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Summary

CVS Caremark Corporation (NYSE:CVS) is a large pharmacy business in the United States. It is the result of a merger between CVS and Caremark in 2007.

Between 2007 and 2009, revenue grew by an average of 13% annually. During the same period, earnings grew by an average of 18% annually. In 2009, the Caremark aspect of the business (pharmacy benefits management) experienced a multi-billion dollar loss of contracts for 2010 due to overpricing and communication issues. Management for that segment has since changed. The CVS aspect of the business (retail pharmacy) has continued to grow into 2010. For 2010, Caremark revenue and earnings are slightly down and CVS revenue and earnings are slightly up.

The uncertainty has resulted in a low stock valuation (P/E less than 11), and it may be an interesting investment opportunity. The company currently has a dividend yield of about 1.25%, with 15% annual dividend growth over the past couple of years.

Overview: CVS Caremark is the result of a merger between CVS pharmacy and Caremark in 2007. Filling over 1 billion prescriptions annually, it is the number 1 provider of prescriptions in the United States.

Business: CVS Caremark has two primary business segments:

  • Retail Pharmacy Segment: CVS Pharmacy provides approximately 7,000 retail pharmacy locations around the United States. Medicines and other products can be conveniently purchased.
  • Pharmacy Services Segment: Caremark provides Pharmacy Benefits Management services to a variety of companies. A PBM works to reduce prices of drugs and increase the efficiency of distribution.

Another aspect of the business worth mentioning here is Minute Clinic.
Minute Clinic is a collection of 570 locations, many of which within CVS pharmacies, where patients can walk in without an appointment and receive basic medical care. Staffed by nurse practitioners and physician assistants, Minute Clinic offers safe, but fairly low-cost service for many simple health issues. Colds, allergies, sprains, infections, rashes, and so forth can be treated at these locations, and they also offer preventative care in the form of vaccinations and health screenings.

Revenue, Earnings, Cash Flow, and Margins: Due to the nature of the merger, the years 2007 through 2009 will be presented in this analysis.

Revenue Growth

Year Revenue
2009 $98.729 billion
2008 $87.472 billion
2007 $76.330 billion

This represents more than 13% average annual revenue growth during this period.

The retail pharmacy segment (CVS) reported $45.1 billion in revenue in 2007, and $55.4 billion in revenue in 2009. This represents approximately 11% annual growth. The pharmacy services segment (Caremark) reported $34.9 billion in revenue in 2007 and $51.1 billion in revenue in 2009. This represents approximately 21% annual growth.

EarningsGrowth

Year Earnings
2009 $3.696 billion
2008 $3.212 billion
2007 $2.637 billion

Over this period, net income has grown by an average of 18% annually.

Operating Cash Flow Growth

Year Cash Flow
2009 $4.035 billion
2008 $3.947 billion
2007 $3.229 billion

Over this period, CVS Caremark has grown its operating cash flow by an average of nearly 12% annually.

Dividends: CVS Caremark offers a small but growing dividend. The company is currently offering a 1.25% dividend yield, but with a low payout ratio of only 13%, it has plenty of room to grow.

Dividend Growth

Year Dividend Yield
2009 $0.305 1.00%
2008 $0.258 0.75%
2007 $0.22875 0.60%

Over this time period, CVS Caremark has grown its dividend by approximately 15% annually.

Balance Sheet: CVS has a very clean balance sheet with a Total Debt/Equity ratio of only 0.33.

Investment Thesis

CVS Caremark is an interesting company. The merger of CVS and Caremark resulted in a company that is complex, and many investors and lawmakers are uncertain about whether this merger was appropriate. Time will only tell, but due to the uncertainty, the stock valuation is quite low, and this could be a nice opportunity.

With a P/E ratio of under 11, combined with large growth between 2007 and 2009, the investment looks easy. With these numbers, investment returns should be spectacular. The catch, however, is that in 2009, CVS Caremark announced that its Pharmacy Services segment (the Caremark aspect of the business) lost $4.8 billion in contracts, and the Medicare part D contracts also fell sharply as well due to overpricing. This combination resulted in a change of management of that business segment. The error is largely (and in my opinion, believably) blamed on poor communication of the new business model to clients.

The odd merger, and poor communication to clients of what that merger means to them, spooked clients into dropping contracts for 2010 during this period in 2009. What this means is that although 2009 revenue and earnings were excellent, the numbers for 2010 aren’t as good because of a loss of contracts. This is the reason for the low stock valuation, as when this was announced, the stock price dropped 20-25% in a single day and hasn’t recovered. For the first half of 2010, CVS has indeed experienced minor reductions in revenue and profits, but has kept EPS in a state of moderate growth. Full year estimates for 2010 EPS are very close to what EPS was in 2009, and 2011 EPS is expected to increase once again.

The good news is that there is a silver lining. The company is focusing on having an effective pharmacy services bidding season for 2011 (unlike their disaster for the 2010 bidding season). The company indicates that the incident was isolated, and with new management, this may very well be the case.

In addition, CVS retail pharmacies are performing very well. Even while the pharmacy services segment reported decreased revenue and profits for 2010 (as predicted by the company last year), the retail segment continued to grow. CVS retail pharmacies had 6.3% same-store sales growth in 2005, 8.1% same-store sales growth in 2006, 5.3% same-store sales growth in 2007, 4.5% same-store sales growth in 2008, and 5.0% same-store sales growth in 2009. They are also constantly increasing their total number of CVS retail pharmacy locations. There were 6,301 locations in 2007, 6,981 locations in 2008, and 7,074 locations in 2009.

What this means it that CVS is both increasing their number of retail pharmacy locations, and obtaining more revenue from each of their locations. This is consistently impressive, and great news for shareholders.

The CVS pharmacy is a great business model. They primarily provide prescription drugs (and increasingly generic drugs to save customers money) and over-the-counter medication, but also provide various things like toothpaste, birthday cards, toys, food, and beauty supplies, all in a very small store that is often located very close to where people work and live.

The prices are pretty good, even though they aren’t quite as competitive as Wal-Mart (NYSE:WMT), and they make up for this by providing their own brand of products at reduced prices compared to identical national brands. It’s also a lot more convenient to stop in at a retail pharmacy to grab a few quick necessities on the way home from work, than it is to go out of one’s way to enter the lumbering parking lot of Wal-mart and deal with all of the hassle and lines there. So, retail pharmacies do have their important niche.

Minute Clinic is another great business, with simple and inexpensive medical treatment in convenient locations without the need to make appointments.

Lastly, the company is growing its dividend and buying back shares, channeling a lot of its cash flow back to shareholders.

Risks

CVS Caremark is a fairly uncertain investment. The retail segment is fairly sturdy, with a solid name brand embedded in a growing industry, and faces primarily demand and commodity cost risks. The pharmacy services segment, however, is the riskier of the two, as the industry is intensely competitive and there are a variety of questions about whether this merger was a good idea or not. 2009 saw a large drop in stock price due to poor performance of this segment. It is said that there is a risk of the company being divided, but some may view that as an opportunity, rather than a risk.

Conclusion and Valuation

CVS Caremark may be a moderately speculative investment. The retail pharmacy segment is rather clear-cut and robust, while the pharmacy services segment is unstable and spooky to investors. Last year they performed poorly, and one must hope that with new management and improved communication to clients, they vastly improve this year.

The good news is that this stock is very cheap. With a P/E of under 11, CVS Caremark stock is at a reduced price compared to competitors like Walgreens (NYSE:WAG) with a P/E of over 13 (which is still fairly low). The 20-25% drop in stock price that resulted from the announcement of lost contracts was an overreaction, as earnings are still strong. Most of the drop was due to uncertainty and the validation of long-term fears that the merger was not a good idea, rather than a massive 20-25% loss in company value.

The uncertainty of the merger, along with the poor performance of 2009 have been factored in, and I expect the company to do quite well over the coming years. All segments of the company are great businesses, with the primary question being whether they are great together or better off as separate entities. I find the current stock price in the upper $20s to be very attractive as an investment.

Disclosure: Author owns shares of CVS at the time of this writing.

Source: CVS Caremark: Dividend Stock Analysis 2010