CVS’ Q2’14 Earnings Driven By Strong Growth In Both PBM & Retail

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CVS Caremark (NYSE:CVS) reported another quarter of strong earnings in Q2 2014 as the company met or exceeded its expectations on every key major parameter. At $34.6 billion, revenue grew 10.7% annually with both the Retail segment as well as the Pharmacy Services segment (which CVS refers to as PBM), exceeding CVS’ expectation. The company’s adjusted Earnings Per Share (EPS) increased 16.5% (to $1.13) in the quarter, which was $0.02 above the high end of its guidance range. Given its strong performance in the first half of 2014, CVS has raised and narrowed its 2014 guidance (mentioned at the end of the article).

CVS is the second largest drugstore chain in the U.S. after Walgreen (NYSE: WAG), 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 Benefits Management (which the company refers to as 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 $70 for CVS Caremark is at a discount of approximately 10% to the current market price. We are in the process of updating our valuation for the company.

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View our detailed analysis for CVS Caremark

Quick Snapshot of the Q2 2014 Earnings

CVS’ PBM revenue increased 16% annually in Q2 2014 driven by net new business, specialty pharmacy growth, drug inflation and improving product mix. Operating profit in the PBM business grew 30%, exceeding company expectations. Revenue from the retail business grew 4.5% annually driven by branded drug inflation as well as increased volumes. Retail GDR (i.e., Generic Dispensing Rate) increased by approximately 160 basis points (t0 84%) compared to Q2 2013. Operating profit in the Retail business grew 6.5%.

Total same-store sales growth, which suffered from a difficult weather and flu season in Q1 2014, re-accelerated to 3.3% sequentially. Pharmacy same-store sales increased 5% annually and were negatively impacted by about 160 basis points due to recent generic introductions. Pharmacy script comps increased 3.9% on a 30-day equivalent basis, The company claims to have gained market share in pharmacy in Q2 2014 as well. Front-store comps declined 0.4% on account of diminishing tobacco sales (CVS exited this business a few months back). Front store traffic continued to decline as customers aggregated their trips. However, the average basket size continues to increase reflecting the strength of CVS’ loyalty programs.

Increasing Coverage Enrollment Due to the ACA & Medicaid Extension

Total prescription revenue earned by U.S. drugstores are expected to reach $350 billion by the end of 2015, growing at 5.3% annually. [1] The Affordable Care Act (ACA) and the Medicaid expansion is expected to extend health coverage to more than 30 million uninsured Americans. CVS claims that several million Americans have gained coverage in recent months which will provide a positive secular trend in pharmacy volume growth for the next several years.

In its earnings call, CVS mentioned that approximately 8 million individuals have enrolled in the public exchanges. The mix of individuals who were newly insured as opposed to those who previously had coverage still remains unclear, with various sources quoting anywhere from 27% of individuals newly insured to as high as 85%, with multiple data points suggesting it might be somewhere in between. With respect to Medicaid, the available data indicates that 6.7 million individuals have gained coverage, up from 3 million in Q1 2014. [2]

We expect CVS Caremark’s share of retail prescriptions filled in US to reach 25% over our forecast period.

Specialty Drugs To Drive Growth In The PBM 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 ranked first (among large publicly traded PBMs) on overall satisfaction in the annual pharmacy benefit manager customer satisfaction report released by PBMI in April 2014. The report is a broad survey which includes the opinions of nearly 400 plans sponsors who represent approximately 65 million members.

Within its pharmacy service management business, 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. At present 60% of specialty revenue in CVS’ PBM segment are dispensed through specialty pharmacy. Specialty revenue grew 34% and 53%  year over year in Q1 2014 and Q2 2014 respectively. Benefits from new business, addition of Coram and the introduction of a new specialty drug Sovaldi (a new hepatitis C drug) drove specialty revenue in the first half of 2014.

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. Among CVS’ clients, specialty now represents about 22.5% of total drug spending and the company projects the same to grow to as much as 50% by 2018. [3]

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. The company has an approximate 15% market share in specialty drugs. It 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.

CVS is optimistic that it can continue to gain specialty pharmacy share, as it focuses on developing innovative offerings that capitalize on the company’s unique ability to optimize cost, quality and access.

2014 Outlook

– Net revenue growth to be in the range of 8% to 9%, raising the midpoint by approximately 260 basis points over the prior guidance.

– PBM revenue growth of 13.75% to 14.75%, approximately 5% higher than the prior guidance. The retail segment is expected to grow 1.25% to 2%.

– CVS has narrowed the retail operating profit by 25 basis points on both ends. The company now expects retail operating profit to increase 7.25% to 8.5% year over year. In the PBM business, given the out-performance in Q2 and increased confidence in the back half of the year, it now estimates operating profit to increase 12.5% to 14.5%

– Adjusted EPS in the range of $4.43 to $4.51, up from the initial guidance of $4.36 to $4.50, which translates into year-on-year growth of 11.75% to 14%.

– GAAP diluted EPS from continuing operations is expected to be in the range of $4.16 to $4.24.

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Notes:
  1. New Study Predicts $350 Billion U.S. Pharmacy Industry by 2015, Identifies Risks to Profitability, Pembroke Consulting, July 30, 2013 []
  2. CVS Caremark’s (CVS) CEO Larry Merlo on Q2 2014 Results – Earnings Call Transcript, Seeking Alpha, August 5, 2014 []
  3. CVS Caremark’s CEO Discusses Q1 2014 Results – Earnings Call Transcript, Seeking Alpha, May 2, 2014 []