After a slight decline in revenues in Q1 2013 CVS Caremark (NYSE:CVS) regained its footing by recording a 1.7% increase in its Q2 2013 revenues. While higher sales of generic drugs and dispensing rates continue to put pressure on the company’s top line growth, the trend has enabled CVS to expand its bottom line, as generic drugs offer higher gross margins. Aided by a rising proportion of generic sales, CVS saw its net income grow by 16% (y-o-y) in Q2 2013.
CVS, the largest U.S. pharmacy based on total prescription revenue, has been reporting earnings growth over the last two years. Much of its success can be attributed to the dispute between its competitor Walgreen (NYSE: WAG) and pharmacy-benefits manager Express Scripts, which saw many of Walgreen’s customers switching over to CVS. However, Walgreen and Express Scripts entered into a fresh agreement in September 2012 which now allows Express customers to fill prescriptions at Walgreen stores. With the renewed agreement we expect CVS Caremark’s top line growth to slow down in the future.
Nevertheless, with 7,531 store across 42 states, its own pharmacy benefit management arm and in-store clinics to help with basic healthcare needs, we think CVS is well equipped to leverage growth in the pharmaceutical industry. CVS remains committed to its goal to create a national primary care platform which provides integrated high quality care that is convenient, accessible and affordable.
The company paid $276 million as dividends in Q2 2013 and expects to complete $4 billion of share repurchases by the end of 2013.
New Generic Products Boost Gross Margins
CVS widened its gross margins from 17.7% in Q2 2012 to 18.7% in Q2 2013, aided by a rising proportion of generic drug sales. The gross margins in the pharmacy service segment and retail segment increased to 5.1% and 31%, compared to 4.2% and 30.1% a year ago, respectively. In addition to rising general drug sales, the increase in services profit was driven by new clients, better acquisition costs and rebate economics, which were partially offset by price compression and remediation as well as higher operating cost in the Medicare Part D business.
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. The pharmacy services’ generic dispensing rate increased to 81% in Q2 2013, a 2.75% y-o-y rise.
Though the substitution of generic drugs will continue for the next three to five years, the pace is expected to slow down. Nevertheless, an estimated $15 billion worth of branded product will come off patent in the next three years, opening them to competition from generic drugs.  Gross profit dollars are approximately 50% higher on generic drugs than on branded drugs.
Though we expect margins to increase, we believe they will remain range-bound over our review period. 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.
Increasing Focus On The Specialty Drug Segment
CVS earned 2% higher revenue (y-0-y) from pharmacy service in Q2 2013 on account of higher than anticipated claims volume driven by new client wins and increased membership primarily from Maintenance Choice and Medicare Part D utilization. Helped by new clients, CVS processed approximately 206 million more pharmacy network claims compared to the same quarter last year.
Within the pharmacy segment, specialty drugs is one of CVS Caremark’s top priority and the company is increasingly focusing on developing the business. It saw 20% y-o-y growth in its specialty revenues driven by drug price inflation, utilization, new product launches as well as new clients. Specialty drugs includes costly treatments for diseases like cancer and multiple sclerosis. Earlier this year, CVS acquired a technology platform to help identify cost savings for the drugs, which pose challenges to employers and health plans.
CVS claims that one area of both employer and health plan client concern is managing their specialty spend across the pharmacy and medical benefits. In addition to managing specialty cost per client, clients are also concerned about the changes resulting from the Affordable Care Act which results in a significant amount of new coverage for people who have previously been uninsured.
The company believes that its differentiated approach to specialty will drive lower overall costs while improving health, and providing value for both payers and patients. It has an entire suite of specialty capabilities including utilization management programs, specialty guideline management, formulary strategies as well as a site care and medical claims added in products.
MinuteClinic Expansion & ExtraCare Loyalty Program To Improve Customer Retention
MinuteClinic are small walk-in medical clinics within the CVS Caremark pharmacy stores available at 684 locations across U.S. They utilize nationally recognized protocols to diagnose and treat minor health conditions, perform health screenings, monitor chronic conditions and dispense vaccinations at much lower prices than a hospital. CVS registered a 32% (y-o-y) increase in revenue from MinuteClinics and opened 25 new places in Q2 2013. It expects to take the total to 150 new MinuteClinics by the end of the year and plans to operate about 1,500 clinics by 2017.  30% of the expansion will be in new markets.
CVS Caremark’s ExtraCare loyalty program currently has about 70 million active subscribers, accounting for 68% of front store sales transactions and 84% of total front store sales.  These have helped the company in maintaining a high customer retention ratio along with attracting new customers to shift to CVS Caremark’s network.
- Narrowed 2013 earnings guidance from $3.89 – $4 to $3.90 – $3.96 per share.
- Diluted EPS from continuing operations is expected to be in the range of $3.65 to $3.71.
- Revenue growth of 2% to 3%: PBM segment to grow by 2% – 3% and the retail segment expected to grow by 2.25% to 3.25%.
- Total comp stores same-store sales to increase by 1% to 2%.
We are in the process of updating our price estimate of $64 for CVS Caremark.Notes: