CVS Health Earnings Preview: Strong PBM Business To Drive Growth. But, Reimbursement Pressure Will Continue To Drag Margins Down

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CVS Health (NYSE:CVS), the second largest drugstore chain in the U.S., is scheduled to report its Q1 2015 results on Friday, May 1st. In the previous quarter (i.e. Q4 2014), the company’s PBM business grew 22% year over year while its retail business also posted strong growth in same-store sales, up 5.5% year over year. While top line grew at a healthy rate, both its operating and gross margins contracted  50 bps and 140 bps respectively. As the negative impacts stayed within expected ranges, the management is confident of continuing the performance in 2015.

We expect the company’s growth momentum to continue primarily driven growth in its specialty pharmacy business. Earlier this month, CVS’ rival, Walgreens (NASDAQ:WBA), announced its results for the quarter ended 28 February 2015 and reported strong growth in Medicare Part D scripts. CVS might also see some benefit due to scripts growth, though growth in PBM might contribute more to the overall top line growth.

We have a price estimate of $81 for CVS Health, which is at a discount of approximately 20% to the current market price.

View our detailed analysis for CVS Health

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Growth In PBM driven by Specialty Pharmacy Revenues

CVS Health’s PBM revenues almost doubled from $47 billion in 2010 to $88 billion in 2014, which represents a CAGR of 17%. Most of this growth was driven by high levels of service and execution along with competitive pricing that generate savings for the company’s clients. Since the last fiscal, the company has started to include revenues from its specialty pharmacy business in the PBM division.

Specialty drugs treat complex diseases such as multiple sclerosis, rheumatoid arthritis, hepatitis C and cancer, among others. Because of the specialized way in which these drugs need to be administered, specialty pharmacies play an important role in providing the support required to effectively deliver these drugs to patients. The Specialty Connect offering, which was rolled out by May 2014, fills this need for greater convenience and access to specialty medications. According to a Drug Channel Institute report, in 2018, six of the ten best-selling drugs by revenue are projected to be specialty drugs, compared with three drugs in 2010 and five in 2012. Given the launch of hepatitis C drugs, Sovaldi and Harvoni earlier this year (which cost $84,000 and $94,500 respectively for a 12-week course of treatment), we believe CVS is in a good position to reap some benefits because of its Specialty Connect program.

Reimbursement Pressure To Continue Due To ObamaCare

Health care expenditures in the United States are currently about 18 percent of GDP, and this share is projected to rise sharply. If health care costs continue to grow at historical rates, the government’s spending on health care will rise to nearly 34 percent of GDP in 2040. The Affordable Health Care Act, commonly known as Obamacare, is aimed at addressing this issue. The government are becoming more involved in the pricing of pharmaceutical products.  CVS and other drug store chains will have a role in evaluating costs and steering patients to generic medications. The cost squeeze is already starting to affect pharmacy retailers’ margins due to the steps taken by the government, like the step down in Medicare Part D rates earlier this year. CVS will be better off compared to its competitors, as it can negotiate better deals with drug makers (due to higher volumes from PBM accounts) and partially offset margin pressure arising from low reimbursement rates. We expect the negative impact of lower Medicare Part D rates to start showing up in the company’s EBITDA margin this quarter. Please note that a growth in Part D scripts might impact the CVS’ retail business positively, as stated earlier.

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