Thesis

Why not buy a company with phenomenal long-term trends, great competitive positioning, high returns on capital, significant uncertainty but little real risk and a free cash flow yield of over 8% growing earnings 15%+ per annum? CVS has been completely thrown out due to all the negative publicity surrounding (1) Wal-Mart’s announcement on reducing prices for certain generics, (2) Average Wholesale Price (AWP) changes resulting in potential reduced reimbursements(e.g. settlement with First Data Bank), and (3) the merger with Caremark that is currently hated by Mr. Market.  We are taking a contrarian view to the negative sentiment and see this as a tremendous opportunity to buy the largest drugstore chain in America undergoing a potential game-changing transaction in the face of extremely strong demographic and generic trends. You can buy this company, which should conservatively grow revenues 8-12%/year for a very long time, for close to 12x our estimate for 2007E free cash flow assuming only $400MM pre-tax synergies that were initially announced.

 

CVS Description

CVS is the largest retail drug store chain in America with 6,197 retail and specialty pharmacy stores.  Approximately 70% of total sales are pharmacy sales of which 94% are sales to customers covered by third party insurance programs.  Of the total pharmacy sales, approximately 11.5% is its pharmacy benefit management business (PBM), which is the fourth largest in the US with about $3.5bn in sales, offering mail-order, specialty pharmacy, plan design, formulary management and claims processing to managed care and other organizations. The other 30% of sales are front store sales from over-the-counter and personal care (10%), beauty and cosmetics (5%) and general merchandise (15%).  CVS private label and CVS exclusive products account for 13% of front store sales and should continue to increase to 18-20% annually over time.  Further, you get material upside optionality from Minute Clinic, which they recently purchased.  More on that later.

 

Growth History:

The company has grown its footprint significantly over the last few years primarily though acquisitions.  In July 2004, the company acquired 1,268 Eckerd retail drugstores and the $1bn Eckerd Health Services business, which included its mail order and PBM business.  Eckerd’s was poorly operated especially leading up to the acquisition, which provided an opportunity for CVS management team to turn around the business, improve margins by merchandising better, institute better inventory controls, and improve customer service and marketing.  At the time of acquisition, we estimate Eckerd’s retail operating margins (excluding its PBM) were below 1% excluding corporate expenses; this assumes its PBM business had 3.5% operating margins.  For the 12 months ending 1/31/04, operating margins for the entire Eckerd chain were 1.9% and in the first quarter 2004 prior to the acquisition they deteriorated to 1.3%.  You can check JC Penny’s 2003 10K (1/31/2004) under discontinued operations for an approximation of Eckerd’s historical financials.  Note, for the same period, CVS’s operating margins were 5.4%.

 

Most recently, in January this year, the company acquired 700 stand-alone Sav-On and Osco drugstores from Albertson’s.  From the audited Sav-On/Osco financials in the 8-K/A dated June 2, 2006, you can see that this business was much better run and provides some room for improvement on margins but not as significant as Eckerd’s.  For the year ended 2/2/2006 and Q1 2006, Sav-On/Osco had 4.5% and 3.9% operating margins excluding corporate expenses.  In 2005, CVS had operating income of 5.5% but this includes the improved but lower margins of the acquired Eckerd’s business.

 

Aside from acquisitions, the company has grown organically from remodeling old stores, relocating old stores and opening new stores.  Approximately half the store base is new or remodeled within the last five years.  Organic growth has been 8.4% and 5.2% in 2005 and 2004, respectively.  Future growth of a minimum of 8% top line will come from 3-4% organic square footage growth and same store sales of at least 4%.  Of note, for the past six years, same store sales (SSS) have not grown less 4% and recent comps have accelerated to high single digits due to the initiation of Medicare Part D – this all in spite of the fact that accelerated generic use is hitting SSS for over 3%.

 

 

Why is it Interesting?

 

We believe the following make it an attractive investment for the long term:

 

Strong Competitive positioning:  The company competes with other drug store chains (Walgreens, Rite Aid), independent drug stores, mass merchants (Wal-Mart, Target, Costco), Supermarkets and Mail Order.  Over the last 10 years, the pharmacy chain stores together have consistently garnered a roughly 41% share.  We estimate CVS’ share is between 13-14% of total pharmacy sales and 32% of the traditional chain.  Independents have been hurt the most over the last 10 years with a 29% share in 1995 whittled down to 18% in 2005 proving that scale and convenience really matters in this business.  CVS, in particular, should continue to prosper not only for the above reasons but also for its unique offering with Minute Clinic and now expanded services through its merger partner, Caremark, which will be discussed further below.  It would be difficult to foresee CVS, Walgreens and Rite Aid not playing a major role in future drug sales.

 

Strong Management:  Given that 70% of sales come from pharmacy, it’s only fitting that its current CEO and Chairman, Tom Ryan, began working for CVS/pharmacy in 1978 as a pharmacist.  He later took over the pharmacy business in 1994 and in 1998 became CEO succeeding the company’s co-founder Stanley Goldstein.  Most of the other managers also grew up in the company.  Chris Bodine, head of merchandising and marketing, joined CVS in 1986 and was promoted to his current position in 2002.  Larry Merlo, head of store operations, has been with the company since 1991 in various roles and is in his current role since 2002.  The company is a great place to work and does a great job retaining personnel.  In fact, a local district manager with whom we spoke has been with the company for 19 years and intends to be there for a long time (and recently bought shares himself).  This management team has a history of innovative marketing and merchandising and consistent same store sales growth.  They were the first retail pharmacy with a digital photo solution and first to launch its ExtraCare loyalty program, now 50MM in size. 

           

Very Strong Demographic Trends:  Growth will be driven by a number of factors for a long time.  The current US population is expected to grow to over 350MM people by 2030.  The aging baby boomer population and more specifically Seniors (Americans over 65) is the fastest growing sector of the total population.  CVS is positioned to capture this growth as they have strong presence in the faster growing states where seniors or more likely situated included Florida in particular.

 

Here are some quick facts:

 

                        Source: U.S. Census Bureau Estimates

 

Age drives drug use.  See more facts below:

                        Source: NACDS Economics Department

 

With the passing of Medicare Part D (the new federally funded prescription drug benefit program), which only became effective January 1^st, 38MM seniors and disabled now have drug coverage (8-10MM who did not have any coverage before).  This should increase utilization of scripts. 

 

Tremendous Generic wave coming:  As more generics proliferate over the next several years, the company’s margins should benefit dramatically (they provide a much higher percent margin and a materially higher dollar margin).  Here are the numbers:

 

                        Source: Express Scripts and IMS Health

 

Also, 59% of total scripts are expected to be generics for 2006, 65% by 2008 and 70% by 2010.

 

Upside from acquisitions:  As mentioned above in the brief description of CVS, there is upside from the acquisition of underperforming Eckerd’s stores and from Sav-On/Osco drugstores.  The Caremark merger should provide additional upside to the previously announced $400MM in synergies.  This will be discussed further below but the company’s purchasing power will be tremendous with combined sales of approximately $90bn for 2007.

 

So What Happened?

 

As of 9/20/06, before a wave of announcements and headlines, the company share price hit $35.50 which was close to its 52-wk high of $36.12, hit just a few days earlier on 9/12/06.  After the following major headlines and announcements, the stock now trades 20% lower.

 

Wal-Mart Generics Program – On 9/21/06, Wal-Mart announced it was reducing its price on certain generics (Now a total of 143 drugs with a total 291 specific drugs including varying dosages) to $4 in Tampa, Florida.  This program was later expanded across Florida and nationwide at the end of November.  The number of drugs covered was also expanded to 331 drugs and included much older and less-used generics until. Then Pravachol was added and another round of fear arose as Pravachol just came off patent.  Target matched this program as did Costco but neither RiteAid nor Walgreens did. 

 

AWP Settlement – On 10/5/06, First Databank, the main US publisher of AWPs (average wholesale price), which is used by insurers and state Medicaid programs to determine how much they reimburse pharmacies for dispensing drugs for their members, announced a proposed settlement to reduce AWPs for many drugs by five percent due to alleged collusion with McKesson that raised AWP prices to increase pharmacy profits for their clients.  Some people believe this settlement will reduce US drug costs by $4bn in 2007.

 

CVS/CMX Merger – On 11/1/06, after a New York Times article leaked a potential merger between CVS and Caremark, both company’s officially announced a merger of equals where Caremark shareholders would receive 1.67 CVS common shares for each Caremark share held.  The CEO from Caremark, Mac Crawford, would become the Chairman of the combined company and CVS’ current CEO, Tom Ryan, would be the CEO of the combined company.  The COO for Caremark, Howard McLure, would become head of the combined PBM businesses.  The market believed and is pricing the stocks as if it still believes this merger was a defensive action.

 

Democrats take control of Congress – On 11/9/06, after it was finally determined that the Democrats took control of both the House and the Senate from the elections, healthcare stocks got hit again as the markets were concerned that Congress may amend the Medicare Part D legislation to let the government negotiate drug prices.

 

Why we think the market has got this wrong?

 

With so much uncertainty, it’s no wonder why everyone is running from these names.  Here are our thoughts on the main issues:

 

Wal-Mart Generics Program – To date the Generic’s program has had a minimal impact on the traditional drugstore chain.  The program has been in Florida the longest and the impact on CVS has been very minimal at less than one script/day.  WAG has reported a similar minimal effect.  More importantly, we believe that this is a loss leader for Wal-Mart.  See below quick math:

 

                        Starting Pharmacist Salary                     >$100,000

                        Hrs/wk                                                 40

                        Wks/yr                                                 50

                        Total hours worked/yr                          2,000

                        Scripts/hr (10-15min/script)                  6

                        Total scripts/yr                          12,000                                    

                        Dispensing cost/script                           $8.33

 

CVS and Walgreens have both told us that it costs anywhere from $8-$10/script excluding the cost to attain the script which may be around $2.  So if Wal-Mart is selling Generics at $4/script they are losing money if you consider the cost to dispense the script.  The only explanation for this behavior is if the total scripts/yr/pharmacist is less than 12,000; therefore, any incremental script would be profitable given that the fixed cost for the pharmacists.  This appears to be a reaction to loss scripts when many cash payers moved on to Medicare part D.  With Medicare Part D coverage, members could choose the most convenient location (which probably was not necessarily the mass merchandiser) – thus backing up our thesis that the traditional drug store chains provide a valuable service to its customers.  In fact, cash payers represent only 5-6% of total sales for CVS (e.g. 94% of customers have third party insurers where they have a co-pay).  For these generic drugs, the average co-pay is just over $5.30 versus the $4 that Wal-Mart charges – hardly a reason to make dramatic changes if you are a consumer of these drugs.  Even though this program covers roughly 25% of prescriptions/yr, they constitute only 5% of total dollars spent on prescriptions according to Walgreens.  As such, WAG and CVS do not believe that managed care companies will put pressure on drug store companies to lower reimbursements on these generics.  If they tried to force them to match those prices, it would only save about 2.5% on drug store spend/yr.  In fact, better sourcing of drugs could give back some of that potential loss regardless.

 

AWP Settlement – All of CVS’ contracts are at will.  So an arbitrary change in the benchmark (which is essentially what AWP is) allows them to go back and renegotiate their contracts.  All the drug chains have said that they are in talks with the payers and there should be no issues in renegotiating the formula so that the reimbursement received is the same and only the discount will change.  We think this is a non-issue.

 

CVS/CMX Merger – The announcement surrounding the merger was obviously not ideal and there probably would have been a better market reaction if the company had been able to go to the market with an analyst day, as was planned.  The merits of the merger will create a dominant force in the distribution of drugs for the following reasons:

 

What is Caremark?

Caremark dispenses pharmaceuticals to eligible participants in health benefit plans maintained by their customers which include employers, unions, government employee groups, insurance companies and managed care organizations.  Given its size and scale, CMX provides value added services by utilizing its information systems to check for safety, drug interactions and generic substitution eligibility.  Caremark is the second largest Pharmacy Benefit Manager (PBM) behind Medco but larger than Express Scripts.  See writeup on MHS by glasshalf902 for a great explanation of what a PBM is and how they make money. 

 

Essentially, the value proposition that PBMs bring to the market is in combining their greater purchasing leverage to help their clients control their medication costs.  Through volume discounts, retail pharmacy networks, mail pharmacy services, preferred drug list administration, claims processing, and drug utilization review, PBMs create an opportunity for health benefit plan sponsors to deliver prescription drugs in a more cost-effective manner, while improving compliance with recommended guidelines for safe and effective drug use. But, this is only the beginning.  Current efforts at data analysis pertaining to cost containment, disease management and outcome measurement enables the large PBM to provide differentiating value-added services.  Companies care about lowering overall healthcare costs – not just lower drug prices.  PBMs help them do this.

 

What is interesting about Caremark?

-         Similar favorable trends as CVS – growing volumes from aging population and new discovery, increased specialty and biologic drug use, generic drugs, mail order and Medicare Part D

-         Strong free cash flow characteristics with minimal capital investment

-         Experienced management team that has been in place since 1998

-         Large scale that provides a sustainable competitive advantage

 

Why this deal makes sense?

-         Reduces overall cost of healthcare, which is exactly what payers, consumers, governments, etc. want

o       Significant purchasing power reduces drug costs

o       Better coordination of outcomes and efficiencies results in better health outcomes (Caremark disease management + CVS pharmacists+ MinuteClinic nurse practioners could help control healthcare costs and reduce doctor visits with better coordination)

-         CVS enhances CMX’s value proposition

o       Minute clinic access (in-store clinics) or offer to add to large employers offices

o       Discounted private label

o       Rewards under ExtraCare

o       Creates greater choice and convenience for consumers

o       Consumers can talk to local pharmacists and have a higher level of personal touch

-         CMX enhances CVS’ value proposition

o       Helps drive store traffic as they sell more services to payers and more convenience (e.g. can pick up mail prescriptions at local CVS)

-         Provides differentiated services to payors and consumers

o       Triple threat: retail pharmacy, mail order pharmacy and specialty pharmacy can be packaged versus fragmented elsewhere

-         The deal is accretive to earnings 1^st year out

-         CVS paid no premium if you look at the average exchange ratio between the two companies over the last 6 months; it’s a better ROI for CVS as it is much less capital intensive

-         Management of CMX obviously believes in the combination as they took a stock for stock deal and stayed on – important to know for incentives

 

Democrats take control of Congress – For at least the next two years, while Bush is in office, we don’t foresee any major changes in Medicare Part D and related Medicare reimbursement rates.    It is hard to believe that the Democrats would risk their chance at retaining both houses of Congress and obtaining leadership in the White House.  However, even if some legislative change were to come to legislation, we believe that government negotiations with pharmaceutical companies could actually increase prices.  We agree with Alain Enthoven and Kyna Fong’s Wall Street Journal article, “Pelosi on Drugs,” dated November 16^th on why such legislation could have the opposite effect.  http://www.ncpa.org/sub/dpd/index.php?page=article&Article_ID=13848  For the full text, you need to go to the Wall Street Journal online.  In summary, the article points out that the inability for the government to exclude certain drugs in their plans reduces their bargaining power whereas private plans can do this more easily.  The article further talks about how pharmaceutical companies can price discriminate between plans and therefore charge lower drugs for some plans and higher for others.  The problem arises if the government demands most-favored-nation status – i.e. they get the lowest prices anyone else gets.  If they get this, then the drug companies are incentivized to raise prices for everyone as Medicare is such a major purchaser.  This thesis has played out with Medicaid.  It could be a disaster for the payers and consumers – not the retailers who provide distribution.  While Enthoven is probably right, and while legislation will probably not pass for some time, it will not prevent serious efforts by the Democrats to grandstand and try to “save the seniors.”  Actually, the odds are greater that Medicare Part D reimbursement may go up – as a result of Democrats trying to fill the donut hole, which is a payment gap built into the reimbursement structure of Part D.

 

What’s the Valuation?

 

CVS

-         2007 consensus sales, which include all previous acquisitions, are estimated at $50bn growing 8-12%/yr based on 3-5% square footage growth and 6-8% same store sales growth

-         Assumed 6.0% EBIT margin (the company had 5.5% EBIT margins in 2005E on $37bn in sales; we assume two years later you get some operating leverage as well as the impact of higher margin generics); makes it $3bn in 2007 EBIT

-         D&A estimated at $800MM; EBITDA of $3.8bn

-         Interest Expense - $270 based on an average debt level of $4.5bn next year; the company is doing a $1bn sale leaseback of acquired real estate in Q4 this year

-         Taxes (assuming 38% rate) - $1,037M

-         Capex (assumed 25% of total capex is maintenance) - $350MM

-         Total Free Cash Flow - $2150MM

-         Mkt cap (fully diluted included all options) - $24.9bn

-         2007 EV (assuming 1.0bn cash (using all capex) taken in 2007)- $28.7BN

-         2007 Mkt cap/FCF - 11.6x

-         2007 EV/FCF - 13.4x

-         2007 EV/EBITDA – maintenance capex = 8.3x

 

CMX

-         Consensus revenues for 2007 – about $40bn growing 6-8%/yr

-         EBIT margin (5.2% assumed); $2,080

-         D&A of $145MM

-         EBITDA of $2,225

-         The company paid off all its debt and has net cash of $900mm on its books; so no interest expense and not giving any credit for interest on the cash

-         Taxes – 39.5% rate; or $822MM

-         Maintenance Capex (25% of total capex) or $30MM

-         Total Free Cash Flow of $1,375

-         Mkt cap (fully diluted included all options) - $21.1bn

-         2007 EV (assuming cash 1.28bn (using all capex) taken in 2007)- $18.3BN

-         2007 Mkt cap/FCF – 15.4x, EV/FCF 13.3x

-         2007 EV/EBITDA-capex = 8.3x

 

Combined

            CVS Free Cash Flow   - $2,150

            CMX Free Cash Flow - $1,375

            After Tax Synergies    - $250 (400*62.5%) – very conservative 1st #s from the co.

            Total free cash flow       $3,775

 

            Combined diluted mkt cap:       $45,975

            Mkt/FCF:                                 12.2x

 

We believe this should, at a minimum, trade at 18x free cash flow or a 48% upside in the next year.  However, if one looks two years out, the company could have paid off all of its debt, would have a plethora of cash on its books and would be trading at less than 10x free cash flow.  A major recapitalization could be affected due to the highly stable nature of these businesses. If so, there are reasonable scenarios in which this stock could more than double.

 

Risks

•       Wal-Mart significantly expands generics program to include more profitable generics

•       CVS/CMX merger does not offer the synergy benefits expected both financially and strategically

•       Renegotiations of contracts due to change in AWP become more difficult than expected

•       Higher regulation by government cuts drug prices and dispensing fees

•       Further headline risk as new democratic congress proposes new legislation that undermines drug chain profitability

•       Most of the risks are headline-related uncertainty.  However, the rapid changes in healthcare could create unforeseen changes that could rapidly change the drug distribution business.  All the trends to date point to the opposite, but one never knows so vigilance in tracking these changes is necessary