Sunday, September 23, 2012

CVS Caremark Equity Research Analysis

The market promptly sold off CVS Caremark $CVS even after it delivered a strong set of results. My suspicion is that a gang of investors were simply waiting for a pop on the results in order to try and be ‘smart’ and sell out in order to monetize the appreciation in the share price following the Walgreen $WAG and Express Scripts $ESRX debacle. Now that Walgreen will restart filling prescriptions from September 15 from Express Scripts. The hot money seems to have flowed back into the stock and away from CVS. Here is why I think that viewpoint is a mistake and why CVS is a core holding for any portfolio.

CVS Caremark’s Recent Results

CVS beat estimates with net revenues rising 16.3% with retail same store sales increasing 5.6%. Moreover, the company raised and narrowed EPS guidance whilst confirming strong cash generation at the company.  Movements in guidance this year:

The stock still sold off!

I think the market now believes that momentum will shift back to Walgreen from mid September. CVS discussed the issue and stated that it believed that it would retain the ‘vast majority’ of scripts in the third quarter and at least 50% in the fourth quarter. I think 50% might be too low a figure and here is why.

Inertia. Simply put, the prescription business is very sticky and whenever I have seen the subject of inertia addressed in behavioral finance tomes, there is always an underestimation of how resistant people are to change. However, not everyone is blind to this fact.

Ever wondered why every single candidate to an incumbent politician uses ‘time for a change’ as part of his/her core campaign? It is because they know that overcoming inertia is a large part of their fight. Moreover, if you think that inertia and behavioral finance is mumbo-jumbo then consider the insurance industry. The whole industry is structured around behavioral finance.

Ever wondered why new customers get more favorable rates than existing customers in terms of car insurance? It is because of inertia. Of course customers could en masse just keep switching for the cheaper deals, but human beings are hard wired to pay a premium for the ‘benefit’ of inertia. And the insurance industry is all too happy for you to pay it.

That said, CVS is undertaking a whole series of measures including advertising, promotions and data analyzing the new clients with a view to ensuring they stay. To go back to the car insurance analogy, the whole Walgreen/Express Scripts debacle was like running promotions in order to gain new customers without actually having to pay for it. A very nice scenario. I think CVS could surprise on the upside with customer retention in the second half.

No matter, the stock has a whole host of other mid and long term profit drivers which makes it extremely attractive.

CVS Caremark’s Profit Drivers

 I think CVS shareholders can look forward to a number of positive catalysts for the stock in future years.

  • Demographics. An aging population will require more prescriptions and CVS is the leading player in  the Medicare Part D prescription drug program.
  • Digital capabilities will allow then to monitor and profile customers better in order to personalize an offering
  • Private label penetration is intended to increase from 17% to 20% and these products typically come with higher profit margins
  • Margins are likely to increase as the patent cliff causes higher adoption of generics
  • Expanding store brands from just being strong in consumer health
  • Growth created by offering a ‘one-stop’ service by being a pharmacy benefits manager (PBM), a retail pharmacy and running a retail clinic
  • Cash flows set to expand rapidly

CVS writes over 20% of the PBM retail scripts in the US and on the retail side has around 7,300 pharmacy stores. It is the leader in the ‘minute clinic’ sector with over 600 locations in operation. It is the confluence of this triangle of operations that differentiates CVS from the competition, of which there is plenty.

Not only is Walgreen a strong competitor in retail but there is also the struggling Rite-Aid $RAD and the ubiquitous name of Wal-Mart $WMT is in the fray too. The latter is a formidable foe but CVS is differentiated via its overall offering and Wal-Mart would have to invest significant time and resources in aping CVS’ offering or in digitally analyzing the customer base in the way that the specialist operators can. In fact, CVS outlined plans to further differentiate itself by expanding the number of minute clinics from 60 to 1,000 by 2016.

The demographic argument is well understood, but I want to focus on a less discussed issue. Everyone knows that aging demographics will create political and financial pressures on health care. However, CVS is likely to be a beneficiary. Private label or store brands tend to be higher margin and companies that make them such as Perrigo $PRGO are set to benefit. Perrigo is attractive in its own right, but it currently trades on 29x earnings and an EV/Ebitda of nearly 17x  whereas CVS trades on 16x and 7.8x these metrics respectively.

In addition, the increasing use of generics is beneficial to margins. Whilst generics may reduce overall revenues, they tend to be higher margin for the retailer as the pharmaceutical companies take a huge portion of the profits for their patented pharmaceuticals. Therefore it is in the interests of CVS and Walgreens to expand generics sales. Indeed, CVS mentioned that operating profit in the retail segment is now expected to be at the high end of prior guidance.

Where Next For CVS?

In my opinion it pays to ignore the market noise. Forget the ‘smart’ traders who think that investing is all about trading in and out on what the street thinks. The company has just told you that it expects to generate $4.6-4.9 billion in free cash flow this year and $4.7 billion each year from 2011-15. This equates to around 7.2% of its enterprise value. Furthermore, the stock looks like a great value as it is set to defensively grow earnings in the teens.

Granted, there are always political risks with this type of stock, but there are always political rewards too. The public wants more in store and generic drugs in supply and they won’t complain if prices go lower even if CVS is making more margin and profitability out of them. In conclusion, the stock looks undervalued, I like the long term story and think there is more to come from this stock.

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