Markets & Finance

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

From Standard & Poor's Equity ResearchWe 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. In July, 2004, it bought 1,268 Eckerd drugstores, as well as Eckerd's mail-order, specialty pharmacy, and PBM businesses, from J.C. Penney (JCP) for $2.15 billion.

Market Profile

CVS is the largest U.S. drugstore chain, based on store count, with about 6,200 stores as of December, 2007, in 44 states and the District of Columbia. There were 44,615 drugstores in the U.S. at the end of 2006, with 47% operated independently and 54% operated by chains (including mass merchandisers and supermarkets). As of December, 2007, CVS had stores in 77 of the top 100 U.S. drugstore markets, holding the No. 1 or No. 2 market share in 58 of these markets, and 75% of all markets in which it operates. It filled more than 528 million prescriptions in 2007, accounting for about 17% of the U.S. retail pharmacy market.

Pharmacy operations are critical to CVS's success, in our view, accounting for 68% of retail store sales in 2007. Payments by third-party managed-care providers under prescription drug plans accounted for 95% of pharmacy sales in 2007. CVS's PBM business generated $34.9 billion in sales in 2007.

We expect total company sales to increase 16%, to more than $88 billion, in 2008, up from $76 billion for 2007, reflecting the Caremark acquisition and the continued turnaround of acquired drugstores. For its retail business, we estimate 3.5% organic retail square footage growth, on the opening of about 180 net new stores, and same-store sales growth of approximately 5.5%.

We see operating margins widening in 2008, reflecting synergies from prior acquisitions that provide increased sales leverage and improved purchasing power, partially offset by a rise in the mix of lower-margin pharmacy sales, higher employee benefit costs, and costs associated with expanding services in health-care clinics. The margin benefits we foresee also include an increased proportion of pharmacy sales coming from wider-margin generic drugs and improved cost management, thanks to inventory and pharmacy efficiency programs. We expect interest expense to rise as the acquisition of Caremark resulted in higher debt levels.

We estimate 2008 operating earnings per share of $2.48, up 29% from $1.92 for 2007.

Valuation

The shares recently traded at 17.5 times our 2008 earnings forecast of $2.48 a share, which was toward the lower end of the company's range of price-earnings ratios over the past three years‚ 16.3 to 20.3.

Because of benefits we see stemming from the acquisition of Caremark Rx, as well as benefits from the integration of acquired retail drugstores, we believe the shares should trade at a price earnings-to-growth (PEG) ratio comparable to the Standard & Poor's 500-stock index, and above CVS's three-year historical PEG multiple of 0.93 times. Applying a multiple of 19 times to our forward 12-month EPS estimate of $2.50, and assuming the shares trade at 1.0 times our projected long-term growth rate of 19% and toward the upper end of its three-year historical range, compared with 1.1 times for the S&P 500, we arrive at our 12-month target stock price of 48.

Corporate Governance

We believe that CVS's corporate governance practices are sound, and are above average for companies within the S&P 500 and the S&P Consumer Staples sector. Its board of directors is currently composed of 12 members, and is controlled by a supermajority of independent outsiders (independent outsiders make up more than 90% of the board). In addition, the full board is elected annually; no former CEO of the company serves on the board; the CEO serves on two or fewer boards of other companies; the performance of the board is regularly reviewed; a board-approved CEO succession plan is in place; outside directors meet without the CEO present; and the company does not have a poison pill in place.

However, shareholders do not have cumulative voting rights in director elections, and the positions of chairman and CEO are combined.

Investment Risks

Risks to our recommendation and target price include potential problems that may arise in implementing and managing acquisitions; a significant slowdown in the U.S. economy, which could curb demand for nonpharmacy retail products; and a reduction in prescription drug reimbursement levels. Additionally, efforts by health-maintenance organizations, managed-care organizations, other PBM companies, government entities, and other third-party payers to reduce prescription drug costs and pharmacy reimbursement rates may impact EPS.


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