Thursday, June 07, 2007

CVS/Caremark (NYSE:CVS): Color on FEP mail-order loss

Several tier-1 firms are commenting on CVS/Caremark (NYSE:CVS) after the co announced it has been awarded the three-year (2008-2010) renewal to service the retail pharmacy benefits and clinical needs of the 4.7-million covered lives Blue Cross Blue Shield Federal Employee Program (FEP) contract. However, the FEP mail-order contract will transition from Caremark to Medco Health Solutions:

- Raymond James recalls the FEP contract was Caremark's largest customer pre-merger (16% of standalone revenue or ~$5.8 billion annually; now ~6.5% of post-merger revenue). CVS/Caremark will retain the large retail benefits and clinical business, some $4 billion in annual revenue but, they believe, low profitability (RJ estimates 6% gross margin). Firm estimates the lost mail-order business generated ~$1.8 billion in revenue and slightly higher profitability (RJ estimate = 10%).

RJ had previously estimated that the loss of the mail-order contract would amount to a $0.07 hit to their 2008 EPS forecast of $2.23 (~3% pressure), assuming that 10% of the gross profit hit is offset by G&A rationalization. Typically, though, they believe that such contract losses are gradual, implying that their $0.07 forecast is likely conservative.

CVS shares have sold off recently on the concerns over the FEP contract renewal and same-store sales deceleration in May (though expectedly driven by tougher comps from Medicare Part D). While the stock may sell off further as investors fret about the rest of PBM selling season, the firm would view any sell-off as an attractive buying opportunity. Reits Strong Buy and $45 tgt.

- Goldman Sachs believes that any weakness will be modest and short-lived. There are four reasons for this. 1) The loss of FEP mail does not change GS 2008 EPS estimate of $2.30. 2) Valuation is compelling. At $37, the P/E multiple on 2008 EPS is only 16x versus 19x for MHS and ESRX. 3) The company can tap its $5bn share repurchase authorization to support shares. Finally, the firm believes some investors may have been waiting for this event to initiate or add to positions.

GSCO would be even more aggressive buyers of the shares on any weakness today.

- Morgan Stanley believes that while bears may portray the loss of the mail contract to be a repudiation of the CVS/CMX combination, they view the business to be merely returning to the lowest cost operator (where it had been for many years prior to 2005) amid a process that was underway well before the merger was completed. In fact, the firm believes the news should alleviate a key near term concern for potential new buyers attracted (as we are) by the stock's hefty discount to its peers despite equally robust growth prospects.

Notablecalls: Looks like CVS is a strong bounce candidate here. I just hope there will be a gap-down on open.

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