AET Aetna Inc. (delisted)

Recently, we reiterated our Neutral recommendation on CVS Caremark Corporation (CVS) with a target price of $41.00.

CVS Caremark reported an adjusted EPS of 57 cents in the first quarter of 2011, beating the Zacks Consensus Estimate of 55 cents but trailing the year-ago quarter’s adjusted EPS of 60 cents.

After sluggish performance in past several quarters, the Pharmacy Benefit Management (PBM) business of CVS registered a robust 18.4% year over year increase during the quarter to reach $14 billion. The significant upside in revenue was primarily attributed to the 12-year contract with Aetna (AET), under which CVS provides PBM services to Aetna customers.

We are encouraged by the company’s initiative for further focus on its key-growth areas under the PBM segment including the acquisition of Universal American's (UAM) Medicare Part D Businesses and the rapidly growing Specialty Pharmacy sector. We are also optimistic regarding the progress in the PBM segment based on CVS’s new business wins and strong client retention. In May 2011, CVS won a three-year, multi-billion-dollar PBM contract to serve more than 5 million Federal Employee Program (FEP) clients, which will act as a potential turning point for the PBM business of the company.

CVS expects to maintain its strong performance in the Retail segment going ahead. The company expects the segment to deliver higher sales (4%−6%) and operating profit (6%−8%) for 2011 with a 2.5%−4.5% rise in same-store sales. In the reported quarter, the company’s same-store sales grew 2.6% resulting in a 4.4% climb in retail revenues.

Moreover, with improved selling, general and administrative leverage during the reported quarter, operating margin in the retail business was 7.5%, up about 15 basis points (bps). We are also impressed with the company achieving more than $700 million in annual purchasing synergies and overhead savings from combining its Retail and PBM segment. We expect this to facilitate future growth.

However, despite implementing diverse strategies to expand its business, CVS continues to face margin pressure. Gross margin during the reported quarter, decreased by 160 bps to 18.4% compared with the year-ago quarter level. The decline in gross margin was primarily attributable to price compression associated with contract renewals, addition of the Aetna business, as well as continued pressure on pharmacy reimbursement rates.

Additionally, although CVS expects to record a 23%−26% growth in PBM revenues for 2011, operating margin of the segment is forecasted to decline 5%−9%. Moreover, lower introduction of generics in 2011 (lowest year in recent history) and expenses associated with the PBM streamlining initiative will also affect the margin.

Furthermore, the presence of many big players like Walgreens (WAG) and Medco (MHS) as health care providers has made the market highly competitive. However, we remain confident about the long-term potential of CVS.

 
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