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|  | JANUARY 13, 2004
 FOCUS STOCK By Phillip Seligman Good Medicine at Caremark Rx This pharmacy benefits manager has been making smart moves, and economic, political, and demographic trends should only help Amid widespread concern over rising health-care costs, we at Standard & Poor's Equity Research think the prospects are bright for the pharmacy benefit management (PBM) industry -- especially for our favorite name in the group, Caremark Rx (CMX ). We like Caremark also because its stock trades at a discount to the S&P 500-stock index, despite having significantly faster and, in our view, more sustainable earnings growth than the index. Caremark carries Standard & Poor's highest investment recommendation of 5 STARS, or buy. We think several factors will drive Caremark's growth, some of which relate to its industry and others that are company-specific. Runaway growth in spending on prescription drugs, partly caused by drug price inflation, rising utilization, and the introduction of new, high-price specialty compounds, creates a continuing need, in our view, for the cost-management tools PBMs provide. Looking ahead, we think the recent passage of the Medicare drug proposal will intensify that need. The legislation has the potential to add a large and expanding senior population into a possible future Medicare-sponsored drug-cost-saving program -- and as that group continues to age, drug usage should increase accordingly. Still, we believe Caremark, like its PBM peers, would be unwilling to participate in the program if doing so requires it to absorb the risk for covering seniors in places where Medicare managed care is nonexistent. PROVEN SAVERS. The regulatory environment for the PBM industry also appears to have become more favorable, particularly as the federal government has recognized its usefulness in helping control health-care costs. In January, 2003, the General Accounting Office issued a report confirming that the PBMs it reviewed produced savings for health plans participating in the Federal Health Benefits Program. Moreover, in an April, 2003, report outlining guidance for pharmaceutical manufacturers' marketing practices, the Health & Human Services Dept.'s Office of Inspector General (OIG) recognized the value of PBMs in controlling drug costs. Caremark has a number of competitive advantages, in our view. One is having four large, automated mail-service facilities. In addition, it operates a network of 19 smaller mail-service pharmacies located around the U.S. that are used to deliver specialized medications to individuals with chronic or genetic diseases and disorders. Caremark also has a number of established, advanced, technology-based systems and services. However, if it's ahead of its industry peers in some respects, we think that it won't be too long before these competitive advantages are erased by its rivals' tech investments. And the competition in the PBM industry continues to intensify. Caremark believes that at least 60 PBMs are operating in the U.S. The industry consists not only of independent outfits but also of PBMs that are divisions of large health plans or managed-care organizations -- or that operate as joint ventures between them. Moreover, some PBMs owned by big health-benefits providers service businesses other than their corporate parent's, making them direct competitors to the independents. Some large retail pharmacy chains also offer PBM services. SAVVY DEAL. Still, Caremark has been able to hold its own. About 60% to 65% of the net new business it sees for 2004 is expected to come at the expense of its largest independent competitors and approximately 20% from smaller PBMs -- not that much different from the book-of-business mix gained in 2003. Moreover, management sees its customer retention rate for 2004 at 97% to 98%, which, in our view, speaks well of Caremark. And its position should be further solidified by its pending acquisition of AdvancePCS, which has roughly double Caremark's revenues, yet lower earnings before interest, taxes, depreciation, and amortization (EBITDA) in a transaction valued at $5.6 billion (90% stock, 10% in cash). We expect eventual Federal Trade Commission approval of the deal, since the combined company will cover only an estimated 25% of the PBM market in terms of lives -- an industry term for the number of end users. Caremark expects $125 million in annual cost savings from the merger, 75% of which will be derived from purchasing efficiencies and the remainder from eliminating administrative redundancies, achieved within the first 12 months after closing. It also sees earnings accretive to Caremark earnings per share in the near term. LITTLE OVERLAP. The acquisition would combine companies that we think will complement one another. In terms of customer mix, AdvancePCS built a large base of managed-care customers, while Caremark focused on the employer marketplace. Significant cross-selling opportunities exist, as neither company's key specialty and disease-management programs overlap. In addition, Caremark sees significant upside potential to AdvancePCS's mail-order service penetration rate, which stands at only 9% vs. Caremark's 45%, the PBM industry's highest. Moreover, we see this transaction creating enhanced growth opportunities stemming from significantly improved cash flow. Although failure of the pending AdvancePCS acquisition would be a letdown to shareholders, if the merger doesn't go through, Caremark's stand-alone prospects remain bright, in our view.
BW MALL
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