CVS Margins Remain Under Pressure, Even As The New Acquisition Helps Meet Expectations

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At the end of last week, CVS Health (NYSE:CVS), the second largest U.S. pharmacy, announced its quarterly earnings for the quarter ending September 30th.  ((CVS Health Press Release)). Unlike the first two quarters of this fiscal when CVS beat expectations, this quarter’s earnings of $1.28 just fell short of the consensus estimate of $1.29. [1]  The primary cause of lower-than-expected earnings was a decline in operating margins in the pharmacy services segment, which makes up for approximately 60% of the pharmacy giant’s revenues.

This quarter’s financials included numbers from the recently acquired Omnicare, a healthcare services provider specializing in long term care and specialty pharmacy (reported in Retail/ Long-Term Care, erstwhile Retail Pharmacy, and Pharmacy Services segments respectively). Fortunately, operating margins from the retail long-term care segment favorably impacted operating margins, partially offsetting a margin decline in the latter. While margin headwinds are expected to persist going forward, CVS plans to offset the earnings impact through pharmacy share gains and stock buybacks. Below, we discuss, in more detail, the key highlights from the earnings releas.

Our price estimate of $102 for CVS Health’s stock is slightly above the current market price. We are in the process of updating our model per the earnings release.

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PBM Business Remains Strong But Margins Decline

A majority of CVS’ revenues come from its pharmacy benefit management business. A hefty decline in operating margins in this segment negatively impacted the overall profits of the firm, this quarter. Excluding integration and transaction costs from the Omnicare acquisition, operating margin in the pharmacy services division declined by 25 basis points to 4.6%. Also, consolidated gross margin declined by 125 basis points -year over year to 17.2%.

The decline was driven by the continued reimbursement pressure and a shift in mix towards the lower-margin Medicare and Medicaid business. However, these trends are seen across the industry and should not be of any serious concern to investors.

On the brighter side, revenue growth in the PBM division remains strong. Consistent with past years, the company continues to have a strong client retention rate of about 98%. Even new business wins continue to flow in at a healthy rate, with a net new business of $11.4 billion so far this fiscal year.

Moreover, Omnicare’s specialty pharmacy platform (which is included in the pharmacy services segment) is expected to complement CVS Health’s capabilities in what is a rapidly growing market. In 2016, Omnicare is expected to be approximately $0.20 accretive to CVS’ earnings per share, excluding any transaction and integration costs.

The Not-So-Explicit One-Time Expenses

With the impending closure of the transaction involving Target’s pharmacy operations, one-time expenses are expected to have a considerable negative impact on earnings this fiscal. While all of the Q3 performance metrics included the benefits arising from the Omnicare acquisition, they “excluded any transaction and integration costs“. In a separate note though, the company mentioned that it incurred $0.10 per share or $115 million of acquisition-related transaction and integration costs during Q3. We believe this is likely the reason behind the 5% drop in CVS’ stock price on earnings day, despite the not-so-disappointing Q3 performance.

In the fourth quarter of this fiscal, CVS expects operating margin to improve by about 80 basis points compared to the year ago period. Adjusted earnings per share is expected to be in the range of $1.51 to $1.55, but excluding any dilution from integration and transaction costs.

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Notes:
  1. Nasdaq []