Has CVS Reached Its Peak?
Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
CVS (NYSE: CVS) benefited from the prolonged contract negotiations between Walgreen (NYSE: WAG) and Express Scripts (NASDAQ: ESRX). From January, when Walgreens announced that Express Scripts clients could no longer use the company’s pharmacies, until July, when Walgreens announced that it came to terms with Express Scripts, CVS’s stock price increased 19.2%. CVS has gained market share in its pharmacy segment from the dispute at the expense of Walgreens.
Berkshire Hathaway sold 1.8 million shares of CVS in the second quarter 2012. Berkshire reported owning 5.66 million shares of CVS in September 2011. By March 2012, the fund increased their holdings to 7.11 million shares. In June 2012, Berkshire had only 5.3 million shares remaining. Warren Buffett another great pick in the retail pharmacy and PBM, since Berkshire reported owning CVS shares, the stock price has grown 33.6%. Buffett saw that CVS would benefit from the Walgreen and Express Scripts dispute, and purchased shares before other investors bought in to his thesis.
On August 7, 2012, CVS reported 2Q 2012 results. Script comps increased 9.8% on a 30-day supply basis and 7.7% when counting 90-day supplies as one script, these results reflected the benefit of the WAG/ESRX impasse. Not only did the dispute boost up their pharmacy segment, it also increased front-end sales. CVS estimated in its second quarter earnings report that front-end sales were positively impacted by the WAG/ESRX impasse more than 100 basis points in the quarter. Retail operating margin improved 90 basis points to 9.3%, enabling an 18% increase in operating income. Investors expected CVS to have a positive 2Q, but many didn’t forecast was the slow start in the 2Q due to a frontloaded allergy season and a dry summer.
The 2007 acquisition of Caremark Rx, a leading pharmacy benefit manager (PBM), benefited CVS retail stores, but the acquisition has cut more of the PBM’s value than it created on the retail side. CVS has struggled to sell its integrated PBM to customers, and operating profits have staggered. YOY comparisons remain difficult in CVS’s pharmacy benefit management segment. Although profitability is showing signs of stabilization, the segment’s operating margin contracted 30 basis points to 2.8%. EBITDA per script was stable at $2.49, and operating income was up 14%. As Express Scripts integrates Medco Health Solutions Inc. and takes advantage of increased bargaining power, we expect CVS to experiences pressure on retail reimbursements.
Both WAG and CVS have made a push to become more than just a pharmacy, but health and daily living destinations. Although both companies have made a push to expand their health care services, CVS has consistently been a step ahead of WAG on the innovation front. CVS started in-store health clinics, a rewards program, and consumer-friendly store layouts. CVS was the first pharmacy to integrate in-store health clinics, and they are winning the race in expanding health care services. The pharmacy has 584 in-store health clinics, while WAG has only 364. WAG is expected to integrate more health care services at a quicker rate than CVS. The acquisition of the largest European pharmacy, Alliance Boots, should help WAG expand their health care services in the optical and distribution side of health-care.
CVS trades at 16 times earnings, substantially higher than WAG, which trades at 12.3 times earnings. CVS stands to benefit from an aging population, health care spending growth, expirations on major brand-name drugs, and health care cost-containment efforts. We expect the contract renewal between WAG and ESRX to have a minimum impact on their pharmacy segments top and bottom line, as most clients will remain in CVS’s network. The optimistic outlook in their retail segment is countered by a rough outlook for their PBM segment. We expect margins to continue to decrease in their PBM segment stemming from industry consolidation and pricing pressures. Overall, we still like CVS as a long-term investment. The company will benefit from the consolidation in the PBM industry and the introduction of several generic drugs replacing brand-name drugs over the next 5 years.
This article is written by Mike Pate and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. The Motley Fool owns shares of Express Scripts. Motley Fool newsletter services recommend Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.