CVS Caremark (1 Yr. PT: $60.76) · SWOT Analysis Financial Summary Industry Overview 13 Industry...

CVS Caremark (1-Yr. PT: $60.76)

Senbet Fund The Robert H. Smith School of Business University of Maryland

Phone: (301) 405-7132 www.rhsmith.umd.edu/senbet fund [email protected]

Disclaimer:

This report is solely for the use of the Senbet Fund and is not to be construed as investment advice or to be used in any other manner by anyone other than the Senbet Fund.

Initiating Coverage on 04/02/2013 Analyst: Mohammad Tariq Consumer Staples / Drug Retail [email protected] / 410.330.6027 The analyst does not own any shares in INGR

Recommendation Price Target

HOLD $60.76

Company Rating LOW HIGH MED.

Risk

Quality

Valuation

Trading Date

Historical Beta .743

Forward Beta 1.01

52 Week High B56.07

Market Capitalization $67.14B

Shares Outstanding 1.23B

Short Interest, % of Float 0.95%

Wall Street Coverage

Number of Analysts 18

12 Month Mean Analyst PT $58.71

Institutional Holding 86%

Analyst Rating 1.9

Miscellaneous Ratios

P/E Ratio (TTM) 18.11

P/E Ratio (Forward) 12.42

Est. 5-Year CAGR 11.10%

PEG Ratio 1.04

Current Ratio 1.34

Average Collection Period 18.56

Days’ Sales in Inventory 37.73

Days’ Sales in Payables 14.95

Debt to Capital (Interest) 13.86%

Highlights 2012 2013E 2014E 2015E

Revenue $123B $125B $126B $128B

EBIT $7.23B $6.84B $6.97B $7.03B

EPS $3.05 $3.00 $3.19 $3.38

Margins 2012 2013E 2014E 2015E

Operating 5.87% 5.47% 5.49% 5.50%

Profit 3.15% 2.92% 2.93% 2.93%

EBITDA N/A N/A N/A N/A

Investment Thesis: Obamacare to Increase Health Coverage — Increased health

coverage will likely increase industry’s revenue Aging U.S. Population — Rising median age of the U.S.

population will spur demand for industry’s services Titan in the Arena — CVS Caremark controls 27% of both

drug retail and pharmacy benefit manager (PBM) industries PBM Division Provides a Safety Net — As PBMs consolidate,

they gain both market share and pricing power which is a negative for the drug retail industry

Mergers & Acquisitions — PBMs and drug retailers are

consolidating at a steady rate. CVS Caremark is gaining market share on both fronts (drug retail and PBM industries)

Comparables:

Stock Performance:

Recent News: CVS Caremark Adds Former J&J CEO Weldon to Board CVS Caremark Corporation : CVS/pharmacy Launches

Innovative New iPad App Featuring a 3D Virtual Store and Digital Pharmacy Experience

Accordant Health Services, a CVS Caremark Company, Receives URAC Case Management Accreditation

Company P/E PEG P/B EV Mkt. Cap

CVS 12.37 1.04 1.78 $76.35B $67.14B

WAG 12.73 1.13 2.35 $49.09B $44.50B

RAD 63.00 -24.25 N/A $7.97B $1.68B




Disclaimer:

This report is solely for the use of the Senbet Fund and is not to be construed as investment advice or to be used in any other manner by anyone other than the Senbet Fund. 2

Table of Contents

Executive Summary 3 Rating—$XX Price Target

Estimates and Valuation

Investment Overview

Business Overview 5

Business Overview

EIC Framework

SWOT Analysis

Financial Summary

Industry Overview 13

Industry Overview

Industry Performance

Key External Drivers

Industry Outlook

Executive Team 19

Investment Positives 20

Investment Issues and Risks 22

Red Flag Analysis 23

Competition 24

Historical Charts 25

Summary/Conclusion

Appendix A: Discounted Cash Flow Analysis 26




Disclaimer:


Executive Summary

Price Targets:

Estimates & Valuation: The discounted cash flow model for CVS Caremark yielded a 1-year price target of $60.76, a 10.1% gain from April 1, 2013 closing price. The price target was derived by: separating cash flows to equity holders, finding the cost of equity for the company and discounting the equity cash flows by the calculated discount rate of 6.94%. The terminal year growth rate used in this calculation was 2%, along with the 10-year Treasury risk-free rate of 1.86%. Best Case: The discounted cash flow model for CVS Caremark yielded a 1-year price target of $63.91, a 15.5% gain from April 1, 2013 closing price. The price target was derived by using leaner cost controls, optimistic year-over-year growth rate and the assumption that Obamacare will play a pivotal role in customer expansion. Worst Case: The discounted cash flow model for CVS Caremark yielded a 1-year price target of $51.81, a (6.4%) gain from April 1, 2013 closing price. The price target was derived by using tighter cost controls, slower year-over-year growth rates and the assumption that pharmacy benefit managers will continue to exert pricing power on retail pharmacies. Investment Overview: [Hoovers] Size matters to CVS Caremark (formerly CVS), the nation's #2 drugstore chain and a leading pharmacy benefits manager with more than 60 million plan members. With more than 7,300 retail and specialty drugstores under the CVS and Longs Drug

Scenarios Price Target 12-Month PT Return %

Best $62.69 $63.91 15.47%

Base $59.91 $60.92 10.07%

Worst $51.47 $51.81 (6.39%)

banners, it trails archrival Walgreen by about 600 stores. CVS has grown rapidly through a string of acquisitions that included the Eckerdand Longs Drug Stores chains. Also, CVS now owns prescription benefits management (PBM) company Caremark Rx. Caremark Rx was combined with CVS's PBM and specialty pharmacy unit PharmaCare Management Services to form Caremark Pharmacy Services. Its MinuteClinic retail health network has more than 600 locations inside CVS drugstores. CVS drugstores are located in about 40 US states, the District of Columbia, and Puerto Rico. The company also operates pharmacies under the Longs Drugs banner in California, Hawaii, Nevada and Arizona.




Disclaimer:


Business Overview

Business Overview: [Company’s Website] CVS Caremark’s combination of health care services and offerings are enabling them to provide end-to-end solutions that impact everything from pharmacy plan design to the ultimate delivery of products and services to customers. The company’s capabilities include: industry-leading clinical and health management programs, specialty pharmacy expertise, leadership in retail clinics, customer service excellence, and our deep knowledge of the consumer gained through the more than five million people we serve every day, seven days a week. CVS Caremark’s business is broken in three divisions: Retail Pharmacy, MinuteClinic, Pharmacy Benefit Management (PBM) Services.

RETAIL PHARMACY: CVS/pharmacy, the retail division of CVS Caremark and is America's leading retail pharmacy with more than 7,300 CVS/pharmacy and Longs Drug stores. CVS/pharmacy is reinventing pharmacy to help people on their path to better health by providing the most accessible and personalized expertise, both in its stores and online at CVS.com. Retail Pharmacy provides customers with prescription medications, related health care products and other remedies in any of its 7,300+ locations. More than 20,000 highly trained Pharmacists are available to

dispense prescriptions as well as helpful advice. The retail stores offer customers 24-hour or extended-hours service in the pharmacy in 72 percent of the locations. Sixty percent of our stores provide drive-thru pharmacy windows as well. The stores also have about 600 in-store MinuteClinic locations up and running, with more coming through 2016. In the front of the store, customers appreciate the company’s wide selection of popular beauty, health and personal care brands, many of which are not available at any other U.S. drugstore. MINUTECLINIC: CVS/pharmacy customers have come to expect great service in the pharmacy and a broad range of offerings in the front of the store. In an increasing number of locations, the company is giving people yet another reason to stop in about 600 stores in 25 states that now feature MinuteClinics, the U.S. leader in retail health care clinics. More than 13 million people have visited MinuteClinic since its founding in 2000, and the company has been busy opening new locations since purchasing the company in 2006. MinuteClinic practitioners specialize in family health care and can diagnose, treat and write prescriptions for common family illnesses such as strep throat and ear, eye, sinus, bladder and bronchial infections. Minor wounds, abrasions, skin conditions and joint sprains are treated, and other common vaccinations such as influenza, tetanus, pneumonia, and Hepatitis A & B are available at most locations. Walk-in camp, sports and college physicals for adolescents are available daily. In addition, MinuteClinic administers a series of wellness services designed to help consumers identify lifestyle changes needed to improve their current and future health, including screenings and monitoring for diabetes, high blood pressure and high cholesterol. MinuteClinics will play an increasingly important role in reducing healthcare costs for insurance plans and self-insured employers. Each location provides quality care at a price that is more

(Continued on page 5)




Disclaimer:


Business Overview

affordable than the typical visit to the doctor's office or emergency room. Of course, when patients have conditions that require a doctor's care, MinuteClinic refers them to their family physician or provides a list of area doctors if they don't have one.

PHARMACY BENEFIT MANAGEMENT SERVICES: Payors and patients have long counted on CVS Caremark for a broad range of services, whether it's managing their pharmacy benefits, filling prescriptions by mail or offering the industry's deepest clinical capabilities. As a pharmacy benefits manager, CVS Caremark manages the dispensing of pharmaceuticals through their mail order pharmacies and national network of approximately 67,000 retail pharmacies (which includes their CVS/pharmacy stores) to eligible members in the benefit plans maintained by their clients and utilize their information systems to perform, among other things, safety checks, drug interaction screenings and brand to generic substitutions. The company’s integrated offerings leverage the clinical expertise and insights from their PBM business along with a broad reach and face-to-face engagement in their retail business to deliver innovative solutions that are unmatched in the marketplace today. These solutions enhance access, lower health care costs and improve health outcomes, and the company has compelling data proving the efficacy of their unique

(Continued from page 4) programs. Among their integrated offerings, the company has seen an enthusiastic response to its Pharmacy Advisor™ program. Capitalizing on their retail presence–unique among major PBMs–CVS Caremark can offer chronically ill patients the benefit of face-to-face counseling in their pharmacies to improve their medication adherence rates and close gaps in care. The company’s Maintenance Choice® program gives qualifying plan participants the option of filling their 90-day maintenance prescriptions by mail or at one of the retail store locations at the same co-pay and payor pricing as mail order, something that is very difficult for a standalone PBM or retailer to offer. Economic, Industry, Competitor Analysis (EIC) Economic: The 2013 fiscal year began with a stock market rally despite sluggish economic recovery and mixed corporate earnings. Cyprus’ recent banking crisis showed that Eurozone remains a risky and unstable financial arena. The “Troika” (European Commission, European Central Bank and International Monetary Fund) agreed to a €10 billion deal with Cyprus making it the fifth country after Greece, Ireland, Portugal and Spain to receive such aid. Conditions in United States are more stable than elsewhere. One key data to interpret is the S&P/Case-Shiller Home Prices Index. The index rose approximately 7.5% twelve months ending in January, the fastest growth since before the housing collapse. Additionally, U.S. new automobile sales are predicted to increase by 6.25% year-over-year in 2013. The likely increase in housing and automobile sales is being driven by a sluggish growth in consumer confidence. The recent consumer sentiment index (CSI) came in at 78.6, a four-month high. The U.S. economic recovery remains sluggish and that appears to be the new normal which investors and consumers are beginning to realize.





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Business Overview

Industry — Porter’s 5 Forces: Threat of New Entrants (Low): The drug retail and pharmacy benefit management (PBM) industries has tremendous entry barriers. Patented drugs pose an impossible regulatory challenge for new competitors to enter. Additionally, there is regulatory pressure to make patented drugs available to everyone at affordable costs. As a result, drug retailers and pharmacy benefit managers (PBM) have strong distribution networks which allows them to provide affordable services to end-consumers. Bargaining Power of Suppliers (Medium): The drug retail and pharmacy benefit management (PMB) industries faces a moderate amount of pressure from its suppliers. On the one hand, the drug retail industry buys directly from manufacturers when they purchase generic drugs and other front store sale items. These transactions allow large industry players (CVS Caremark, Walgreens, Rite Aid) to dictate prices. On the other hand, third party administrators (insurance companies, health & welfare funds, public administrations etc.) Power of Buyers (Low): The drug retail and pharmacy benefit management (PBM) industries grant very little power to buyers. When consumers visit retail pharmacies, a significant portion of their spending goes toward drugs. Consumers have very little control in dictating the price of drugs. Threat of Substitutes (Low): Consumers do have substitutes for front store sale items such as: beauty products, personal and household goods, that they can easily purchase

(Continued from page 5) from discount wholesalers or online retailers. However, a majority of the industry’s revenue comes from drug sales and healthcare services provided by pharmacy benefit managers (PBM). Those services and products are extremely difficult to substitute because consumers always seek medicine when they’re sick. Additionally, there is a tremendous cost associated with clients changing their PBM service provider due to highly niche channels. Intensity of Rivalry (High): There is a tremendous level of rivalry in the drug retail and pharmacy benefit management (PBM) industries. Third party administrators’ retention rate is extremely high for PBMs because of specific and niche channels. On the other hand, drug retail industry is just as competitive with three large competitors in addition to smaller and local pharmacies. Finally, discounted drugs in Wal-Mart are increasing the level of rivalry in the industry. Competitive — ROIC vs. WACC & Other Ratios The following chart is from Bloomberg with multiple key metrics of several companies in the drug retail and pharmacy benefit management (PBM) industries. The ROIC and the WACC analysis determines the short run profitability of a company from an economic value perspective. The greater the difference between a company’s ROIC and the WACC the better it is for investors. Additionally, if the company’s ROIC is greater than the industry’s ROIC, that means the company holds a competitive advantage because the company is earning higher returns compared to its industry peers.





Disclaimer:


Business Overview

SWOT Analysis: (Canadean) CVS Caremark is a pharmacy services provider based in the U.S. Strong presence in the U.S., broad service portfolio and steady revenue growth are the key strengths of the company. Its future growth may be driven by growth in emerging markets, collaborations and agreements along with growth of web-based stores. However, legal issues and single retail format are areas of concern. Additionally increasing competitive pressures and

rising manpower costs may pose challenges to the company's business growth and profitability. Strengths: The company is one of the largest drugstore chains in the US. Through its Retail Pharmacy division, CVS Caremark operates 7,327 retail drugstores, 30 onsite pharmacies, 657 retail health care clinics and a web-store CVS.com. It is one of the largest specialty pharmacy and largest retail clinic operator. Additionally, the company operates its Pharmacy Service division through 31 retail specialty pharmacy stores, 12 specialty mail order pharmacies and four mail service pharmacies, located in 22 states, the District of Columbia and Puerto Rico. With its strong presence in drugstore industry, the company enjoys high bargaining power with its suppliers and enhanced customer loyalty. Operating through Retail Pharmacy and PBM Services, the company provides diverse range of

(Continued from page 6) end-to-end solutions, across the entire spectrum of pharmacy care. CVS Caremark, through its Pharmacy Services business, provides full range of Pharmacy Benefit Management (PBM) services. These include disease management programs, mail pharmacy program, prescription management systems, specialty pharmacy, plan design and administration, formulary management, Medicare Part D services, discounted drug purchase arrangements, onsite pharmacies, retail pharmacy network and quality assurance. The broad service portfolio enables the company in protecting itself against demand fluctuations in certain industry segments. It generated revenues of $107 billion during FY2011, an increase of 11.28% as compared to $95.8 billion in FY2010. This was principally due to the increased sales of Pharmacy Services and Retail Pharmacy segments by 24.90% and 3.90%, respectively. Furthermore, its revenue grew at a cumulative rate of 8.93% during 2007-11. Weaknesses: The company operates a single retail format drugstore. As consumers continue to consolidate their shopping trips, the company is competitively weaker compared to supermarkets with an in-store pharmacy. It may lose some of its market share, especially in the generic drug and over-the-counter categories due to concentration on a single format and presence of diversified retail competitors. CVS Caremark has been subject to several lawsuits in the U.S. regarding information related to prescription drug claims submitted by its pharmacies, inaccurate pricing of some drugs, disclosure of its operations and labor violations. Majority of the legal troubles are just allegations and not actual lawsuits pending. Opportunities:


Strengths: Broad Service Portfolio

Steady Revenue Growth

Strong Presence in U.S.

Weaknesses: Legal Issues

Single Retail Format

Opportunities Collaborations Emerging Markets Web-Based Stores Growth

Threats: Competitive Pressures

Rising Manpower Costs




Disclaimer:


Business Overview

Emerging markets offer a strong growth opportunity to the company, which may leverage its strong brand and product portfolio to take advantage of rapid growth in these markets. It is estimated that 17 high-growth pharmaceutical markets including China, Brazil, Mexico, India, Russia, South Korea and Turkey will contribute nearly 48% of the global pharmaceutical industry’s growth by 2013, and 50% by 2020, up from 37% as of 2008. Additionally, annual pharmaceutical sales in emerging markets is expected to reach $400 billion by 2020, equivalent to current sales in the US and five major European markets combined. The company's various agreements and collaborations paves the way for organic growth. During FY2011, CVS Caremark entered into various agreements and alliances to bolster its service portfolio and market presence. For example, CVS Caremark recently entered into an agreement with Charlotte and Cleveland to install MinuteClinic stations at various sites in order to enhance quality and provide affordable health care services. The company stands to benefit from the growing trend of online retail, which provides consumers the convenience of shopping from home, doing away with the time consuming journey and saving on the transportation cost. By providing assurance to customers about credit card payment security and timely delivery at minimal cost, more product information and availability, user friendly features and other technological enhancements, CVS may further enhance its online shops and benefit from increased revenues. Threats: Increasing manpower costs may have an adverse affect on the retailers, such as CVS Caremark. The tight labor markets, government mandated increases in minimum wages and a higher

(Continued from page 7) proportion of full-time employees are resulting in an increase in labor costs. Eight states including Arizona, Colorado, Florida, Montana, Ohio, Oregon, Vermont and Washington, increased the minimum wages by 28 to 37 cents, taking the hourly wage between US$7.64 and US$9.04, effective from January 1, 2012. Significant proportion of workers in the retail sector, fall under the purview of minimum wages. Any such rise in the minimum wages increases the operating costs of retailers

such as the company and has an adverse affect on their profits. The company’s markets are characterized by intense competition, evolving industry standards and business models. Operating through its Retail Pharmacy and Pharmacy Services business segments, CVS Caremark competes with numerous large and small drugstore chains, supermarkets, discount retailers, membership clubs, internet retailers and retail health clinics. Its key competitors include PBM companies such as Medco Health Solutions, Inc., and Express Scripts, Inc., Wellpoint and retail pharmacies such as Walgreens, Longs and Rite Aid. These competitors have strong presence in the market and cater to wide customer base. Financial Summary: CVS Caremark is the largest integrated pharmacy health care provider in the United States. The company has diversified its traditional drug retail





Disclaimer:


Executive Summary

business model with pharmacy benefit management (PBM) services after it merged with Caremark in 2007. The 2012 business segment revenue breakdown is as follows:

The proportion of revenue between retail pharmacy and pharmacy services was approximately 50-50 at the end of 2011. However, pharmacy services revenue increased $14.6 billion, or 24.7% in 2012 due to new client starts, drug cost inflation and the growth in Medicare Part D program. On the other hand, retail pharmacy revenue increased $4.1

billion, or 6.8% in 2012 due to a 5.5% increase in same store sales and new retail stores.

(Continued from page 8)




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Industry Overview

Industry Overview: (IBIS World) Drug Retail: Drug retail industry sells a range of prescription and over-the-counter medications, health and beauty items, toiletries and consumable goods directly to consumers on a walk-in basis. Industry companies may also provide basic health and photo processing services. Primary activities of the drug retail industry is as follows:

The drug retail industry is in the mature stage of its life cycle. Industry sales growth is slowing, rivalry among companies is high, weaker players are going out of business or are being acquired, and the remaining players are growing through consolidation. New players are also deterred by the strong rivalry between the top two players (Walgreen Company and CVS Caremark), which dominate about 57.9% of the market.

The drug retail industry is dominated by the sales of branded prescription drugs, over-the-counter nonprescription medication and specialty prescription drugs. Products and services segmentation in the drug retail industry is as follows:

Pharmaceutical purchases are the main reason that consumers visit drug stores. Additionally, according to the US Department of Health and Human Services, consumers aged 65 and older are estimated to account for about 30% of pharmacy expenditure. This group receives a relatively high number of prescription drugs due to the group’s relatively high number of chronic diseases and disorders, and limited non-drug alternatives. Major market segmentation based on age group is as follows:




Disclaimer:


Industry Overview

Pharmacy Benefit Management: The industry includes firms that provide pharmacy benefit management (PBM) services. Industry firms are third-party administrators of government and employer-sponsored prescription drug programs. They are primarily responsible for processing and paying prescription drug claims. Top four firms in the PBM industry are expected to account for the vast majority of industry revenue, about 91.0% in 2012. Over the past five years, major players such as Express Scripts and Medco Health Solutions have aggressively acquired smaller firms in an attempt to increase their retail pharmacy network. The 2010 Patient Protection and Affordable Care Act will expand prescription drug coverage, which will boost prescription drug use and industry fees as a result.

Accounting for the majority of industry revenue in 2012, retail pharmacy services have remained a steady source of revenue for the industry. A considerably large portion of retail pharmacy services is mail order, which includes the processing, fulfillment and delivery through the mail of brand name and generic pharmaceuticals to patients who submit prescriptions or refill requests to an industry client. The retail pharmacy segment also includes face-to-face retail pharmacy services, which are performed through a company’s retail pharmacy network (i.e. a group of external pharmacies that have contracted an industry firm to manage their pharmacy operations). Roughly 44.5% of PBM industry’s revenue comes from government health programs. Also, employer-sponsored programs also contribute heavily to industry’s revenue. The 2012 market segmentation is as follows:




Disclaimer:


Industry Overview

Industry Performance: (IBIS World) Drug Retail: Walgreen Company, CVS Caremark and Rite Aid continue to dominate the Pharmacies and Drug Stores industry. During the five years to 2013, industry revenue is expected to grow at an average annual rate of 1.6% to $247.7 billion. Lingering unemployment and uncertainties with healthcare reform have been causing consumers to hesitate with prescription drug purchases, leading to lackluster front-end sales in 2011 and early 2012. Front-end sales have endured sluggish growth due to product price increases that operators have tried to pass on to consumers. Reductions in third-party reimbursement rates from private and government plans have been putting pressure on industry players. In 2013, however, industry revenue is expected to rise 2.0% as a result of increasing disposable incomes and the aging population. Revenue growth will further be facilitated by the skyrocketing incidence of flu, which is considered as the most severe in at least a decade, according to the Centers for Disease Control and Prevention. Severe flu is projected to increase pharmacy trips and same-store sales, particularly in the winter months, as more people will seek to receive a flu vaccine and purchase over-the-counter medications and disinfectant supplies.

Pharmacy Benefit Management (PBM): PBM service providers implement prescription drug benefits for more than 215 million Americans, making them a vital part of managing costs and providing consumers with prescription medications in the US healthcare system. According to the Utilization Review Accreditation Commission, a healthcare non-profit organization, about 95.0% of consumers with pharmacy drug benefits receive these benefits through a PBM. Over the past five years, IBISWorld estimates that Pharmacy Benefit Management industry revenue has grown at a 0.9% average annual rate to about $226.6 billion in 2012. Growing demand for industry services was driven by rising prescription drug manufacturing costs and growth in healthcare and prescription drug use by an aging population with increasing rates of chronic illness. However, industry revenue growth was tempered by weak prescription drug spending as consumers shifted from higher-priced brand name medications to cheaper generic versions and over-the-counter medications.




Disclaimer:


Industry Overview

Key External Drivers: (IBIS World) Drug Retail: There are a number of key external drivers that impact the drug retail industry, including but not limited to: per capita disposable income, number of people with private health insurance, number of adults aged 65 or older, number of physician visits and federal funding for Medicare and Medicaid.

Overall, the key external drivers are projected to increase and should benefit the drug retail industry. People aged from between 45 - 65 years represent 40% of industry’s revenue. The retiring baby boomers is likely to add more senior citizens into the economy who will have frequent healthcare expenditures. As a result, the proportion of sales coming from senior citizens is likely to increase in the near future. Following the 2008 recession, per capita disposable income is beginning to increase. When coupled with the effects of Obamacare, increased government spending in healthcare is going to lead to more people having health insurance, which will result into increased number of visits to physicians.

Pharmacy Benefit Management (PBM): There are a number of key external drivers that impact the PBM services industry, including but not limited to: total healthcare expenditure, number of employees, median age of population, regulation and number of physician visits.

With recovering U.S. economy, the total healthcare expenditure is likely to increase because of increased government intervention and the general rise in pharmaceutical services. Macroeconomic recovery will also add more people into the workforce which will create additional demand for employer-sponsored coverage groups. The median age of population is increasing mainly because of the retirement of baby boomers which will serve as a significant revenue driver for the industry. However, the PBM industry is heavily regulated with numerous government policies influencing pricing, marketing and distribution. With Obamacare granting more people with health coverage, there is a likelihood the government will exert its influence on the industry.




Disclaimer:


Industry Overview

Industry Outlook: (IBIS World) Drug Retail: The drug retail industry revenue is anticipated to grow an average rate of 2.8% annually and total $284.0 billion by 2018. This forecast includes a 3.6% increase in 2014, when most provisions of healthcare reform will come into effect.

Many blockbuster drugs began facing expiring patents starting in 2011. Industry players anticipate that average pharmacy prices will likely decline due to the introduction of generic versions of branded drugs. In contrast, sales of over-the-counter (OTC) drugs will advance, partly because of patent expirations on prescription drugs, faster approvals from the Federal Drug Administration and rising personal disposable income. While generics boost sales volume, their lower prices will cause revenue growth to soften during these years.

The industry will benefit from an increase in sales volumes as more people gain insurance coverage for prescription drugs. An estimated 32 million newly insured individuals would mean a boost in demand for prescription drugs. Pharmacies will also see heightened traffic in their in-store clinics due to increasing healthcare insurance coverage and a projected shortage of primary care physicians. According to government data and estimates from the Associated Press, 5 million people live in areas designated as having a shortage of primary care physicians. Given the inadequate supply of primary care doctors, millions of the newly insured are anticipated to turn to retail clinic services.

Reimbursement levels for prescription drugs dispensed for consumers on Medicaid or Medicare are a challenge. Proposals surrounding healthcare reform include revisions to cost calculation methods, which may reduce reimbursement rates and the resulting profit margin on some medications. The issue is exacerbated by the continued consolidation of PBMs, which leads to larger companies with more price-negotiating power. The share of prescriptions paid for by third-party administrators has grown in recent years, and is forecast to continue. As a result, a larger percentage of revenue is susceptible to reduced reimbursements or pricing pressure.




Disclaimer:


Industry Overview

Pharmacy Benefit Management (PBM): Over the next five years, IBISWorld projects that PBM industry will increase its revenue at a 4.5% average annual rate to about $282.2 billion in 2017.

In early 2010, healthcare reform was passed under the Patient Protection and Affordable Care Act (PPACA). The industry is forecast to gain sales from the reform while also losing some profitability. Demographic shifts, growth in drug prices and sales volumes and broader insurance coverage also will affect total prescription drug expenditures, which underpins demand for pharmacy benefit services. People with prescription drug coverage have a 75.0% higher drug use rate and also tend to spend more on prescription drugs, according to US government statistics. Therefore, as uninsured Americans gain insurance, pharmaceutical spending is likely to rise proportionally. By 2015, the Utilization Review Accreditation Commission projects that Americans will spend more than $450.0 billion dollars on prescriptions. Despite healthcare reform’s boost to prescription drug sales and industry revenue, the increasing prevalence of generic drugs will cut into PBM profit margins. IBISWorld projects that the average industry profit margin will make a negligible climb up to 4.0% of revenue in 2017, an increase from about 3.8% in 2012.




Disclaimer:


Executive Team

Executive Shares Past Experience Age

Larry J. Merlo Chief Executive Officer

749,460 Served as COO of CVS Caremark from May 2010 to March 2011

Served as President of CVS/pharmacy and Executive Vice President of CVS Caremark from January 2007 to May 2010

57

David M. Denton Chief Financial Officer

124,559 Served as Senior VP and Controller/Chief Accounting Officer of CVS Caremark, from March 2008 to December 2009

Served as Senior VP, Financial Administration of CVS Caremark and CVS/pharmacy, Inc. from April 2007 until March 2008

Served as Senior VP, Finance and Controller of PharmaCare Management Services, Inc., the Company’s PBM subsidiary, from October 2005 through April 2007

MBA from Wake Forest University

47

Mark Cosby President, CVS/Pharmacy

109,582 Responsibility for all Retail Stores, Distribution Centers and E-Commerce site, CVS.com, as well as Merchandising, Supply chain, Marketing, Real Estate, Front Store and Pharmacy Operations

Served as Macy’s President of Stores where he was Responsible for all Store Operations and Support Functions Nationwide

MBA from University of Wisconsin, Madison

54

Jonathan Roberts President, CVS Caremark Pharmacy Services

96,036 Served as COO of the Company’s PBM division, a Position he had held since October 2010

Served as EVP of Rx Purchasing, Pricing and Network Relations, from January 2009 to October 2010

Senior VP and Chief Information Officer of CVS Caremark Corporation from January 2006 until January 2009

Bachelors, Pharmacy, Virginia Commonwealth

56

Andrew J. Sussman, M.D. President, MinuteClinic

Served as Executive VP and COO of UMass Memorial Medical Center from May 2004 to August 2009

Served as an Associate Professor of Medicine at the University of Massachusetts Medical School

Served as Chief Medical Officer of the Brigham and Women’s Physicians Organization before 2004

45




Disclaimer:


Investment Positives

Obamacare to Increase Health Coverage: Patient Protection and Affordable Care Act, commonly called Obamacare, is estimated to bring an additional 35 million people into health coverage. The increase in insured individuals is likely to spur prescription sales. When coupled with the steady rise in prices for prescription medicine, CVS Caremark stands ready to reap the awards of Obamacare. Aging U.S. Population: The median age of the U.S. population is slowly increasing mainly because of the retiring baby boomers. People aged 45 and above accounts for 70% of the entire industry’s revenue (approximately $173 billion). Additionally, aging also increases the chances of chronic or other illnesses that may need prescribed medicine.

Titan in the Arena: Drug retail and pharmacy benefit management combine for approximately $474 billion in industry revenue. CVS is a titan in this space and commands a 27% market share ($128 billion). With over 7000 retail stores in the U.S., CVS Caremark is positioned to take advantage of the recovering U.S. economy.

PBM Division (Caremark) Provides a Safety Net: Pharmacy benefit managers serve as the middle man between drug retailers and third party administrators (insurance companies, employee-sponsored plans, Medicare and Medicaid etc.). There are only 40 PBMs in the United States and they’re consolidating and gaining market share steadily. With the increase in market share, PBMs are able to exert pricing pressure on drug retailers. However, CVS Caremark’s own PBM division makes up 27% of the entire industry. With such a large exposure to the PBM industry, CVS Caremark is able to mitigate any pricing pressure in its own pharmacies while putting pricing pressure on its competitors. Mergers & Acquisitions: The last blockbuster deal the company closed was when it acquired Caremark in 2007 to form CVS Caremark. Now, CVS Caremark is equally exposed to both drug retailing and pharmacy benefit management industries. There is widespread consolidation taking place in both of these industries in order to overcome industry wide margin compressions and gain pricing power.




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Investment Issues & Risks

The Health of the Economy in General and in the Markets They Serve: CVS Caremark’s business is affected by the economy in general, including changes in consumer purchasing power, preferences and/or spending patterns. These changes could affect drug utilization trends as well as the financial health and number of covered lives of their PBM clients, resulting in an adverse effect on their business and financial results. Mitigating Factor: Economy is slowly recovery with a rise in consumer spending and increased health coverage due to recent regulations. These factors point to a higher number of customers in CVS’s pharmacies and revenue. Efforts to Reduce Reimbursement Levels and Alter Health Care Financing Practices: The continued efforts of health maintenance organizations, managed care organizations, PBM companies, government entities, and other third party payers to reduce prescription drug costs and pharmacy reimbursement rates may impact the company’s profitability. Mitigating Factor: There are only 40 PBMs in the United States and they’re consolidating and gaining market share steadily. With the increase in market share, PBMs are able to exert pricing pressure on drug retailers. However, CVS Caremark’s own PBM division makes up 27% of the entire industry. With such a large exposure to the PBM industry, CVS Caremark is able to mitigate any pricing pressure in its own pharmacies while putting pricing pressure on its competitors.

Risks of declining gross margins in the PBM industry: The PBM industry has been experiencing margin pressure as a result of competitive pressures and increased client demands for lower prices, enhanced service offerings and/or higher service levels. Government intervention in the form of Obamacare has also contributed to client demands for lower prices, enhanced service offerings etc. Mitigating Factor: CVS Caremark maintains contractual relationships with generic pharmaceutical manufacturers and brand name pharmaceutical manufacturers that provide them purchase discounts and/or rebates on drugs dispensed by pharmacies in their retail network and by their mail order pharmacies. An Extremely Competitive Business Environment: Each of the retail pharmacy business and the PBM business currently operates in a highly competitive and evolving health care environment. CVS Caremark’s competitive success is impacted by the ability of their retail pharmacy business to establish and maintain contractual relationships with PBMs and other payers on acceptable terms and by the ability of their PBM business to establish and maintain contractual relationships with network pharmacies on acceptable terms. Mitigating Factor: Drug retail and pharmacy benefit management combine for approximately $474 billion in industry revenue. CVS is a titan in this space and commands a 27% market share ($128 billion). With over 7000 retail stores in the U.S., CVS Caremark is positioned to take advantage of the recovering U.S. economy.




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Red Flag Analysis

There are no red flags in CVS Caremark.




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Competition

Drug Retail: Walgreen Co. (Mkt Share: 30.9%) Walgreen Co., the largest US drug store chain, provides multichannel access to consumer goods and services, and pharmacy, health and wellness services to communities across America. Walgreen offers its products and services through drug stores, mail, telephone and the internet. It sells prescription and nonprescription drugs and general merchandise, including household products, convenience foods, personal care and beauty items. Its pharmaceutical services include retail, specialty, infusion, medical facility, long-term care, mail and respiratory services. The company’s main product segments are in pharmaceuticals, with 65.0% of sales from prescription drugs. Generic prescriptions account for about two-thirds of sales. The remaining 25.0% of Walgreen’s sales comes from selling general merchandise. Rite Aid Co. (Mkt Share: 11.0%) Rite Aid is the third-largest drug store chain in the United States, with more than 4,600 stores in 31 states. Rite Aid drug stores sell prescription drugs (accounting for about 68.0% of total revenue) and front-end products, including over-the-counter medications, health and beauty aids, personal care items and cosmetics. The company tries to differentiate its store through wellness and loyalty programs, private brands and its strategic alliance with GNC, a leading retailer of vitamin and mineral supplements. Rite Aid offers a variety of private-brand products, which contribute about 17.0% to its front-end sales; the company plans to increase the number of private-brand products during 2013.

Pharmacy Benefit Management: Medco Health Solutions (Mkt Share: 32.3%) Headquartered in New Jersey, Medco Health Solutions provides public and private employers with clinically driven pharmacy services that both lower the cost of healthcare and improve the quality of treatment for over 65 million members. The company currently employs 22,100 full-time employees and 1,100 part-time employees that collaborate with payers, retail pharmacies, physicians, pharmaceutical manufacturers, Medicare and Medicaid and health insurers to, among other services, manage drug utilization, distribute prescription drugs and provide customized plan design for client members. Medco splits its operations into two reportable segments: pharmacy benefit management and specialty pharmacy. In mid-2011, Medco Health Solutions entered into a merger agreement with Express Scripts. The merger will combine the companies into a new holding company named New Express Scripts. The deal was approved by the Federal Trade Commission in early 2012 but continues to face considerable opposition from independent pharmacies that claim the new company will push their pharmacies out of business by using aggressive price-cutting tactics to leverage their mail-order operations. Express Scripts Inc. (Mkt. Share: 21.6%) Headquartered in Missouri and employing about 13,210 people, Express Scripts offers a variety of services to its clients, including retail network pharmacy management and retail drug card programs, home delivery services, specialty benefit services and patient care contact centers.




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Historical Charts




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Appendix A: Discounted Cash Flow Model




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CVS Caremark (1 Yr. PT: $60.76) · SWOT Analysis Financial Summary Industry Overview 13 Industry...

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