Defensive Play CVS Will Benefit From Walgreen Dispute

Includes: CVS, ESRX, WBA
by: Takeover Analyst

As the Walgreen (WAG)/Express Scripts (NASDAQ:ESRX) dispute plays out, there appears to be one clear winner of it all: CVS Caremark (NYSE:CVS). When Express Scripts loses its network with Walgreen, CVS will subsequently gain a significant amount of a share and be better positioned to penetrate the market. The drug retail store will further benefit from solid progress in PBM, stellar management, and strong free cash flow generation. Add the fact that the company specializes in selling inelastic products and you have a defensive play to hedge against a volatile economy.

From a multiples perspective, CVS does not appear cheap. It trades at a respective 15.2x and 11.9x past and forward earnings, while offering a dividend yield of 1.31%. Walgreen, on the hand, trades at much lower multiples of 11.1x and 10.3x past and forward earnings, respectively, while offering a dividend yield of 2.76%. In addition, CVS is also more leveraged with net debt standing at 18.2% of market value compared to 2.9% of market value for Walgreen.

With that said, CVS is generating solid free cash flow while management is giving the heads up that shareholders will see a more aggressive capital allocation policy in the quarters ahead. Share repurchases increased during the third quarter and I anticipate the sequential growth in such activity to be very accretive to EPS. This policy will be supported by FCF levels rising possibly above $4.2B in 2012. Moreover, cash holding are expected to rise and de-risk the business as a result.

Furthermore, on the recent third quarter earnings call, CVS CEO Larry Merlo noted stellar performance:

We reported strong third quarter results this morning with adjusted earnings per share from continuing operations of $0.70, $0.02 above the high end of our guidance. This was primarily driven by a better-than-expected performance in our PBM, as well as the impact of the accelerated share repurchase we announced and executed in the quarter. We also delivered $1.5 billion in free cash flow this quarter, bringing the year-to-date total to $3.9 billion.

Now recognizing our strong performance year-to-date, as well as our solid outlook for the remainder of the year, we are narrowing our 2011 EPS guidance range. We now expect to deliver adjusted earnings per share from continuing operations of between $2.77 and $2.81 compared to our previous guidance of $2.75 to $2.81. In addition, and consistent with prior guidance, we expect to generate free cash flow for the year of between $4 billion and $4.2 billion.

Third quarter results beat guidance and were buoyed up by optimism for the UAM acquisition and PBM business. When CVS purchased Universal American Medicare Part D for around $1.3B, it doubled the size of its program and became the country's largest provider of this plan -- unlocking revenue and cost synergies in the process. CVS is also positioned to experience both margin expansion and solid top-line growth in PBM.

CVS won an impressive amount of business in PBM, and although costs will assuredly rise, the drug store has locked in a sustainable market share that will be beneficial to long-term shareholder value. During the third quarter alone, this segment grew by a staggering 24% and remains a catalyst going forward. Offsetting this slightly is PDP, which I anticipate quarter declines until the start of Q2 2012.

An upside trend in generics, operational improvements, and a partnership with Aetna (NYSE:AET) are nevertheless more substantial. Joining forces with Aetna, CVS will create a a new Medicare prescription plan in 43 states -- a strategy that has worked in similar past partnerships -- and there is little reason, in my view, to doubt future success. Management has also brought in a strong operator as CEO: Larry Merlo, who is setting the company on the path toward cost reductions and greater profitability. As CVS' gross margins are 740 basis points behind Walgreen's 28.4%, this is an area that should and can be improved.

Consensus estimates for EPS are that it will increase by 4.1% to $2.80 in 2011 and then by 14.6% and 11.5% more in the following two years. Of the 20 revisions to estimates, all 20 have gone up for a positive change of 0.83%. Assuming a 15x multiple -- higher than the current one -- and a conservative 2012 EPS estimate of $3.10, the rough intrinsic value of the stock is $46.50. This implies a 21.9% margin of safety -- high, but not high enough, in my view, to justify the "strong buy" rating on the Street, especially when Walgreen is trading at less than three-quarters of its PE ratio. As I argued earlier, Walgreen also has strong fundamentals and will produce steady ROIC despite the ESRX dispute.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.