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CVS Caremark Corporation (CVS - Analyst Report) reported third-quarter 2013 adjusted earnings per share (EPS) of $1.05, up a significant 23.9% year over year. The result also beat the Zacks Consensus Estimate by 3 cents. This reflects the seventh consecutive quarter of positive earnings surprise for CVS.

The quarterly result exceeds the company’s expectation of $1.00– $1.03 for the third-quarter. Without these adjustments, reported EPS in the quarter surged 29.5% to $1.03.

Per management, the EPS upside was led by higher profitability on the back of increased generic drugs dispensed and the growth of Maintenance Choice program in the Pharmacy Services and Retail Pharmacy segments.

Quarter Under Review

Net revenue improved 5.8% year over year to $31.97 billion in the third quarter, surpassing the Zacks Consensus Estimate of $31.49 billion.

The Pharmacy Services segment revenues increased 7.8% to $1.4 billion in the quarter. The segment gained from drug cost inflation in specialty pharmacy business and broad-based growth of claims. However, the generic wave in the pharmaceutical industry adversely affected the segment revenues.

The higher claims from new client wins led to 2.0% year over year rise in CVS’ pharmacy network claims to 200.9 million. The new client gains and ongoing adoption of the Maintenance Choice program increased the Mail Choice claims processed to 21.0 million, up 3.1% on a year-over-year basis.

Revenues from CVS’ Retail Pharmacy improved 5.0% year over year to $16.3 billion. Same-store sales increased 3.6% while front-end same store sales declined 1.0% 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. Front-end same-store sales decline was attributed to softer traffic during the quarter.

Pharmacy same store sales were up 5.7% from the year-ago quarter. Despite the generic introductions that dragged sales by 320 bps, CVS posted pharmacy same store sales growth.

Moreover, counting 90-day scripts as one script, pharmacy same-store prescription volumes improved 1.4% from the year-ago quarter. When 90-day scripts were converted into 3 scripts, same-store prescription volumes grew 4.5% from the prior-year quarter.

The generic dispensing rate (the proportion of all generic prescriptions to total number of prescriptions dispensed) soared 170 bps to 81.0% in the Pharmacy Services segment and 160 bps to 81.5% in the Retail Pharmacy segment.

Gross margin expanded 19 bps to 18.9% on the back of higher profitability across both segments due to generic introductions. Gross margin for the Pharmacy Services business improved 60 bps to $6.6% while the same for the Retail Pharmacy segment was 30%, down 10 bps from the year-ago quarter.

Operating expenses were up 1.1% on a year-over-year basis to roughly $3.9 billion in the quarter. However, operating margin expanded 76 bps to 6.8%. Operating margin for the Pharmacy Services segment expanded 90 bps to 5.2% while the same for Retail Pharmacy franchise improved 60 bps to 9.0% in the quarter.

CVS exited the quarter with cash and cash equivalents and short-term investments of $1.61 bllion, down from $1.38 billion at the end of 2012. Year-to-date net cash provided by operating activities declined 14.1% to $4.2 billion. This along with year-to-date capital expenditure of $1.30 billion (versus $1.31 billion in the year-ago period) resulted in free cash flow of almost $3.07 million year-to-date, down 24.3% from the year-ago period.

During the third quarter, CVS opened 49 new retail drugstores and closed one retail drugstore. Further, the company relocated 22 retail drugstores. As of Sep 30, 2013, CVS operated 7,665 locations, which include 7,601 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 third quarter, CVS raised its guidance for 2013 adjusted EPS to the range of $3.94 – $3.97 compared with $3.90 – $3.96 earlier. The current Zacks Consensus Estimate of $3.95 lies within the guidance range.

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.


Our Take

CVS continues to report strong quarterly results. We are encouraged by CVS’ third-quarter 2013 results which edged past the Zacks Consensus Estimate in both ways. 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.

We are upbeat about CVS, owing to its consistent, stellar earnings performance. Currently, the stock carries a Zacks Rank #2 (Buy). Other better-performing stock that are worth a look include Rite Aid Corp. (RAD - Analyst Report) carrying a Zacks Rank #1 (Strong Buy) and GNC Holdings Inc. (GNC - Snapshot Report) and Herbalife Ltd. (HLF - Snapshot Report) both carrying a Zacks Rank #2 (Buy).

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