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CVS Caremark Corporation (CVS - Analyst Report) reported second-quarter 2013 adjusted earnings per share (EPS) of 97 cents, up a significant 19.5% year over year. The result also beat the Zacks Consensus Estimate by a penny. This reflects the sixth consecutive quarter of positive earnings surprise for CVS. The quarterly result tallies with the high end of the company’s expectation of 94 – 97 cents for the second-quarter.

Per management, the EPS upside was led by higher profitability on the back of the generic wave in the pharmaceutical industry. On a reported basis, net income was $1,121 million (or 91 cents), higher than net income of $967 million (or 75 cents) in the prior-year quarter.

Quarter under Review

Net revenue improved 1.7% year over year to $31,248 million in the second quarter, surpassing the Zacks Consensus Estimate of $31,185 million.

The Pharmacy Services segment revenues increased 2% to $18,800 million in the quarter. The segment gained from drug cost inflation in specialty pharmacy business and volume growth across all channels. However, the generic wave in the pharmaceutical industry adversely affected the segment revenues.

The higher claims from new client wins led to 4.1% year over year rise in CVS’ pharmacy network claims to 205.9 million. The new client gains and ongoing adoption of the Maintenance Choice program increased the Mail Choice claims processed to 20.7 million, up 1% on a year-over-year basis.

Revenues from CVS’ Retail Pharmacy improved 1.9% year over year to $16,139 million. Same-store sales increased 0.4% while front-end same store sales declined 0.4% year over year. Same store sales improved on account of higher same store prescription volumes. This positive impact was partly tempered by the introduction of generic drugs and unfavorable calendar shifts (the shift of Easter holiday to the first-quarter 2013). Front-end same store sales decline was attributed to the adverse effect of 65 basis points (bps) from the shift of Easter holiday.

Pharmacy same store sales inched up 0.8% from the year-ago quarter. Despite the generic introductions that dragged sales by 670 bps, CVS posted pharmacy same store sales growth. This is a marked improvement from the first quarter.

Moreover, counting 90-day scripts as one script, pharmacy same-store prescription volumes improved 1.8% from the year-ago quarter. When 90-day scripts were converted into 3 scripts, same-store prescription volumes grew 5% from the prior-year quarter.

The generic dispensing rate (the proportion of all generic prescriptions to total number of prescriptions dispensed) soared 270 bps to 80.7% in the Pharmacy Services segment and 280 bps to 81.9% in the Retail Pharmacy segment.

Gross margin expanded 100 bps to 18.7% on the back of higher profitability across both segments due to generic introductions. Gross margin for the Pharmacy Services business improved 90 bps to $5.1% while the same for the Retail Pharmacy segment was 31%, up 90 bps from the year-ago quarter.

Operating expenses were up 3.4% on a year-over-year basis to roughly $3,868 million in the quarter. However, operating margin expanded 70 bps to 6.3%. Operating margin for the Pharmacy Services segment expanded 80 bps to 3.6% while the same for Retail Pharmacy franchise improved 60 bps to 9.9% in the quarter.

CVS exited the quarter with cash and cash equivalents and short-term investments of $1,179 mllion, down from $1,380 million at the end of 2012. Year-to-date net cash provided by operating activities declined 36.7% to $2,542 million. This along with year-to-date capital expenditure of $804 million (versus $818 million in the year-ago period) resulted in free cash flow of almost $1,738 million year-to-date, down 45.7% from the year-ago period.

During the second quarter, CVS opened 23 new retail drugstores, closed one retail drugstore and one retail specialty pharmacy store. Further, the company relocated 24 retail drugstores. As of Jun 30, 2013, CVS operated 7,617 locations, which include 7,553 retail drugstores, 18 onsite pharmacies, 30 retail specialty pharmacy stores, 12 specialty mail order pharmacies and 4 mail order pharmacies in 45 states, as well as the District of Columbia and Puerto Rico.

Guidance

Following the second quarter, CVS narrowed its guidance for 2013 adjusted EPS to the range of $3.90 – $3.96 compared with $3.89 – $4.00 earlier. The current Zacks Consensus Estimate of $3.97 lies outside the guidance range. The revision is on account of the timing of share buyback activity.

On the other hand, CVS reiterated its expectations for 2013 free cash flow and cash flow from operations in the range of $4.8 – $5.1 billion and $6.4 – $6.6 billion, respectively. The guidance includes the completion of the accelerated share repurchase agreement of $4 billion.

For the third quarter of 2013, CVS expects adjusted EPS in the band of $1.00– $1.03. The current Zacks Consensus Estimate of 97 cents lies below the company’s outlook.

Our Take

CVS continues to report strong quarterly results. We are encouraged by CVS’ second-quarter 2013 results which edged past the Zacks Consensus Estimate. The company continues to benefit from the introduction of generics that push profits higher. It also witnessed robust double-digit growth in pharmacy benefit management (PBM) on the back of a strong selling season. Furthermore, same-store sales and pharmacy store sales also improved after a weak first-quarter.

We are upbeat about CVS, owing to its consistent, stellar earnings performance. Currently, the stock carries a Zacks Rank #2 (Buy). Other Zacks Rank #2 stocks are Cardinal Health, Inc. (CAH - Analyst Report) and BioScrip Inc. (BIOS - Analyst Report). Another stock that looks attractive is McKesson Corporation (MCK - Analyst Report) that posted upbeat performance in the first quarter of fiscal 2014 last week. The stock carries a Zacks Rank #1 (Strong Buy).
 

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