CVS Caremark (NYSE:CVS) is primed for continued growth in 2012 and we expect to see solid top and bottom-line growth. It wrapped up 2011 with a successful turnaround in its Pharmacy Benefits Management (PBM) business by winning high-profile contracts. Its core pharmacy business stayed robust and is certain to benefit from significant margin expansion as more and more prescription drugs go generic this year. CVS may also see a significant opportunity on the retail side from the Walgreen-Express Scripts split, and hopes to tap an additional 20 million transferred prescriptions out of Walgreen in 2012. CVS Caremark is an integrated pharmacy services provider and drugstore chain that competes with Walgreen (NYSE:WAG), Wal-Mart (NYSE:WMT) and Rite-Aid (NYSE:RAD) in its Prescription Drugs, OTC Drugs and general merchandise segment. It also competes with Medco Health Solutions (NYSE:MHS) and Express Scripts (NASDAQ:ESRX) in its Pharmacy Benefits Management segment.
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Disposing of skepticism about its integrated pharmacy and PBM business model after some major setbacks in 2009-10, like the exit of Walgreen from its network with billions of dollars worth of business), CVS Caremark aggressively expanded its PBM business in 2011. It won multiple high profile contracts, including CalPERS, Aetna, FEP and Universal American and turned around the company’s outlook for the business. The division contributes 16% value of the drug retailer’s stock.
Revenues in the Pharmacy Services segment increased 25%, primarily driven by the Aetna contract as well as new activity resulting from the acquisition of the Medicare prescription drug business of Universal American (worth $5.5 billion annually). With the new FEP and Universal American contracts in place from 2012, PBM revenues should see further revenue growth this year which has provided further upside to our forecasts. CVS also succeeded in retaining more than 98% of the business for 2012 through contract renewals. Even though contract renewals come with margin compression, it is expected to be offset over time by strong top-line growth.
Strong Core Pharmacy Business, Margin Expansion
With an aging population and 2010 health reforms that have expanded insurance coverage as well as Medicaid and Medicare Part D plans, the prescription drugs market in the U.S. is expanding rapidly. Yet the biggest driver of the drug retail industry will be the expansion of generic drugs in the U.S. as patents for a large number of branded drugs expire over the next few years. Lower cost generic drugs will moderate top-line growth but may also provide a boost to industry margins as gross profit dollars are approximately 50% higher for generic drugs than branded drugs.
CVS expects nearly $100 billion in branded drugs sales to lose patent protection by 2015. For example, Pfizer’s blockbuster drug Lipitor, that generated $11 billion revenues in 2010, lost patent protection in November 2011.
However, there are chances that increased reimbursement rate pressure could offset expected upside to the drug retailers’ gross margin gains. The trend of PBM industry consolidation including the possibility of merger between U.S.’s two largest PBMs, Express and Medco, could lead to more reimbursement pressure from the PBM industry on the drug retailers.
Overlap Between CVS and Walgreen Footprints Could Bring Significant Business in 2012 as WAG-ESRX Part Ways
As Express Scripts walks away from Walgreen with a large part of its 90 million prescriptions in 2012, Walgreen expects to retain no more than about 10 million prescriptions and the rest would more likely land into open market. As customers are less likely to switch PBMs as long as they can find easily accessible pharmacy alternatives, CVS with its strong retail presence, expects an almost certain opportunity on the retail side in 2012 and hopes to add about 20 million new prescriptions.
CVS Caremark drugstores have a significant overlap with Walgreen stores with an estimated 43% of CVS stores within 1 mile of a Walgreen store, 78% within 3 miles and 85% within 5 miles. It is thus well positioned to service Express Scripts members and capture corresponding financial benefit as those scripts become available in the open market and Express members look for a new pharmacy to serve their needs. Around 75% to 85% of the 90 million Express prescriptions transferred from Walgreen are likely to land into open market and CVS hopes pick up between 20% to 30% of those transferred scripts, i.e around 20 million incremental prescriptions in 2012. This could translate into $175 million to $235 million in incremental EBIT, helping the pharmacy’s comparable sales grow by approximately 300 basis points in 2012, partially offset by corresponding increase in SG&A expenses.
We have a $45 price estimate for CVS Caremark, about 5% ahead of the current market price.