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CVS Caremark (CVS - Analyst Report) reported third quarter 2012 earnings per share (EPS) of 79 cents, up 21.5% year over year. However, after excluding the impact of certain acquisition related expenses from both the periods, the adjusted EPS in the reported quarter came in at 85 cents, ahead of the Zacks Consensus Estimate by a penny and 21.4% higher than the year-ago quarter. 

Net revenue during the quarter increased 13.3% year over year to $30.2 billion, in line with the Zacks Consensus Estimate. The Pharmacy Services segment posted a robust 22.2% increase in revenues to $18.1 billion during the reported quarter. The company benefited from client additions during the fiscal 2012 selling season, drug cost inflation and growth in the Medicare Part D business, which the company acquired from Universal American Corp. (UAM - Snapshot Report) last year.

All these factors also led to a 10.0% year-over-year increase in CVS’ pharmacy network claims to 197.0 million. The new client gains and the ongoing adoption of the Maintenance Choice program also drove the Mail Choice claims processed growth by 16.3% to 20.4 million.

Revenues from CVS’ Retail Pharmacy increased 5.5% to $15.5 billion with same-store sales climbing 4.3%. Walgreen’s (WAG - Analyst Report) loss of the Express Scripts (ESRX - Analyst Report) contract in January 2012, coupled with a strong underlying prescription growth supported the company’s pharmacy same-store sales, which grew 5.3% in the quarter. Front-end same-store sales increased 2.2% year over year.

Additionally, when 90-day scripts were counted as one script, pharmacy same-store prescription volumes climbed up 8.7%. When 90-day scripts were converted into 3 scripts, same-store prescription volumes increased 11.1% year over year. On account of the recent generic introductions, pharmacy same-store sales witnessed a decline of 905 basis points (bps).

The generic dispensing rate (the proportion of all generic prescriptions to total number of prescriptions dispensed) in the quarter increased 500 bps to 79.3% in the Pharmacy Services segment and 420 bps to 79.9% in the Retail Pharmacy segment.

Gross margin during the quarter contracted 73 bps to 18.7%. Operating expenses were up 6.6% on a year-over-year basis to $3.8 billion. However, operating margin remained almost flat year over year at 6.0%.

CVS exited the third quarter with cash and cash equivalents of $1.23 billion, compared to $1.41 billion at the end of fiscal 2011. Year-to-date net cash provided by operating activities were $4.9 billion compared to $5.0 billion for the same period last year.

During the third quarter, CVS opened 45 new retail drugstores, closed 3 retail drugstores. Additionally, the company relocated 18 retail drugstores. At the end of the quarter, CVS operated 7,500 locations, which include 7,423 retail drugstores, 28 onsite pharmacies, 31 retail specialty pharmacy stores, 12 specialty mail order pharmacies and 6 mail order pharmacies in 44 states, as well as the District of Columbia and Puerto Rico.

Guidance

Anticipating a benefit from the company’s accelerated share repurchase program (announced in September 2012) and its expectation about retaining at least 60% of the prescriptions gained from the Walgreen and Express Scripts impasse, the company is raising and narrowing its guidance for 2012. The company now expects adjusted EPS of $3.38−$3.41 (earlier guidance being $3.32−$3.38). The current Zacks Consensus Estimate of $3.36 remains below the guidance range.

The company reiterated its 2012 free cash flow and cash flow from operations guidance at $4.6–$4.9 billion and $6.2–$6.4 billion, respectively. The fiscal 2012 guidance includes the completion of the accelerated share repurchase agreement of $1.2 billion.

Our Take

We are encouraged by the improved performance of CVS’ Pharmacy Services segment, mainly on account of significant new client wins in a strong 2012 selling season. However, earlier in July, the long-standing contractual dispute between Walgreen and Express Scripts came to an end with both the companies announcing a multi-year retail pharmacy network agreement.

Although CVS is still optimistic about retaining at least 60% of the business gained from the dispute through the fourth quarter 2012, we prefer to remain on the sidelines until visibility improves in this regard.

However, the mega-merger between Express Scripts and Medco Health Solutions in April this year further intensified the competitive landscape in the PBM industry and put CVS in a tight spot. Moreover, concerns linger given the margin pressure felt by the company.

CVS currently retains a short-term Zacks #2 Rank (Buy). Over the long term (3-6 months), we have a Neutral recommendation on the stock.

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