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CVS Caremark (NYSE:CVS) reported third quarter 2011 EPS of 65 cents, 8.3% up year over year. However, after excluding the impact of certain one-time items, adjusted EPS came in at 70 cents, surpassing the Zacks Consensus Estimate of 67 cents and 9.3% higher than the year-ago quarter adjusted EPS.

Net revenue increased 12.5% year over year to $26.7 billion, almost in line with the Zacks Consensus Estimate.

The Pharmacy Services segment posted a robust 25.8% increase in revenues to $14.8 billion during the reported quarter. The significant growth was primarily on the back of the long-term contract with Aetna (NYSE:AET) as well as the acquisition of the Medicare Part D business of Universal American Corp. (NYSE:UAM).

These contracts, combined with an increase in covered lives in the company’s existing Medicare Part D business, also led to a 39.8% year-over-year rise in CVS’ pharmacy network claims to 179.2 million. The Aetna contract also drove the Mail Choice claims processed growth by 8.0% to 17.5 million.

Revenues from CVS’ Retail Pharmacy increased 3.8% to $14.7 billion with same-store sales climbing 2.3%. While Pharmacy same-store sales rose 2.4%, front-end same-store sales spiked 2.0%.

Pharmacy same-store sales witnessed a 200 basis points (bps) drop due to recent generic introductions, whereas the Maintenance Choice program had a positive impact of 140 bps on a net basis.

Gross margin during the quarter contracted 175 bps to 19.4% primarily due to 14.9% rise in cost of revenues. Operating margin declined 30 bps to 5.9%.

CVS exited the third quarter, 2011 with cash and cash equivalents of $1.7 billion, up from $1.4 billion at the end of fiscal 2010. The company’s continuous share buyback program benefited the bottom line. Year to date, the company returned over $3 billion to its shareholders in the form dividends and share repurchases.

During the third quarter, CVS opened 39 new retail drugstores, closed 1 retail drugstore. Additionally, the company relocated 14 retail drugstores. At the end of the third quarter, CVS operated 7,384 locations, including 7,304 retail drugstores, 31 retail specialty pharmacy stores, 32 apothecary pharmacy stores, 13 specialty mail order pharmacies and 4 mail order pharmacies in 44 states, the District of Columbia and Puerto Rico.

Guidance

Based on a solid quarter, CVS narrowed down its EPS outlook for fiscal 2011. The company now expects adjusted EPS of $2.77–$2.81 (earlier guidance being $2.75–$2.81). The current Zacks Consensus Estimate of $2.78 is within this range. The guidance for cash flow from operations and free cash flow for fiscal 2011, however, remained unchanged at $5.5–$5.6 billion and $4.0–$4.2 billion, respectively.

Our Recommendation

We are encouraged by the improved performance of CVS’ Pharmacy Services segment for the third consecutive quarter, which had earlier been a drag on the company’s performance. We are also encouraged by CVS’ several recent contract wins over Medco (NYSE:MHS) in the recent past, which include Federal Employee Program (NYSEARCA:FEP) contract in May 2011, as well as the biggest US public pension fund Calpers.

We are confident about CVS Caremark’s longer-term potential based on its retail execution, deployment potential and the strong 2012 generics cycle. However, the proposed merger between Express Script (NASDAQ:ESRX) and Medco will intensify competition in the Pharmacy Services segment.

CVS currently retains a short-term Zacks#3 (Hold) Rank, which also reflects our ‘Neutral’ recommendation over the long term.

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Source: CVS Beats, As Pharmacy Services Show Strength