Financial analysts are showing renewed faith in CVS Caremark Corp.’s integrated business model.

CVS Caremark, Analyst Day, financial analysts, integrated business model, pharmacy benefit manager, PBM, drug store chain, CVS/pharmacy, pharmacy sector, Russell Redman, Mark Miller, William Blair & Co., Ed Kelly, Credit Suisse, Lisa Gill, J.P. Morgan, Deborah Weinswig, Citi Investment Research, Ross Muken, Deutsche Bank Securities, retail/PBM model, retail pharmacy, Express Scripts, Walgreens, contract wins, Maintenance Choice, Rite Aid, drug chain

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Analyst Day Preview: CVS is well-positioned

December 19th, 2011

NEW YORK – Financial analysts are showing renewed faith in CVS Caremark Corp.’s integrated business model.

Operating a retail drug store chain and a pharmacy benefit manager (PBM), the company is well-positioned to prosper amid recent shifts in the pharmacy sector, according to analysts. That view is a far cry from earlier this year, when a disappointing performance by the PBM stoked media and investor scrutiny of CVS Caremark’s retail/PBM model — including calls to break it up.

“In light of recent industry developments, we feel incrementally better about the combined strategic assets owned by CVS Caremark,” analyst Mark Miller of William Blair & Co. wrote in a research note last month. “With its 90‐day-at-retail (Maintenance Choice) option offering 4% savings to payers (and increased convenience for payers’ beneficiaries), we believe [Wall] Street sentiment may shift toward viewing the retail/PBM entity as the winning model in the U.S. pharmacy industry.”

CVS Caremark is slated to give its 2012 profit outlook at its Analyst Day event on Tuesday in New York City.

Strong third-quarter results, reported early last month, struck a positive note with analysts and investors. Total revenue rose 12.5% year over year, including gains of 3.8% in the retail pharmacy and 25.8% in the PBM. Adjusted earnings per share of 70 cents topped the prior-year EPS of 64 cents and the average analyst forecast of 68 cents.

“We are a believer in the integrated PBM/retail pharmacy model and believe the company should continue to gain traction in the marketplace over time,” J.P. Morgan’s Lisa Gill observed.

CVS Caremark upped the lower end of its 2011 earnings guidance by 2 cents to a range of $2.77 to $2.81. That spurred analysts to hike their 2011 EPS forecast on the low and high ends to between $2.77 and $2.83, with an average estimate of $2.80.

“It’s clear CVS is finally turning the corner and is now actually positioned to benefit from multiple industry opportunities, including the Express Scripts-Medco merger, Walgreens-Express Scripts dispute and generics wave. The key hurdle at this point is whether management’s 2012 guidance actually lives up to expectations,” Ed Kelly of Credit Suisse stated in a CVS Caremark analysis titled “Story Starting to Come Together.”

Kelly added, “While we remain somewhat concerned about the cadence of guidance for next year (especially in the PBM), we believe the market better appreciates this dynamic.”

A successful streamlining initiative and major contract wins have breathed new life into the PBM unit, although competitive pricing has pressed margins, according to analysts. “Despite setbacks over the past few years, we continue to believe the company is not getting sufficient credit for its PBM business, which we believe should see a reacceleration of operating profit growth in 2012,” Gill wrote.

In an analyst conference call, CVS Caremark gave a positive update on the PBM selling season, she added. “The company stated that 70% of the contracts scheduled for renewal for 2012 have been completed and the retention rate stands at 98%. Importantly, management commented that it is maintaining a rational pricing strategy.”

CVS Caremark also is poised to benefit from synergies via its Maintenance Choice program, which lets mail order customers pick up prescriptions in CVS stores; its expanded Medicare Part D business, seen as a high-growth market; and its burgeoning MinuteClinic operation, which stands to see more activity from more locations, more clinical affiliations and more insured consumers as health care reform takes hold, analysts said. On the retail side, the company is getting a lift from its ExtraCare loyalty program, store clustering initiatives, inventory reduction, and expanded store brands and exclusive brands.

“We believe CVS’ unique business model continues to put it in the best position to capitalize on the disruptions in the industry,” wrote Deborah Weinswig of Citi Investment Research.

One of those disruptions involves a stand-off between two rivals. Walgreen Co. and Express Scripts Inc. remain at a contract impasse and, if it continues, the drug chain will proceed with its announced plan to leave the prescription benefit manager’s pharmacy provider network starting January 1.

Analysts say that scenario sets up CVS/pharmacy, as well as Rite Aid Corp., to add retail pharmacy market share.

“We believe a resolution between Walgreens and Express Scripts before year-end is becoming less likely, probably no more than 25% at this point,” Kelly wrote last month in a research note on the impact of the dispute. “Consequently, CVS and Rite Aid have the opportunity to gain market share as Express Scripts customers are forced to shift their prescriptions away from Walgreens.”

Credit Suisse estimates that CVS’ retail unit stands to pick up at least $1.1 billion in sales from Walgreens; $175 million to $180 million in earnings before interest, taxes, depreciation and amortization (EBITDA); and 9 cents in earnings per share. Rite Aid would gain an estimated $380 million in revenue.

And those estimates may be conservative, Kelly noted. “Our analysis assumes the pickup in prescriptions by CVS and Rite Aid is proportional with their current market shares,” he wrote. “In reality, we believe their gains will be bigger, given that Walgreens customers are more likely to switch to another chain pharmacy over independent pharmacies, mass merchants and supermarkets.”

So far, CVS hasn’t really seen a business lift since Walgreens unveiled its Express Scripts network exit plan in late June, and CVS’ stock price has stayed about the same, according to analysts.

“The company noted that the impact in the quarter [ended Sept. 30] was minimal, although it did see some script transfers,” Ross Muken of Deutsche Bank Securities stated in a research report. “Going forward, the company believes that if the dispute is not resolved by the beginning of 2012, it would see further script transfers that could drive incremental growth in the retail segment.”

Any sizable benefit for CVS from the Walgreens-Express Scripts dispute likely would come early next year, according to Weinswig.

“While the company said it may continue to experience script transfers in fourth quarter 2011, the greatest opportunity comes in January 2012,” she wrote in an analysis. “Management believes it is in a good position to service Express Script members and ensure that they have uninterrupted, convenient access to pharmacy care, as well as excellent customer service. CVS expects to capitalize on this significant opportunity if Walgreens and Express Scripts do not reach an agreement.”