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The rumors of Caremark's death have been greatly exaggerated

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August 03, 2010 – Comments (4) | RELATED TICKERS: CVS , ESRX , AET

Back in April, I went long CVS Caremark (CVS) stating the following:

My investment strategy now involves finding cheap, dividend-paying stocks that have some sort of free embedded call option that could act as a catalyst for significant earnings improvement down the road.

While its dividend isn't as high as I normally like (around 1%), CVS is much cheaper than its main competitors. Looking at the stock at a simplistic level and comparing its P/E ratio to its main competitors we see that CVS currently trades at around 14.4 times its real trailing earnings (not some analyst's guess of how it will do in the future). That compares very favorably to its number one competitor in the pharmacy segment, Walgreen which trades at around 17 times trailing earnings (I'm ignoring the mess that is Rite Aid).

The great thing about CVS is that it's not just a pharmacy, it also engages in pharmacy benefit management (PBM) through its Caremark division. PMBs are hot, hot, hot. Take a look at companies like Express Scripts Inc. (ESRX), which trades at over 33 times trailing earnings, or Catalyst Health Solutions (CHSI), which trades at 30 times.

Granted, Caremark hasn't exactly been knocking the cover off the ball to use a baseball analogy (heck it is spring after all), but its business seems to have stabilized. Anyone who uses Caremark now has made a conscious decision to do so because their contract likely had to be renewed so we are unlikely to see any mass client defections in the near future. Besides Caremark has been left for dead by investors. It's super cheap compared to its competitors.

Now onto the good part, the caralysts. They include the following:

- The likely influx of new customers created by the expansion of healthcare that the government recently passed.

- Increased profitability as a result of the coming wave of generic drug introductions, which are more profitable for pharmacies and PBMs than branded medications.

- A demographic tailwind from aging customers who will need more medicine.

So there you have it. A cheap, dividend-paying stock, with specific event driven catalysts that could significantly improve the company's results, and in turn its stock price in the years ahead. The majority of my personal portfolio now consists of companies like this. If I find some time, I'll write up a short blurb on another one.

Thus far this investment has been unsuccessful.  The company's stock price has dropped by more than 15% since I gave it the thumbs-up in CAPS.  Having said that, all of the reasons that I originally purchased it for are still valid.  The pieces are still in place for this to be a winning long-term trade, so I'm not all that concerned about the fluctuation of the company's stock price over a few short months.

At the time I believed that when purchasing CVS investors were being given ownership of one of the country's largest pharmacies that stands to benefit from significant demographic, legislative, and industry tailwinds and that they were being given the company's Caremark Pharmacy Benefit Management Service which had been left for dead essentially for free.

I figured that CVS was attractive enough on its own to be a solid investment for the next several years and that the stock essentially had a free embedded call option in Caremark which it could unlock value in through a spin-off or by improved.

I'm not about to say that the division is firing on all cylinders, but to borrow a phrase from Mark Twain, the rumors of Caremark's death have been greatly exaggerated.  The turnaround at Caremark seems to have already begun.  Check out this fantastic article on Caremark by Dow Jones Newswires: CVS-Caremark Drug Benefit Turnaround Tied to Sharper Marketing

http://www.automatedtrader.net/real-time-dow-jones/9078/cvs-caremark-drug_benefit-turnaround-tied-to-sharper-marketing 

Last week Caremark announced that it had reached a twelve-year agreement to manage Aetna's (AET) in-house pharmacy benefits operation.  In addition to the Aetna contract, Caremark has poached two smaller contracts from rival ExpressScripts (ESRX) The company has now locked up $8.6 billion in net new business for 2011.  That's a dramatic turnaround from the $4.8 billion that it lost for 2010.

This investment may not be winning yet, but I have confidence that it will outperform the S&P 500 over the next several years. 

Deej 

4 Comments – Post Your Own

#1) On August 04, 2010 at 11:37 AM, facwinjeff42 (< 20) wrote:

Great angles, Deej. Those new contracts will be big for Caremark. Additionally, this is another stock that will benefit long-term from the inevitable economic turnaround and upswing.

My only worry would be the behemoth Walgreen's killing off CVS. But Aetna clearly has 12 years of faith, and I figure CVS couldn't have made it this far if it didn't have solid market footing.

I like the detailed way you followed up on your April piece. Good stuff.

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#2) On August 04, 2010 at 5:37 PM, TMFDeej (99.28) wrote:

Thanks facwinjeff42.

Deej 

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#3) On August 06, 2010 at 2:14 PM, ikkyu2 (99.26) wrote:

I've been watching this space since 2005, when I started owning Walgreen stock.  At the time WAG was a blue chip, AA+, solid stock that promptly lost 50% of its value.

Front end continues to decline; overhead gets more expensive; labor is more expensive and lower quality; shrink grows every quarter; and worst of all, in the core business of retailing drugs, titanic forces are conspiring to crush margins.

All these companies are competing for a slice of a shrinking pie, and they are facing competition from PBMs that they have never had to face in their previous decades of existence.  I think they're all ill-positioned to compete and I think the entire sector is going to underperform. 

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#4) On August 07, 2010 at 6:58 PM, facwinjeff42 (< 20) wrote:

Very interesting commentary, ikkyu2. I hadn't considered those points. Thank you.

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