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CVS Caremark (NYSE:CVS) will be releasing its first-quarter earnings for fiscal 2013 on May 1. The company delivered strong results for FY 2012 as net revenues grew by $16 billion over 2011 revenues to reach $123 billion. This was supported by growth of 24.7% and 6.8% in Pharmacy Services Segment revenues and Retail Pharmacy Segment revenues, respectively.

As per our estimates, the Retail Pharmacy segment contributes two-thirds of the stock's value. This segment reported a gross profit margin of 30% for 2012, up from 29.3% in 2011. However, the gross margin in the Pharmacy Services segment, which contributes 34% to the stock's value, fell from 5.6% to 5.2% in 2012. Going forward, we estimate the margins in this segment to remain under pressure owing to increased pressure from third-party payers to reduce reimbursement payments for prescriptions.

Although the increased substitution of generic drugs over branded products have increased the margins, they have been partially offset by passing on the savings to the plan subscribers. The total generic dispensing rate, which implies the percentage of generic drugs in a consumer's prescription, grew to 78.5% in 2012 from 74.1% and 71.5% in 2011 and 2010, respectively. We estimate the substitution of generic drugs to continue albeit at a slightly slower pace.

Retail Pharmacy Segment to Increase Overall Revenues

Retail pharmacy revenues, which include the front-store sales, contributed about $63 billion out of the total $123 billion in revenues for CVS Caremark. Prescription revenues represented more than two-thirds, while front-store sales represented about a third of the total retail pharmacy revenues.

We estimate that the prescription revenues will continue to increase in the first quarter due to favorable industry trends, which include an aging U.S. population consuming a greater number of prescription drugs and the increased impact of Affordable Care Act, which has provided coverage to more than 30 million uninsured Americans. The U.S. Census Bureau projects that within the next two decades the proportion of total population over 65 years will increase from 13% to 19%, whereas the population between the ages of 20 years and 65 will decline from 60% to 55%. An aging population, combined with the fact that older people contribute to a larger proportion of expenditure on drugs, will lead to an increase in the prescription drugs market.

Generics, Private Labels and Front-Store Sales to Boost Margins

Front-store sales of $20 billion coupled with a high gross profit margin contributes significantly to the overall profitability of the company. It also results in an increased customer traffic across stores and helps maintain customer stickiness. Front-store same-store sales rose 5.1% in 2012 over the prior year and we estimate that number to increase going forward, supported by a solid ExtraCare customer loyalty program, which enables CVS Caremark's customers to earn points and redeem them for discounts/products.

The company also carries over 4,600 private label products that normally have a higher gross margin than other branded goods. These private labels represented about 18% of its front-store revenues. In addition to this, the company has been increasingly substituting generic drugs in place of branded drugs, which has helped it to improve overall margins. The gross profits increased by 9.4% for 2012, and stood at $19.1 billion as compared to $17.5 billion for 2011.

We will revise our $53 Trefis price estimate for CVS Caremark after the earnings release.

Disclosure: No positions.

Source: CVS Caremark Earnings Preview: Generics And Front-Store Sales Can Lift Margins