CVS Earnings Supported By Strong PBM Performance

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Drug retailer CVS Caremark (NYSE:CVS) announced its Q3 2013 earnings on November 5. Reporting adjusted EPS of $1.05 (excluding $0.04 per share in gains from a legal settlement), the company beat Wall Street estimates and exceeded its own guidance by $0.02 per share. A strong performance in the Pharmacy Services Segment (which the company refers to as PBM), a favorable tax rate, and a lower-than-expected average share count were the main factors behind CVS’s robust quarterly earnings.

CVS regstered 5.8% annual growth in total revenues. Pharmacy same-store sales grew 5.7%, though total same store sales were up just 3.6%, as “front-store” (i.e., non-pharmacy) sames store sales decreased 1.0%. This decrease in the general merchandise metric reflected a continuous increase in basket size, more than offset by lower traffic in the quarter. The company-wide gross margins increased by 0.2% to 18.9% compared to Q3 2012, primarily driven by better acquisition cost, rebate economics, higher Medicare Part D margins, and an increase in the generic dispensing rate. With the PBM and retail segments growing by 8% and 5%, respectively, CVS’s operating profit increased by just over 19% year to year.

With 7,601 stores across 42 states, CVS is the second largest drugstore chain in the U.S. after Walgreens. With its Pharmacy Services Segment (PBM) and in-store clinics to help with basic healthcare needs, CVS is well-equipped to leverage growth in health care consumption. It remains committed to its goal to create a national primary care platform that provides integrated high quality care that is convenient, accessible and affordable. Management remains confident the company can gain market share across its offering.

We are in the process of updating our price estimate of $65.25 for CVS Caremark, which is almost in line with the current market price.

View our detailed analysis for CVS Caremark

Strong Growth In The Pharmacy Benefit Management (PBM) Business

At $19.5 billion, CVS’s PBM revenues increased by 7.8% year over year, due to higher-than-anticipated claims volume from the Maintenance Choice program, as well as higher inflation within the specialty business. CVS is the only retail drugstore chain that has its own Services arm (PBM) which allows it to offer scale to its retail clients. The company 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 service plans for its clients, helping them to minimize costs. The company claims that its health plan client footprint spans 25 states covering approximately 70% of the eligible exchange population. [1]

CVS has a 30% market share in the managed Medicaid market and believes it is well-positioned to gain additional share through Medicaid expansion. The company estimates the managed Medicaid market will grow by 40% through 2016. ((CVS Caremark’s CEO Discusses Q3 2013 Results – Earnings Call Transcript, Seeking Alpha, November 5, 2013))

Increasing Focus On The Specialty Drug Segment

Within the pharmacy segment, specialty drugs are one of CVS Caremark’s top priorities and the company is increasingly focusing on developing the business. With 22% higher revenues compared to Q3 2012, CVS witnessed strong growth in its specialty business in Q3 2013, mainly driven by drug price inflation, utilization, product launches and new PBM clients.

Specialty drugs include 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 through both pharmacy and medical benefit programs. 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 pharmaceuticals 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.

Lower Generic Substitution Tapers Top-Line Growth But at Higher Gross Margins

Although generic drugs offer higher gross margins, they are priced lower compared to branded drugs. 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. Generic drugs continued to replace branded drugs in 2013, albeit at a slower pace.

Generic introductions negatively impacted CVS’ pharmacy same-store sales by 3.2% in Q3 2013 as compared to a 6.7% negative impact in Q2 2013. Though generic dispensing rate increased to 81% in Q4 2013, the sequential year-over-year rate of increase declined to 1.7% in Q3 2013 compared to 5% in Q3 2012. CVS expects fewer generic conversions in the current quarter. Nevertheless, an estimated $15 billion worth of branded products will come off patent in the next three years, opening them to competition from generic drugs.

CVS expects its overall gross margin to be down significantly in Q4 2013 year to year, on account of a contraction in both the retail and PBM business as well as fewer new generics available to offset continued reimbursement pressure. That said, management increased guidance for the year.

Outlook

- CVS raised and narrowed its 2013 adjusted EPS guidance to $3.94 – $3.97 compared to $3.90 to $3.96 (excluding the $0.04 benefit from the legal settlement).

- GAAP diluted EPS from continuing operations to be in the range of $3.73 – $3.76.

- Q4 adjusted EPS to be in the range of $1.09 – $1.12.

- Q4 GAAP EPS from continuing operations is expected to in the range of $1.03 – $1.06.

- PBM revenues to increase by 3.5% to 5% in Q4 2013.

- Retail segment revenues and same-store sales to increase by 3.5% – 5% and 2.25% – 3.75% in Q4 2013, respectively.

- Total Q4 2013 revenue to be up approximately 2.75% – 4.25% (year over year).

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Notes:
  1. CVS Caremark’s CEO Discusses Q3 2013 Results – Earnings Call Transcript, Seeking Alpha, November 5, 2013 []
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