3 Reasons CVS Caremark Looks Healthy

by Susan J. Aluise | August 10, 2012 11:00 am

Investors have a lot to like about CVS Caremark (NYSE:CVS[1]) in the wake of the pharmacy giant’s strong second-quarter earnings release on Monday. Among them are a booming pharmacy benefit management (PBM) business and gains from rival Walgreen’s (NYSE:WAG[2]) spat with Express Scripts (NASDAQ:ESRX[3]).

Nevertheless, the market gave CVS shares a bitter pill on the news — knocking the stock down nearly 2% on more than double average daily volume on Tuesday. You can blame the slip on worries that the company would forfeit its new customer gains now that WAG is back in the Express Scripts family[4]. Walgreen shares inched up on the news.

CVS has recovered, but the market’s knee-jerk reaction to its earnings shows how jitters over the chain’s future competitive health can turn good news into a disappointment. But was the market’s gut reaction right, or just a case of one-day nerves?

First, let’s look at the numbers. CVS earnings rose more than 18% in the quarter to $966 million (75 cents a share), while revenue grew more than 16% to a record $30.7 billion. Earnings for the Caremark PBM operations rose more than 14% in the quarter. Same-store sales — sales at stores open a year or more, a critical measure of retailers’ health — rose 5.6%.

A lot of that same-store gain was Walgreen’s loss. WAG, which has seen its earnings hammered from a rancorous contract dispute with ESRX this year, has resolved that spat and will once again fill Express Scripts prescriptions starting next month. Had the squabble continued, Walgreen could have lost some $5 billion in total annual sales. (Express Scripts represents Missouri[5] in InvestorPlace‘s Real America Index[6].)

CVS’s strong retail growth at Walgreen’s expense is one factor that spooked investors. After all, those gains easily could be wiped out if those new customers go home to WAG this fall.

The company also faces a risk on the PBM side from the Express Scripts-Medco Health merger, which regulators approved in April. Express Scripts, which reported quarterly earnings on Monday, blew away analysts’ expectations as the company barely felt a pinch from the WAG spat[7] and has been able to realize benefits from the $29 billion Medco deal sooner than expected.

Still, here are three reasons CVS Caremark stock still looks healthy:

CVS Will Fight to Keep ESRX Customers

Don’t expect CVS to let those new customers wander quietly back to Walgreen. The WAG-ESRX contract dispute added significant market share and generated a 3-cent-per-share benefit during the second quarter. Although Walgreen will re-enter the Express Scripts network on Sept. 15, CVS President and CEO Larry Merlo said his company stands to gain an additional five cents a share in 2012 if it holds on to just half of the former Walgreen customers.

CVS has already put in place a number of customer-retention programs that it says are based on “sophisticated analytics,” although for competitive reasons it didn’t share details with analysts in the earnings call.

Caremark Has Landed New Business

CVS Caremark is moving aggressively to head off the PBM threat stemming from the Express Scripts-Medco economies of scale. It already has begun a massive effort to streamline its PBM operations, aiming to shave $1 billion in costs by 2015. Although CVS Caremark has battled some contract losses, its launch of a co-branded Medicare prescription drug plan with Aetna (NYSE:AET[8]) is a big plus.

The company also has inked a number of new PBM contracts that all told add $640 million in net new business for 2013.

Solid Fundamentals

CVS boasts more than 7,300 retail pharmacies and 550 in-store “Minute Clinics.” CVS Caremark also is the nation’s second-largest PBM, having lost top billing after the ESRX-Medco merger. With a market cap of $57.7 billion, CVS is trading around $45, about 8% below its 52-week high on July 18. The stock has a price-to-earnings growth (PEG) ratio of 1.2, indicating it could be slightly overvalued, and a forward P/E of about 12.

By comparison, Walgreen also is trading around 12 times earnings and has a PEG ratio of 1.2. The two stocks’ fundamentals differ most on dividends: WAG’s current yield is 3.1%, more than double CVS’s 1.4%.

Bottom Line: CVS is a well-run business on both sides of its operations — retail and PBM — and it’s taking solid steps to boost its competitive position. On the PBM front, I think CVS has what it takes to go the distance with ESRX, even with the advantages Medco brings. From a retail perspective, WAG has a tough job ahead luring customers back into the fold. I don’t see Walgreen’s acquisition of Boots[9], a European pharmacy chain, earlier this year giving it a big boost. I rank CVS a buy, with a price target of $51.

As of this writing, Susan J. Aluise did not hold a position in any of the stocks named here.

Endnotes:
  1. CVS: http://studio-5.financialcontent.com/investplace/quote?Symbol=CVS
  2. WAG: http://studio-5.financialcontent.com/investplace/quote?Symbol=WAG
  3. ESRX: http://studio-5.financialcontent.com/investplace/quote?Symbol=ESRX
  4. WAG is back in the Express Scripts family: http://investorplace.com/2012/07/get-into-express-scripts-in-a-hurry/
  5. Express Scripts represents Missouri: http://investorplace.com/real-america-index/missouri-express-scripts-esrx-making-pharmacies-easy/
  6. Real America Index: http://investorplace.com/real-america-index/
  7. a pinch from the WAG spat: http://articles.chicagotribune.com/2012-08-08/business/chi-express-scripts-ceo-dispute-with-walgreen-wasnt-a-big-negative-20120808_1_express-scripts-chief-executive-george-paz-walgreen
  8. AET: http://studio-5.financialcontent.com/investplace/quote?Symbol=AET
  9. Walgreen’s acquisition of Boots: http://investorplace.com/2012/06/3-reasons-to-flee-walgreen/

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