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Following the third quarter earnings release, we reaffirm our long-term ‘Neutral’ recommendation on CVS Caremark (CVS - Analyst Report), the largest provider of prescription and related health care services in the U.S.

The company surpassed bottom-line Zack Consensus Estimate for the ninth successive time in the third quarter. Adjusted EPS increased 21.4% year over year to 85 cents, beating the Zacks Consensus Estimate by a penny. Net revenues increased 13.3% to $30.2 billion, on the back of solid growth across both operating platforms.

Although the company continues to witness retail sales growth, helped by market share gain, we are concerned about the Walgreen (WAG - Analyst Report)-Express Scripts (ESRX - Analyst Report) resolution in July which may create distress for CVS Caremark. While we derive comfort from the fact that CVS Caremark’s pharmacy benefit management franchise continues to gain foothold, we are wary that the merger of Express Scripts and Medco has put CVS Caremark in a tight spot.

Several drugs (recording annual U.S. sales of about $100 billion) are losing their patent rights through 2016, allowing for vast market proliferation and incremental sales. Riding the generic wave, CVS Caremark is perfectly on track to continue positive growth performance through 2012 and beyond. Demographic trends in the domestic market should drive utilization rates for years to come.

Despite being confident of achieving margin pressure expansion in 2012, CVS Caremark continues to face margin pressure. While gross margin contracted 73 basis points in the third quarter, operating margin was flat on a year-over-year basis.

Based on an encouraging 2012 selling season, the expectation to retain at least 60% clients and an expected benefit from accelerated share buybacks, CVS Caremark raised its 2012 earnings per share guidance during the most recent earnings release. The company now expects adjusted earnings per share of $3.38−$3.41 (earlier guidance being $3.32−$3.38).

The current Zacks Consensus Estimate of $3.37 remains below the company’s guidance range.  Concerns remain that the company may find it challenging to retain 60% of the prescriptions gained from the Walgreen and Express Scripts impasse, given the current trends. Moreover, efforts to retain clients might hurt margins, which are already under pressure.  

While CVS Caremark still appears to be a safe bet, we remain on the sidelines owing to macro as well as company-specific headwinds. The stock currently carries a short-term Zacks #3 Rank (Hold).

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