Strong Prospects, Weak Valuation for CVS

CVS CAREMARK DOESN'T GET ANY RESPECT from Wall Street these days.

True, its shares (CVS), which traded in the mid-30s late last week, have rallied from the mid-20s in March. But they fetch 11.6 times next year's consensus profit estimate of $3.01 a share, a big discount to the valuations of drug retailer Walgreens (WAG) and pharmacy-benefit managers such as Medco Health Solutions (MHS) and Express Scripts (ESRX).

That discount could very well narrow, however, because CVS Caremark 's 6,900 drug stores turned in strong second-quarter results, and there are hints of improvement in its pharmacy-benefit management business. "Not a lot has to go right here for this to be a 40-plus stock," says Peter Langerman, co-portfolio manager of the Mutual Shares Fund (TESIX), which holds the shares. "Put a 15 multiple on it, and you are well into the 40s."

CVS IS THE NO. 1 RETAIL PHARMACY chain, slightly ahead of Walgreens. The company consists of two segments, each generating about half of its revenue: the retail stores and Caremark, the pharmacy-benefit management outfit it acquired for $26.5 billion in stock in early 2007. It was a bold move, but the jury is still out on its merits. PBMs contract with corporations, governments, unions and other clients to run the prescription-drug portion of their health plans. With plenty of scale, they have the clout to negotiate successfully with pharmaceutical makers, and they generally favor generic drugs.

The CVS Caremark PBM, which counts more than 3,000 organizations as clients, distributes drugs through the mail, which is cost-effective, and via its retail network of about 64,000 drug stores, including those operated by CVS. The company has made progress in creating synergies between the two units.

"If you look at the last two years of Caremark [being] part of CVS], the margin story has taken a few steps back, relative to peers," says Helene Wolk, a Sanford C. Bernstein analyst. But, she argues, margins will start to improve next year with the help of more generic drugs. Her price target is 44.

One problem: Caremark has lost some big contracts in recent years, and it's not expected to soon gain market share. The lost contracts include one for $2 billion with the Federal Employees Mail Plan and another for $400 million for the Chrysler UAW retirees.

That's made it hard to get traction, much less increase business, though "the [benefits] consultants are saying we're back to a more stable environment," says Dave Rickard, CVS Caremark's chief financial officer. But Rickard adds that combining CVS and Caremark has led to roughly $700 million in annual savings, primarily through increased leverage with pharma companies.

AND, EVEN WITH THE LOST contracts, Caremark remains formidable. Sanford Bernstein puts its market share this year at 17.5%, just behind industry leader Medco's 17.8%, and sees that improving in the next few years as it gets more business. While market-share gains would help, they "are not necessary for Caremark to become a significant contributor to EPS growth at CVS," Wolk notes, emphasizing the importance of the generic business.

To attract more customers, CVS has started Maintenance Choice. Under this program, customers can have 90-day prescriptions for chronic conditions filled at one of its pharmacies, while paying the mail-order price -- typically less than what's charged in the store. Maintenance Choice has signed up 270 plan sponsors out of the more than 3,000 with which CVS has contracts.

What about health-care reform? If more people are covered, as the White House wants, that could help business. On the other hand, profits could be hurt by reimbursement curbs. "Generally, I think the whole thing is pretty neutral" for CVS, says Wolk of Sanford Bernstein.

Caremark's operating margin slipped to 4.9% in the second quarter, down from 5.8% a year earlier. That's partly the result of discounting contracts with certain key clients to keep their business. In contrast, Medco sported double-digit growth in operating profits for the year's first half because it had more new business and did less discounting than CVS did.