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Gene Marcial's Stock Picks

Marcial: Will Wal-Mart's Generics Hurt CVS and Medco?

CVS Caremark Corp.—52-week price

Will Wal-Mart (WMT) become a big headache for giant pharmacy companies CVS Caremark (CVS) and Medco Health Solutions (MHS)?

On May 5, Wal-Mart announced plans to go generic. It launched a pilot program in Michigan offering a 90-day supply of 300 generic prescriptions, for $10 each, with free mail delivery.

The news shook up CVS and Medco investors, and shares of those companies inched lower that day. But they bounced back the following day, as analysts advised investors not to panic. CVS recovered to 32 on May 6, from 31 the previous day, and Medco crept back to 45, almost where it was the previous day. Wal-Mart stayed put at 50.

CVS is the largest pharmacy health-care company in the U.S. It operates 6,900 drugstores and, through its pharmacy benefit management unit, offers health-plan sponsors and participants access to a network of more than 60,000 pharmacies. Medco, which Merck & Co. (MRK) spun off in 2003, is the largest U.S. pharmacy benefit manager in terms of revenues and prescription count.

Analysts assert that Wal-Mart's move won't materially wound CVS and Medco as some had feared. "This latest evolution of Wal-Mart's generics program should have no direct impact on pharmacy benefit management companies' prescription volume," says Lisa C. Gill, health-care analyst at JPMorgan Chase (JPM). One reason: Wal-Mart's program targets the "cash" market, she notes. For CVS and Medco to be severely affected, "we would have to see Wal-Mart make greater traction in the employer [corporate] market," she adds.

Unpromising precedents

At this point, Wal-Mart doesn't have the ability to drive up its share in that market, which accounts for roughly 85% of drug spending. So "we don't believe the company is likely to see success going forward," says Gill.

She recalls that in 2006, Wal-Mart started a similar generic program priced at $4 for a month's supply. That was followed last year with a 90-day, $10 per three-month-supply program. Gill says neither has fared well. One reason, she says, is that the cost of Wal-Mart's generic program is roughly equivalent to the co-pay amount for an insured member, and as such wouldn't much affect prescription volumes. CVS and Medco, as well as Walgreen (WAG), another retail pharmacy chain, already provide mail-order delivery of medicines.

Wal-Mart, however, is optimistic. It says the generic plan signals the company's commitment to help consumers save money on prescriptions regardless of whether or not they live close to a Wal-Mart pharmacy. The company says it has set no definite time for deciding whether to expand the generics program beyond Michigan. Sales of health-care items at Wal-Mart were strong last year at its U.S. stores.

Nonetheless, Wall Street analysts who track CVS and Medco remain upbeat on both companies. Of the 24 analysts who track CVS, 20 rate it a buy and none recommend a sell. In Medco's case, 22 of 27 analysts recommend buying the stock, and none is tagging it a sell.

CVS discount card loyalty

After tumbling to a low of 23.98 a share on Mar. 9, 2009, CVS has pushed up to 31. JPMorgan Chase's Gill, who rates the stock overweight, notes that the company reported solid first-quarter results. Revenues from its retail-store segment exceeded her forecasts, and the pharmacy benefit management unit also posted strong sales, she says. (JPMorgan Chase has done business with CVS.)

Despite the weak economy, CVS is achieving what has been expected of it, with its retail business continuing to gain market share; pharmacy benefit management operations are also thriving. "We continue to expect that 2010 will show further progress slightly faster, especially in its pharmacy benefit management business," says Meredith Adler. health-care analyst at Barclays Capital (BCS), who rates the stock outperform.

CVS is gaining market share because of its "differentiated" offering, argues Adler. For example, CVS provides discounts on certain items at its stores based on individual customer preferences. Its discount cards have developed a strong customer following and loyalty, especially in these times of tough economic conditions, she adds.

Medco is a pure play on pharmacy benefit management, and as such fully benefits from the industry's bright prospects. "We expect revenues to rise 6.5%, to $54.6 billion, in 2009," up from 2008's $51.2 billion, says Standard & Poor's analyst Phillip M. Seligman, who rates the stock a buy, with a 12-month target of 55 a share. He figures it will earn $2.77 a share in 2009 and $3.25 in 2010, vs. 2008's $2.13. Drivers for growth, he says, include a 94.6% retention rate of existing business—and a net new business of $6.1 billion gained thus far in 2009.

Medco's stock, which hit a low of 31 a share on Oct. 27, 2008, has been winging up, rising to 44 on May 8. Some analysts expect the stock will reach 55 in a year, surpassing its high of 50, reached on Sept. 12, 2008.

Efforts by the government and health-plan sponsors to control drug costs are benefiting Medco, Seligman notes. And as consumers try to save money by turning more to generics and mail-order prescriptions, Medco's margins will continue to expand. The bulk of its revenues and earnings are derived from rebates and discounts on prescription drugs that it gets from pharmaceutical companies, as well as cost-efficient service delivery.

The bottom line: CVS and Medco deliver specialized and personalized attention to their customers, which is the essence of pharmacy benefit management. This is why their services will be in constant demand, and why the shares continue to represent long-term value for investors.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.

Marcial writes the Inside Wall Street column for BusinessWeek. In 2008, FT Press published the book Gene Marcial's 7 Commandments of Stock Investing.

Marcial writes the Inside Wall Street column for BusinessWeek. In 2008, FT Press published the book Gene Marcial's 7 Commandments of Stock Investing.

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