DRUGGIST CVS

Caremark

ExpressScripts

The merger uncertainty has some investors avoiding CVS shares, but they might be a bargain with or without Caremark. More on that in a moment. The company turned up recently in our Earnings Momentum screen.

Our screen looks for companies that have recently beaten Wall Street's earnings forecasts. Shares of such companies tend to jump right away on such good news, but they also tend to keep climbing. As far back as the 1960s and as recently as last year researchers have documented a phenomenon they call PEAD, or post-earnings announcement drift. It's the tendency of stocks to drift higher for six months to a year following good earnings news, outperforming the broad market in the process. Investors, it seems, are slow to fully appreciate the underlying improvements that an upside earnings surprise suggest.

Our screen also looks for rising earnings estimates, strong earnings growth over the past three years and projections for more of the same over the next year. See our screen recipe for details on all the demands and use our stock screener to run the search for yourself anytime. Recently it reduced an 8,000-company database to a list of eight.

CVS has beaten earnings estimates in each of its past four quarters by an average of 4%. Its shares are now up 180% since appearing in this column in an April 2003 search for down-but-not-out stocks. We noted at the time that while the company's drug sales were off, it was selling more generic drugs, which cost less than branded drugs but carry greater profit margins.

CVS is still benefiting from that shift to generics. It's also gaining market share and putting some recently acquired assets to profitable use.

Fourth-quarter results for CVS, reported Feb. 1, showed sales increasing 24% year-over-year to $12.1 billion. Same-store sales improved by 8.7%. Same-store sales exclude the effect of acquisitions and new-store openings made within the past year. CVS bought 700 Save-On and Osco drug stores from grocer Albertson's in June. Fourth-quarter profits, excluding one-time items, increased 10.3%. The results appear to be carrying over to 2007. Sales for the month of January, which CVS also reported on Feb. 1, increased 24% year-over-year while same-store sales rose 8.6%.

The company said 2007 earnings will likely total $1.87 to $1.93 a share. The midpoint, $1.90, implies earnings growth of 22%. Analysts say CVS should continue selling more generic drugs while reducing operating costs as it integrates the stores it bought last year. They also expect a larger contribution from Minute Clinics. CVS currently operates 155 of the clinics, most of which are located in its drug stores. They provide quick care for common ailments with clear, up-front pricing. Deer tick bites, for example, cost $59 to treat while a bladder infection for females runs $69. CVS plans to open 300 more of the clinics in 2007.

Industry watchers say services like Minute Clinic should help differentiate CVS from low-cost competitors like Wal-Mart Stores, which now offers a select number of generic drugs for $4 apiece. CVS claims a purchase of Caremark would create between $800 million and $1 billion in new sales for the company as, for example, Caremark customers pick their pills up at CVS and purchase a couple of front-of-the-store items while they're there. The company also calls "conservative" its estimate of $500 million in yearly cost savings through, for example, increased purchasing power.

The risk to shareholders, of course, is that CVS pays too much. ExpressScripts is presently offering more money, about $26 billion in cash and stock. Caremark managers call the ExpressScripts offer "highly conditional" and "uncertain" and say it creates "no strategic advantage." Caremark shareholders will vote on the CVS offer on Feb. 20.

This column recommended shares of Caremark in a March 2004 search for accelerating sales growth. They're up 84%. It also recommended ExpressScripts in a March 2003 screen for rising profit forecasts and again two years later in a search for reasonable price/sales ratios. Shares are up 159% since the first story and 70% since the second.

CVS at today's share price might be too cheap to ignore. The stock fetches 17 times Wall Street's 2007 earnings forecast. Analysts expect the company to increase its earnings by 14% a year over the next five years. Those numbers make for a PEG ratio (price/earnings ratio divided by earnings growth forecast) of 1.2. That suggests the stock trades at a discount to the broad market of more than 20% relative to the company's growth potential. A successful purchase of Caremark without a runaway bidding war would likely make CVS a better deal still.