CVS Caremark (NYSE:CVS), the largest U.S. pharmacy based on total prescription revenue, reported its Q4 2013 and full year earnings on February 11. Supported by strong performance in both the retail pharmacy and pharmacy services segments, the company reported 4.6% annual growth in its Q4 2013 revenue ($32.8 billion). Drug price inflation in the specialty business combined with new specialty clients and products contributed to 5.2% growth in the PBM segment and strong pharmacy same-store sales led to 5.6% growth in CVS’ retail business. Growth in the quarter was partially offset by an increase in the generic dispensing rate which grew 1.1% annually to 81.1% and a marginal decline in its front store business.
Though CVS witnessed a slight annual decline in its gross margin and operating margin in Q4 2013, it delivered strong bottom line growth for the full year. In 2013, CVS’s net income increased by 18.5% compared to 2012. The company generated $1.3 billion of free cash flow during Q4 2013 and approximately $4.4 billion for 2013.
It opened 58 net new stores in Q4 2013, which takes the total to 7,659 stores. CVS is the second largest drugstore chain in the U.S. after Walgreen and remains committed to its goal to create a national primary care platform that provides integrated high quality care that is convenient, accessible and affordable. CVS’ management remains confident that the company can gain market share across its offerings.
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Our price estimate of $65 for CVS Caremark is almost in line with the current market price. We are in the process of updating our valuation for the 2013 earnings.
Strength In CVS’ Core Business To Offset Lower Tobacco Sales
Earlier this month, CVS declared its decision to exit the tobacco industry by the end of October 2014. The company feels that the decision is consistent with its growing role in the changing healthcare marketplace. It sees this as an opportunity to connect with consumers as an expert in health and beauty and to build loyalty with them.
On a 12-month basis, CVS estimates that it will loose approximately $2 billion in annual revenue from tobacco sales and an additional $0.5 billion from the rest of the shoppers’ basket. Given the expected timing for implementing this change, this will cost $0.06 to $0.09 per share in 2014. However, CVS is confident of maintaining its earnings and segment operating profit guidance as well as the five-year financial targets provided at its Analyst Day conference. It believes that the growing strength in its core business, especially the retail pharmacy business, as well as its profit enhancing initiatives will help offset the $.06 to $.09 EPS shortfall.
Impact of the Affordable Care Act; CVS Is Well-Positioned to Serve New Customers
Though the enrollment on the public healthcare exchanges has been slow and bumpy at the outset, CVS claims that all signs point to improvements in the enrollment process and increasing awareness among eligible consumers. The latest data shows 3 million exchange enrollees. In January’14, HHS reported that December Medicaid terminations were up 73% over a three-month baseline period in states expanding Medicaid. ((CVS Caremark’s CEO Discusses Q4 2013 Results – Earnings Call Transcript, Seeking Alpha, February 11, 2014))
The aging U.S. population and the introduction of the Affordable Care Act, which is set to expand insurance to approximately 30 million 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.  With its Pharmacy Services Segment (PBM) and in-store clinics to help with basic healthcare needs, we think CVS is well-equipped to leverage growth in health care consumption.
On account of Walgreen’s payment dispute with Express Scripts, many Walgreen customers switched over to its competitors last year. CVS aimed to retain a minimum of 60% of the Walgreen scripts in 2013. In its earnings call, CVS reported that its retention rate was ahead of its exception and does not expect any change in the same going forward.
Agreement with Cardinal Health To Help Source Generic Drugs
CVS recently signed a 10-year agreement with Cardinal Health to form the largest generic sourcing and entity in the U.S., the largest generic drugs market. With the combined volume and capabilities of the two companies, the venture can help spur innovative purchasing strategies with generic manufacturers that create value while enhancing supply chain inefficiencies.
The increasing generic substitution in the last few years put pressure on CVS’ top line growth, as 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.
The agreement with Cardinal Health can enable CVS to negotiate better prices for generic drugs.
Q1 2014 Outlook
- Revenue to increase 4.25% to 5.50%. Retail revenue to grow by 3% to 4.5%.
- Retail and PBM operating profits to grow by 14.5% – 16.5% and 21.25% – 28.25%, respectively.
- GAAP diluted EPS of $0.97 to $1 per share.
- Revenue growth of 4.25% to 5.5%.
- Retail revenue to growth between 0.75% to 2%. PBM revenue to increase 7.25% to 8.5%.
- Retail operating profit growth of 7% to 8.75%. PBM operating profit to be up 6.75% to 10.75%.
- Adjusted EPS to be between $4.36 and $4.50.
- GAAP diluted EPS from continuing operations to be in the range of $4.09 to $4.23.Notes:
- New Study Predicts $350 Billion U.S. Pharmacy Industry by 2015, Identifies Risks to Profitability, Pembroke Consulting, July 30, 2013 [↩]