CVS To Retain Its Growth Momentum In Q1’14

CVS Caremark (NYSE:CVS) has been reporting strong growth over the last two years and much of its success can be attributed to the dispute between its competitor Walgreen (NYSE: WAG) and pharmacy-benefits manager Express Scripts. However, resolution of the Walgreen–Express Scripts dispute (in September 2012) along with rising sales of generic drugs have restricted CVS Caremark’s top-line growth in the last few quarters.

After a slight decline in revenues in Q1 2013, CVS regained its footing by recording a marginal increase in its Q2 2013 revenues. A strong performance in the Pharmacy Services segment (which the company refers to as PBM) re-accelerated CVS’ growth in Q3 2013 (5.8% annual growth) and Q4 2013 (4.6% annual growth). And a favorable tax rate benfitted the net margin.  The company will reports its Q1 2014 earnings on May 2 and anticipates its revenue to grow between 4% to 5%.

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. With its Pharmacy Services Segment (PBM) and in-store clinics to help with basic healthcare needs, CVS’ management remains confident that the company can gain market share across its offerings.

Our price estimate of $64 for CVS Caremark is almost in line with the current market price. We will update our valuation after the Q1 2014 earnings release.

View our detailed analysis for CVS Caremark

Strength In CVS’ Core Business To Offset Lower Tobacco Sales

In February, 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 lose 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.

Specialty Drugs To Drive The Pharmacy Service Business

Within its pharmacy service management business, which accounts for approximately 60% of its total revenue and 30% of its valuation, specialty drugs are one of CVS Caremark’s top priorities and the company is increasing its focus on developing this business. Specialty drugs treat complex diseases such as multiple sclerosis, rheumatoid arthritis, hepatitis C and cancer, among others. A new report released by CVS in November 2013 projects that specialty drug spending will more than quadruple by 2020, crossing $400 billion a year.

CVS operates approximately 30 retail specialty pharmacy stores (under the CarePlusCVS/pharmacy name) and 12 specialty mail order pharmacies located in 22 states in the U.S., Puerto Rico and the District of Columbia. CVS Caremark has an approximate 15% market share in specialty drugs. 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.

The recent acquisition of Coram LLC, the specialty infusion services and internal nutrition business unit of Apria Healthcare Group Inc, has expanded CVS’ competitive offerings in specialty services.

Generic Substitution To Increase Towards The End Of The Year

Generic drugs are comparatively lower priced but offer higher gross margins (approximately 50% higher) than branded drugs, a trend that has negatively impacted CVS’ top line growth but improved its margins. The total generic dispensing rate, which factors 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 generic wave peaked in Q1 2013 and hit a trough in Q1 2014.

In its recent earnings call, Walgreen announced that it anticipates the rate of decline in new generics introduction to moderate in the current quarter and turn positive towards the end of the year. Despite the slower substitution, an estimated $15 billion worth of branded products will come off patent in the next three years, opening them to competition from generic drugs. ^[1]

CVS recently signed a 10-year agreement with Cardinal Health to form the largest generic sourcing entity in the U.S., which is the largest generic drugs market in the world. 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 agreement with Cardinal Health can enable CVS to negotiate better prices for generic drugs.

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1. CVS Caremark’s CEO Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, August 6, 2013 [↩]