CVS/Caremark Corporation (CVS)

CVS/Caremark Corporation (CVS)

Snapshot:

·  Price: 34.97

·  P/E: 21.86

·  PEG (5 yr expected): 1.16

·  EPS: 1.60

·  52-week range: 27.09-36.14

Overview:

CVS/Caremark Corporation operates around 6,200 retail drugstores and specialty pharmacy stores in the United States. In addition, the company offers pharmacy benefit management services, through PharmaCare and the recently acquired Caremark. The company gains 95% of its sales from the retail pharmacy business, of which prescription drugs make up 70%. Based in Woonsocket, Rhode Island, the company was founded in 1892 as the CVS Corporation. In March 2007, the name was changed to CVS/Caremark Corporation, reflecting the merger with Caremark Rx, a leading pharmacy benefits manager. With a market cap of 28.95B, it is second to only Walgreens in the drug stores industry, which has a market cap of 45.62B. The stock is currently at 34.97.

Industry Overview:

The drug store retail industry is a great investment opportunity at the moment. Here’s why:

·  Doctors have been relying more and more on prescription drugs to treat medical problems

·  The baby boomers (born between 1946 and 1954) are now between the ages of 53 and 61, causing a bulge in the aging population that will cause a surge in demand for medical care, including prescription drugs

·  The demand for prescription drugs, which make up a large majority of revenue for retail drug store chains, is relatively inelastic. As a result, the industry is less cyclical than most retail businesses, though “front” store sales do tend to fluctuate. This is especially important with the present economic uncertainty.

·  Drug store chains are branching into all different aspects of the healthcare business, allowing them to benefit from the growing sector. With the Caremark merger, CVS has increased its ability to benefit from the industry’s favorable trends. Additionally, CVS, Walgreens, and Wal-Mart have all been testing in-store clinics with great success, a possible generator of revenue in the future.

Competition:

·  Walgreens Co. (WAG) is CVS/Caremark’s main competitor. As previously mentioned, it has a larger market cap than CVS. It is growing at a significantly lower rate than CVS; quarterly revenue growth was 14.6% for WAG as compared with 24% for CVS. A recent ranking by J.D. Power and Associates showed both CVS/Caremark and Walgreens as highly ranked in terms of customer satisfaction in retail stores. The study also showed Caremark and PharmaCare lead the mail order segment, indicating an edge for CVS/Caremark. While WAG should also benefit from favorable industry trends, particularly the growth of an aging population, CVS is priced more attractively than WAG. The P/E of CVS is 21.84 as compared to WAG’s 23.60 and the forward P/E of CVS is 18.42 in comparison to WAG’s 21.88. When the differences in growth are factored in, CVS still seems to be a better value; its PEG ratio is 1.16 compared with WAG’s 1.37.

·  Wal-Mart (WMT) is a more indirect competitor of CVS. Its new program offering generic drugs for $4 will not directly affect sales at CVS, as CVS has the edge in both its convenience of location and a reputation for great specialty knowledge in the pharmaceutical area. However, Wal-Mart’s program, while not directly vying with CVS for customers, could be harmful because it introduces the idea that drugs should be cheaper.

·  Rite-Aid Corp. (RAD) is a distant third in the drug store business, with a market cap of only 3.4B. With negative earnings, it will have to wage a great uphill battle if it intends on competing with the much bigger, and much more established, companies of CVS and Walgreens.

CVS / WAG / WMT / RAD
Market Cap / 28.95B / 45.68B / 205.23B / 3.41B
P/E / 21.86 / 23.63 / 18.38 / N/A
PEG (5 yr) / 1.16 / 1.37 / 1.05 / N/A

Financials:

Overall, CVS has healthy financials. The merger with Caremark added to the debt of the company, but the investment should pay off in the future, especially with the resulting increase in purchasing power and the cost synergies. In the short term, the company’s healthy earnings will be able to support the short-term debt. Caremark’s acquisition added to the debt of the company- Net Borrowings were $2.78B in 2006, compared to -$626M in 2005. Total debt is now $5.06B, with a debt-equity ratio of .51. The Current Ratio is 1.484. While this is less than the industry’s 1.57 average, it is not far off in spite of the added debt from the merger. As shown below, CVS/Caremark has larger margins than the industry, and expects to increase these margins as a result of the merger. Additionally, CVS posted a same-store sales jump of 7 percent in March over the prior year, attributed to sales growth in both prescription drugs and “front” store merchandise.

CVS/Caremark / Industry
Gross Margin / 27.25 / 22.71
Operating Margin / 5.57 / 4.99
Profit Margin / 3.12 / 2.93

Summary of Financials (in thousands)

30-Dec-2006 / 30-Dec-2005 / 1-Jan-2005

Total Revenue

/ 43,813,800 / 37,006,200 / 30,594,300
Gross Profit / 11,939,000 / 9,901,200 / 8,031,200
Operating Income / 2,441,600 / 2,019,500 / 1,454,700
Net Income / 1,368,900 / 1,224,700 / 918,800
Current Assets / 10,391,500 / 8,392,700 / 7,919,500
Total Assets / 20,569,800 / 15,283,400 / 14,546,800
Current Liabilities / 7,000,700 / 4,583,900 / 4,858,800
Total Liabilities / 10,652,200 / 6,952,200 / 7,559,600
Total Stockholder Equity / 9,917,600 / 8,331,200 / 6,987,200
Net Tangible Assets / 5,404,200 / 5,739,100 / 4,220,800
Net Income / 1,368,900 / 1,224,700 / 918,800
TCF Operating / 1,742,400 / 1,612,100 / 914,200
TCF Investing / (4,593,200) / (911,600) / (3,163,300)
TCF Financing / (2,868,100) / (579,400) / 1,798,200
Change in Cash / 17,300 / 121,100 / (450,900)

Valuation:

As mentioned before, CVS is a very attractive stock because of its relative valuation to the industry, as well as its chief competitor, Walgreens. The P/E of CVS is 21.84 as compared to WAG’s 23.60 and the industry’s 25.08 and the forward P/E of CVS is 18.42 in comparison to WAG’s 21.88. When the differences in growth are factored in, CVS still seems to be a better value; its PEG ratio is 1.16 compared with WAG’s 1.37. Its EPS for the current year is estimated at 1.86.

While the stock is nearing its 5-year high, I think the stock will continue to climb as a result of the Caremark merger and its expansion into the profitable healthcare industry, as detailed in the industry overview.

CVS/Caremark / Industry
P/E / 23.61 / 25.11
Beta / 0.44 / 0.60
Price to Sales / 0.90 / 0.74
Price to Cash Flow / 25.60 / 17.23

Opportunities:

CAREMARK MERGER

The reduction in costs and increased purchasing power resulting from the merger will result in increasing operating margins. In 2006, CVS had an operating margin of 5.6% and Caremark’s was 4.7%. Analysts anticipate the merger should drive operating margins to about 6.5% in 2008 and even higher long term. Additionally, the merger will allow CVS a greater presence in the pharmacy and healthcare business, which is an extremely favorable industry due to demographic trends. Finally, the merger will give CVS a bigger stake in fast-growing areas of prescription drug spending, including specialty pharmacy and disease management.

LESS CYCLICAL BUSINESS

With the present economic worry about rising oil prices and the softening housing market, it is extremely beneficial that CVS/Caremark is not a cyclical business, and derives most of its revenue from the sale of goods with a relatively inelastic demand. The beta of both Walgreens and CVS/Caremark is historically lower than the S&P 500, showing the industry is somewhat sheltered from the effects of economic volatility.

FAVORABLE INDUSTRY TRENDS

The demographic trends and doctors’ increasing dependence on prescription drugs to treat medical problems guarantee that the drug store business will continue to be highly profitable. Additionally, the trend towards market consolidation will help deter upstart competitors by increasing barriers to entry and will ultimately increase the market share of the major companies, CVS/Caremark and Walgreens. Additionally, while the retail pharmacy aspect of the stores is the major driver of revenue, the increasing high-margin offerings of the “front” store should help sales growth, especially as studies show 1 out of every 3 people makes an additional purchase when picking up medication. CVS/Caremark, with the country’s biggest loyalty card program, ExtraCare, should especially benefit from this trend.

Risks:

CAREMARK MERGER

CVS and Caremark are very different companies and the merger will be difficult to execute, especially as the two companies have different clients. CVS has targeted consumers, while Caremark has targeted insurance companies and the like. Fortunately, CVS has a great history of successful mergers, which speaks to the probability of success in this latest venture. Additionally, analysts have argued that the merger will threaten other drugstore chains and PBMs, causing CVS/Caremark to be a greater target in the field. While this is true, it is not a reason to not invest in the stock, as its status as a target comes with a greater market share and greater purchasing power.

GOVERNMENT LEGISLATION

The government and businesses have been pressured to lower rising healthcare costs. A particular concern for drug stores is the idea that a Democratic-controlled Congress will push to lower reimbursement rates, which would cut the profitability of drug retailers. While this is a possibility, it is unlikely given a Republican president and only a slim Democratic majority in two legislative bodies. However, should legislation be passed, it would significantly hurt the margins of CVS/Caremark.

Recommendation:

The drug store retailer industry is a great one at the moment, with the increasing reliance on prescription drugs and the growth of an aging population. Additionally, the economic uncertainty of the moment makes the non-cyclicality of the business extremely attractive. In the drug store business, CVS/Caremark is a standout in customer satisfaction and sales growth, and is presently cheap relative to competitors. The merger with Caremark promises increasing future margins and allows CVS to benefit even more so from the burgeoning healthcare industry. For all these reasons, I rate CVS/Caremark a BUY.