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CVS Caremark Remains at Neutral

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Recently, we reiterated our Neutral recommendation on CVS Caremark Corporation (CVS) with a target price of $38.00.

CVS reported an adjusted EPS of 65 cents in the second quarter of 2011, surpassing the Zacks Consensus Estimate by a penny but meeting the year-ago quarter’s adjusted EPS.

After a period of sluggish performance, CVS’ Pharmacy Benefit Management (PBM) segment grew for the second consecutive quarter. During the quarter, this segment recorded a robust 23.2% year-over-year increase in revenues to reach $14.6 billion. The year-over upside was primarily driven by a 12-year contract with Aetna (AET), under which CVS provides PBM services to Aetna customers as well as the new acquisition of the Medicare Part D business of Universal American Corp (UAM).

The company is also confident of achieving further growth in 2012 based on the huge potential of generic drugs. The amount of branded drugs expected to go off-patent in 2012 will more than double than that recorded in the past five years. Moreover, benefits from the company’s streamlining initiatives are expected to outweigh related costs in 2012.

We are also confident about further progress in the PBM segment based on CVS’s new business wins and strong client retention. By the end of the second quarter, the company completed more than 50% of 2012 renewals, including the Federal Employee Program (FEP) Retail contract, AT&T and General Electric totaling approximately $4 million. Alongside, the company maintained its retention level at 98%. In May 2011, CVS won a three-year contract to provide integrated pharmacy benefit services for the Blue Cross and Blue Shield Government-wide Service Benefit Plan or FEP.  Moreover, CVS also won new contracts from US public pension fund California Public Employees’ Retirement System (CalPERS).

The company is also planning to further emphasize on its key-growth areas such as Universal American's Medicare Part D Businesses, Aetna and rapidly growing Specialty Pharmacy sector.

CVS also expects to maintain its strong performance in the Retail segment going forward. The company expects the segment to deliver higher sales (3%−4%) and operating profit (7.5%−9%) for 2011 with a .5%−2.5% rise in same-store sales. In the reported quarter, the company’s same-store sales grew 2.6% resulting in a 3.6% climb in retail revenues.

However, despite implementing diverse strategies to expand its business, CVS continues to face margin pressure. Gross margin during the reported quarter decreased 180 basis point (bps) year over year to 19.1%. The decline in gross margin was primarily attributable to price compression associated with contract renewals, addition of the Aetna business, as well as continued pressure on pharmacy reimbursement rates. Moreover, operating margin contracted 60 bps to 5.6%.

In addition, the proposed merger of Express Script (ESRX) and Medco (MHS) is expected to further challenge CVS’ Pharmacy Services segment. The deal would combine two of the three largest US drug benefit managers and create an industry leader that holds over one-third of the market.  We expect the combined entity to be better placed to compete with CVS. However, we remain confident about the long-term potential of CVS.

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