Markets & Finance

CVS's Potent Growth Potion


By Joseph Agnese At least one corner of the U.S. economy isn't suffering from lackluster growth: retail pharmacies, where sales are estimated to have topped $188 billion in 2002, up 15% from 2001. And retail drug sellers should continue to benefit from a number of favorable industry trends such as an aging American population consuming a greater number of prescription drugs, pharmaceuticals being used more often as the first line of defense for managing illness, the growth of managed care, and the introduction of new and better drug therapies.

What's the best way for investors to capitalize on these trends? We at Standard & Poor's think industry leader CVS (CVS) is poised to benefit not only from the growth in health-care spending but also from some effective cost-control measures, superior use of technology, and a focused expansion strategy. The shares carry S&P's highest investment ranking of 5 STARS (buy).

Measured by net sales of $24.2 billion in 2002, CVS is the second-largest retail drugstore chain after Walgreen (WAG). Based on store count, it's the largest pharmacy chain, with over 4,000 outlets in 32 states and Washington, D.C. CVS operates in 60 of the top 100 U.S. drugstore markets and is No. 1 or 2 in market share in 73% of the markets in which it operates. It holds the leading market share in 35 of the 100 largest U.S. drugstore markets.

CLOSINGS AND OPENINGS. Its stores sell prescription drugs and a wide assortment of general merchandise, including over-the-counter drugs, greeting cards, film and photofinishing services, beauty products, seasonal merchandise, and convenience foods. (CVS refers to these as front-end products.) It filled more than 316 million prescriptions in 2002, accounting for an estimated 12% of the U.S. retail drug market and over 21% of chain drugstore sales.

In an effort to trim costs and boost profitability, CVS completed a restructuring in early 2002 in which it closed 229 stores, leaving it well positioned to reach its long-term goal of 12% to 15% earnings growth. It plans to open 250 to 275 new stores in 2003 with a focus on three areas: entering new markets, adding stores within existing markets, and relocating existing stores to more convenient, freestanding sites.

Its stores are primarily located in strip shopping centers or freestanding locations, with a typical unit ranging in size from 8,000 to 12,000 square feet. CVS continues to relocate many strip-center locations to freestanding sites, and it anticipates that the stand-alone stores will account for 70% to 80% of the total over the long term. With approximately half of its store base newly opened or significantly remodeled within the past five years, CVS is establishing itself in some of the fastest-growing drugstore markets in the U.S., including Tampa, Fort Lauderdale, Orlando, Miami, Chicago, Las Vegas, Dallas, and Houston.

LOYALTY REWARDS. Pharmacy operations accounted for 68% of sales in 2002 (66% in 2001). Payments by third-party managed-care providers under prescription-drug plans accounted for over 92% of total pharmacy sales in 2002 (91% in 2001). Pharmacy will continue to be a key focus for CVS, reflecting its ability to succeed in the rapidly growing managed-care arena and its ongoing purchase of prescription files from independent pharmacies.

Front-end sales have benefited directly from the success of pharmacy operations. As shoppers come in to have a prescription filled, they often make other purchases as well. During 2002, front-end sales accounted for 32% of the total (vs. 34% in 2001). These sales typically provide wider gross margins than pharmacy sales.

Front-end operations should continue to get a boost from CVS's relationship-marketing program, called ExtraCare, under which it offers special promotions and incentives to its best customers to reward their patronage and encourage increased loyalty. Over 33 million CVS customers have an ExtraCare card.

SPEEDY DELIVERY. One of the keys to this operating strategy is technology, in which CVS has made significant investments aimed at improving customer service and exploring ways to provide more personalized product offerings and services -- while lowering costs and increasing operating efficiency. In addition to being one of the first in the industry to install a chainwide automatic prescription-refill system, CVS has introduced its Excellence in Pharmacy Innovation & Care (EPIC) system, a multiyear project that reengineered the way its pharmacists communicate and fill prescriptions. EPIC continues to improve quality assurance and customer service while reducing labor costs.

CVS also is implementing the Assisted Inventory Management (AIM) system, which more effectively links CVS stores and distribution centers with suppliers to speed the delivery of merchandise to its stores. This helps reduce out-of stock positions and lower investment in inventory.

At S&P, we look for sales to grow by about 8% in 2003, aided by approximately 150-165 new stores (representing over 4% growth in total square footage) and approximately 6% comparable-store sales growth, partially offset by about 45 to 50 store closings. Pharmacy comparable sales are expected to grow about 8%, partially offset by a number of higher-priced products being switched to generic versions. Front-end store sales should decline slightly in 2003, with stiff retail competition continuing and difficult comparisons in the first half of the year.

SET FOR GROWTH. Margins will likely be pressured due to a shift in the sales mix, reflecting a rise in the proportion of lower-margin pharmacy sales, increased sales to less-profitable customers covered by third-party insurance programs, and higher employee benefit costs. However, CVS should be able to offset these unfavorable trends as major drugs continue to come off patent, resulting in increased sales of higher-margin generics. The AIM and EPIC initiatives should also aid cost-management efforts. First-quarter comparisons will likely be hampered by the Easter holiday's shift from the first quarter in 2002 into the second quarter in 2003.

All told, we believe CVS has positioned itself well to achieve its long-term earnings-per-share growth target of 12% to 15%, and we see earnings reaching $1.96 in 2003, up 12% from $1.75 in 2002, excluding nonrecurring items.

The stock recently traded at 13 times our 2003 EPS estimate of $1.96, near its historical average low and below the 16 average multiple of its industry peers. Applying a multiple of 16 times 2003 earnings per share, near the current S&P 500 multiple and slightly below the average of its industry peers (based on estimated earnings), values the shares at $31.36. On a

discounted free cash-flow basis, we value the shares at $37.20, or 48% above their recent price. Blending the two valuations, we derive a price target of $34, or about 36% above the stock's recent price. Analyst Agnese follows drugstore stocks for Standard & Poor's


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