 20% of the U.S. retail pharmacy market. 
Total prescription revenues of U.S. drugstores are expected to reach $350 billion by the end of 2015, growing at 5.3% annually and we expect CVS to benefit from the trend.  The easy accessibility of its stores and a more convenient shopping experience gives CVS a competitive edge over its competitors. The addition of new stores to its network can help expand its market share.
We believe that CVS Caremark’s prescription revenues will continue to grow due to favorable industry trends, which include an aging U.S. population and the Affordable Care Act, which has provided coverage to more than 30 million uninsured Americans. The U.S. Census Bureau projects that within the next two decades the proportion of total population over 65 years will increase from 13% to almost 20%, whereas the population between the ages of 20 years and 65 will decline from 60% to 55%. An aging population combined with the fact that older people contribute to a larger proportion of expenditure on drugs will drive demand in the prescription drugs market.
On the flip side, the rising proportion of generic drugs and private labels can limit revenue growth as these products are priced lower compared to branded drugs.
Strong Pharmacy Benefit Management Business
CVS is the only retail drugstore chain that has its own pharmacy benefit management arm. Pharmacy benefit management contributes approximately 44% to the stock’s intrinsic value, as per our estimate, and accounts for approximately 60% to the company’s total revenue.
CVS maintains a national network of over 67,000 retail pharmacies that serve customers covered under the programs administered by Caremark. In addition to this, it also designs customized pharmacy benefit plans for its clients helping them in minimizing costs.  We estimate the number of pharmacy network claims processed by Caremark to grow at around 3% year-on-year, crossing 1 billion by the end of our review period.
Generic and Private Labels To Aid Gross Margin Growth
Though generic drugs and private brands are comparatively lower priced than branded drugs, they offer higher margins to pharmacist. We expect higher generic, private label and front store sales to boost margins.
Here are some facts supporting our view:
- 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.
- Additionally, over the next five years around $80 billion worth of drugs will lose patent protection, opening them to competition from generics. Gross profit dollars are approximately 50% higher on generic drugs than on branded drugs.
- CVS management believes that the proportion of private label products will increase from 18% in 2012 to around 20-25%.
However, we expect to see a decline in revenue per pharmacy network claims processed over our review period as CVS sells a higher proportion of generic drugs in the future. 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. Thus, though we expect margins to increase, we believe they will remain range-bound over our review period.Notes:
- CVS Caremark 10K, 2012 [↩] [↩]
- New Study Predicts $350 Billion U.S. Pharmacy Industry by 2015, Identifies Risks to Profitability, Pembroke Consulting, July 30, 2013 [↩]