CVS: The Drugstore of Choice

S&P sees growth opportunities in the company's retail and pharmacy benefit management businesses, and it ranks the stock a strong buy

by Joseph Agnese From Standard & Poor's Equity Research

We believe CVS Caremark (CVS; recent price, 43) is well positioned for market-share gains, following the acquisition of Caremark Rx in March, 2007, and the continued turnaround of recent drugstore acquisitions. We have a favorable long-term outlook on the U.S. drugstore industry, as we expect an aging population to boost demand for prescription medications.

We see the March, 2007, acquisition of Caremark resulting in more than $700 million in synergies in 2008, reflecting benefits from economies of scale, including substantial purchasing savings and overhead cost reductions. In the longer term, we believe CVS's ability to improve access and offer greater convenience through its mail and retail businesses will help generate new customer wins, as the company leverages retail offerings to gain new clients. Additionally, we believe an improved merchandise assortment reflecting increased private-label goods and exclusive offerings, along with improved convenience, will help CVS gain market share.

The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).

Company Profile

Based in Woonsocket, R.I., CVS Caremark operates one of the largest drugstore chains in the U.S., based on revenues, net income, and store count. The company offers prescription drugs and a wide assortment of general merchandise, including OTC drugs, beauty products, cosmetics, film, photo finishing services, seasonal merchandise, greeting cards, and convenience foods. As of December, 2007, net selling space in retail and specialty drugstores was 56.5 million square feet, with about two-thirds of its stores opened or remodeled in the past five years. Most new stores being built range in size between 10,000 sq. ft. and 13,000 sq. ft. and typically include a drive-through pharmacy.

In March, 2007, CVS acquired Caremark Rx for about $26.5 billion in stock and a cash dividend. The acquisition combined two of the largest pharmacy benefit managers in the U.S. CVS's pharmacy benefit management (PBM) segment provides a full range of services including mail-order pharmacy, specialty pharmacy services, plan design and administration, formulary management, and claims processing. Customers are primarily employers, insurance companies, unions, government employee groups, managed-care organizations, and other sponsors of health-benefit plans and individuals throughout the U.S.

Between 1996 and 2004, the company experienced a compound annual growth rate (CAGR) for earnings per share (EPS) of 15%, reflecting strong sales growth and slightly narrower margins, in our view. Total sales grew at an eight-year CAGR of 24%, on an 18% CAGR in store count and higher comparable store sales. Margins narrowed over this period, owing to a change in the product mix due to increased sales of lower-margin pharmacy items and increased sales to third-party insurance plans despite greater sales leverage.

However, from 2005 to 2007, the company experienced a CAGR for revenues of 36% and an expansion in EBIT (earnings before interest and taxes) margins from 5.5% to 6.3%, reflecting, we believe, benefits from acquisitions and increased sales of wider-margin generic drugs. We think the company is well positioned to continue to produce positive sales and margin trends, based on an improving pipeline of new drugs expected to come to market in the next few years and benefits from the acquisition of Caremark in March, 2007.

CVS's long-term strategy focuses on expanding its retail drug business in high-growth markets and increasing the size and product offerings of its PBM business. Pharmacy operations are expected to be a key focus, reflecting what we see as CVS's ability to succeed in the rapidly growing managed-care arena and its ongoing purchase of prescription files from independent pharmacies. Historically, the company has grown largely through acquisitions. In June, 2006, CVS acquired 700 stand-alone drugstores from Albertsons for $2.93 billion in cash.