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  • 1. JANUARY 2008 PRESENTATION TO KELLOGG INVESTMENT MANAGEMENT CLUB
  • 2. CVS Caremark Buy Recommendation Trading Statistics 19 Summary Income Statement '07 - '09 Price Target Share Price $35.49 20 2007E 2008E 2009E % CAGR Sum-of-the-Parts $ 42.96 52 Week High 42.60 72 Revenue $75,861 $86,049 $93,297 10.9% DCF 50.09 52 Week Low 30.45 77 % growth 13% 8% % of 52 Week High 83.3% 139 Gross Profit 13,697 12,841 16,124 8.5% Blended $ 46.53 Share Count 1,477 % margin 18% 15% 17% Upside 31% Market Value $52,415 153 EBITDA 5,886 7,333 8,173 17.8% Net Debt (Cash) 8,406 160 % margin 8% 9% 9% Enterprise Value $60,821 EPS $1.92 $2.32 $2.70 18.7% P/E Ratio 18.5x 15.3x 13.1x 1
  • 3. CVS Caremark Company Overview CVS Caremark operates as an integrated retail pharmacy and pharmaceutical benefit manager (PBM). The company offers a unique spectrum of services under a novel business model that will allow it to gain market share in an increasingly consumer-oriented Rx marketplace s CVS Caremark business is currently comprised of the following segments s Retail pharmacy segment (CVS) - Operates roughly 6,200 retail locations, in 43 states; generates revenues primarily through Rx dispensing fees and front-end store sales - Slower grower, with analysts predicting growth of high single, to low double digits s Pharmacy services segment (Caremark) - Largest pharmaceutical benefit manager in the U.S., managing roughly 20% of total Rx claims in the U.S. - CVS acquired the Caremark for approximately $27 billion on March 22, 2007, at roughly 14x trailing EBITDA - Faster grower given market dynamics, double digit growth s Breakdown of revenue and profitability as follows (for 2008E) Revenue by Segment ($86bn total revenues) EBIT by Segment (estimated, $5.9bn total) Retail PBM Services Retail PBM Pharmacy 41% Pharmacy Services 37% 31% 45% Front-End Front-End Store Store 18% 28% 2
  • 4. Industry Backdrop – PBM Business Model PBMs operate “behind the scenes”, but serve as the lynch pin connecting payors (insurance companies), patients, pharmacies and Rx manufacturers/wholesalers in the complex pharmaceutical distribution process s PBMs operate electronic data interchange (EDI) systems that link in with retail pharmacy computer systems and manage Rx claims process s Patients health insurance information is entered into system, and EDI informs pharmacist about benefits and patient copayments/coinsurance requirements s Electronic bill created and reimbursement process then managed by PBM s PBM works with patient’s insurance carrier for payment, and cedes resulting payment to retail pharmacy (since retail pharmacy initially bought the drug from a manufacturer/wholesaler and is still owed money) s Essentially, PBMs serve insurance carriers, managed care organizations, and other payors that have outsourced management of their pharmacy benefit to the PBM s In addition to simply managing the claims process, PBMs are tasked with reducing pharmacy costs for their clients - PBMs develop lists of preferred drugs (formularies) for payor plan members, with various teiring structures that encourage utilization of cheaper pharmaceuticals - PBM will include certain pharmaceuticals on the formulary in exchange for discounts and rebates from manufacturers, with most of these rebates (60-70%) being passed on to the insurance carriers - In addition, PBMs provide disease management services for high-cost/high-touch patients. PBMs act as the first line of defense in managing these difficult patients (call-centers, home-visits, etc.) and save insurance companies money by limiting the number of doctor office/hospital visits of these patients 3
  • 5. Industry Backdrop – How PBMs Make Money s PBMs are typically paid a claims management fee (by insurance payors) on every prescription that is filled s Low margin, as fee equates to roughly $0.10 per script s PBMs also generate profits by capturing “spread” income on pharmaceuticals s PBMs receive a contracted reimbursement rate for prescriptions filled at the pharmacy, and then enter into separate reimbursement contracts with retail pharmacies s Ability for PBM to capture pricing spread in this structure - Ability for PBM to capture pricing spread in this structure - Size matters, as larger PBMs can typically capture more spread s Largest pricing spread achieved on generic prescription fills - Insurance carriers are happy to cede greater margin and spreads to PBMs in exchange for much lower generic drug cost (generics are typically 3-4x cheaper than branded drug equivalents) - PBMs thus benefit when pharmacies dispense generics instead of branded drugs s PBMs have expanded into non-traditional service channels in order to further reduce costs for their clients s Specialty/mail-order pharmacies - PBMs directly fill and mail prescriptions for chronic indications. This process reduces costs by eliminating the retail pharmacy and wholesaler markups (PBMs purchase direct from manufacturers) - Again, spread pricing model and strong manufacturer rebates (due to high cost nature of “specialty” products) yield higher profitability for PBMs in this segment s Disease management - As mentioned on previous slide, PBMs manage higher cost patients for insurance companies, and typically receive a flat fee per patient managed 4
  • 6. CVS Caremark Investment Thesis s Market is undervaluing CVS, as shares look attractive on both a sum-of-the-parts and DCF basis s Overall PBM market poised for continued growth s Caremark, as the industry leader, is positioned perfectly to capitalize on macro industry trends s Pairing Caremark with the retail pharmacy CVS provides a compelling value-added service; market does not fully appreciate this revolutionary business model s Ability of combined entity to better drive generic utilization (higher margin business) s Significant cost savings associated with increased scale and buyer power. CVS Caremark has more leverage to negotiate with pharmaceutical manufacturers s Specialty pharmacy, disease management and selective front-end discounts will drive patient satisfaction and increase foot traffic s Overall, revenue and cost synergies will allow Caremark to compete more aggressively for PBM business and realize contract wins - Greater cost savings can be passed on to insurance payors and thus switching costs can be overcome. Market currently underestimating the potential for PBM contract wins s CVS’ core business is one of the most defensibly positioned retail/consumer plays in the market; risk of slowdown in consumer spending should not significantly impact the company s Perceived merger integration risk overdone; CVS and Caremark have each independently integrated large acquisitions and the combined company has already raised synergy guidance twice since the close of the transaction 5
  • 7. Industry Backdrop – PBM Industry Appears Attractive s PBMs have benefited from the rapid growth in prescription spending, and this growth is expected to continue s Growth of 6-10% per year through 2010, and overall market growth from $260bn in 2006 to $500bn in 2016 s Opportunity for PBMs to continue to profit from increased generic utilization s Currently, only 60% of scripts (industry wide) are filled with a generic and analysts believe that this generic fill rate will continue to increase going forward s Over the next 5 years, branded drugs with over $50bn of sales will lose patent protection, which provides further upside opportunity for PBMs with regards to generic fills s In addition, adoption of HSAs and consumer-directed health initiatives should drive generic utilization s Finally, PBMs like Caremark that have specialty pharmacy operations, are well positioned to benefit as specialty Rx spend grows by 20% per year Drug Market – 2005 ($210bn) Drug Market – 2009 ($316bn) Generics Generics $32 bn $54 bn 15% 17% Specialty Drugs $40 bn 19% Traditional Specialty Drugs Traditional $90 bn Drugs Drugs 28% $172 bn $139 bn 55% 66% 6
  • 8. CVS Caremark – Driving Increased Generic Utilization Historical separation of pharmacies and PBMs has limited maximum utilization of generics s Pharmacy/pharmacist have not been properly incentivized to switch patients to generics since earnings to the pharmacy are less impacted by generic utilization s CVS Caremark pharmacists will now proactively look to switch patients to generics, so that profits are enhanced in the company’s PBM segment. Pharmacists essentially will have a mandate to focus on switching patients to generics s Increased generic utilization over the near/mid-term will continue to expand margins at Caremark s In addition, proactive switching will benefit consumers, as lower co-pays will lead to out-of-pocket cost savings s In addition, Caremark dispenses a fewer percentage of generics relative to Express Scripts and thus should have room to expand generic utilization going forward 7
  • 9. CVS Caremark – Specialty Pharmacy Opportunity Combined company poised to drive greater patient satisfaction in treatment of chronic/specialty indications s Increasing pressure by insurance payors to fill prescriptions for chornic/specialty indications via mail-order pharmacies (cheaper overall costs) s Caremark has this mail-order capability, but can now also ship to CVS retail locations for customer pick-ups s Industry research suggests that patients prefer picking up scripts in a retail pharmacy (vs. mail-order). Ability to interact with pharmacist and “double check” that their treatment plan is O.K. s By offering so called “mail-in-retail” pick-up options, CVS will benefit from increased customer foot traffic - Of customers that pick up prescriptions, 38% will buy an OTC medication and 80% will make a general purchase s In addition, Caremark’s disease management capabilities will reduce CVS’ historical customer leakage problems s CVS on its own had a lot of specialty pharmacy customer leakage (>50% per year), as its pharmacists weren’t equipped to deal with demands of specialty pharmacy/chronic patients. Caremark should help reduce this leakage s Furthermore, ability for CVS to offer OTC/front-end discounts to retain these patients and drive foot-traffic 8
  • 10. CVS Core Business – Not That Bad CVS retail business is a very defensibly positioned business that should perform well even in a bearish economy s Roughly 82% of the company’s revenues overall are generated from its pharmacy operations, which is one of the least discretionary sectors in the economy s Of CVS’ remaining “front-end” sales, roughly half is attributable to true consumer discretionary items vs. OTC and other medications s CVS better positioned vs. competitors, as companies like WAG generate roughly 25% of their business via discretionary items s In addition, ability for CVS to expand margin for front-end products as it continue to launch CVS branded products - CVS branded products are lower revenue but higher margin products - 14% of products sold at CVS are of CVS brand vs. 17% at WAG (WAG brand) CVS 2008E Sales CVS Front-End Sales Breakdown Retail Rx $32 bn Front-End Discretionary OTC $16 bn $8 bn $8 bn PBM $38 bn 9
  • 11. Compelling Valuation Investors have sold off CVS Caremark, waiting for the company to “prove out” the new business model s CVS shares now trade at 15.5x FY+1 earnings, which is below the pre-Caremark historical average s This seems unwarranted, especially given that large PBMs trade at >20x forward earnings (and Caremark represents 40% of the total company’s profits) Enterprise Value / Price / 52-Week Equity Enterprise EBITDA Earnings per Share EBITDA Company Stock Price High Low Value Value 2007E 2008E 2009E 2007E 2008E 2009E Margin ('07) RETAIL PHARMACIES Walgreen 34.45 49.10 32.50 34,154 35,025 8.3 8.1 7.2 16.6 15.3 13.4 7.7% Longs Drugs 45.96 59.20 41.51 1,733 1,927 7.0 6.3 6.2 17.0 14.8 13.6 5.2% Shoppers Drug Mart CAD 50.00 58.11 47.26 10,840 11,906 12.4 10.9 9.5 22.1 19.3 16.8 11.5% Mean 9.2x 8.4x 7.6x 18.6x 16.5x 14.6x 8.1% Median 8.3 8.1 7.2 17.0 15.3 13.6 7.7% PBMs Express Scripts 63.66 79.10 34.18 16,042 17,927 15.3 13.3 11.9 27.4 22.2 18.7 6.4% MedcoHealth 47.47 54.63 28.38 25,396 26,786 13.5 11.5 10.3 26.9 22.0 18.9 4.5% Mean 14.4x 12.4x 11.1x 27.1x 22.1x 18.8x 5.4% Median 14.4 12.4 11.1 27.1 22.1 18.8 5.4% CVS/Caremark $35.49 $42.60 $30.45 $52,415 $60,821 10.3x 8.3x 7.4x 18.5x 15.3x 13.1x 7.8% 10
  • 12. Sum-of-the-Parts Analysis Conducting a sum-of-the-parts analysis on a conservative (e.g., below consensus) 2008E EBITDA indicates the presence of significant upside. This upside does not take into account multiple expansion potential that could be realized given the transformational CVS Caremark business approach Fiscal Year Ending December 31, 2007 2008 Notes Revenue Growth/Margin Drivers Sum-of-the-Parts Build-Up Total Sq. Ft. of Sales Floor (000s) 57,000 58,642 Amount Multiple Value Total Retail Locations 6,250 6,430 Pharmacy EBITDA $ 3,969 8.4x $ 33,423 New Stores 180 In-line with '07 growth PBM EBITDA $ 2,530 12.4x $ 31,421 2008 Cost Synergies $ 700 10.0x $ 7,014 Total Sq. Ft. Growth 2.9% % Expansion Growth Pull Through 75% Per Analyst reports Total Enterprise Value $ 71,858 Less Debt (9,160) Growth Att. To New Stores Development 2.2% Plus Cash 755 Equity Value $ 63,452 Retail Pharmacy Same Store Growth 5.0% Below Industry Rx growth target of '06-'09 Share Count 1476.9 Retail Front-End Same Store Growth 1.8% In-line with December reported growth Price Per Share $ 42.96 Current Price $35.49 Total Retail Pharmacy Growth 7.2% Upside/(Downside) 21.1% Total Front-End Growth 3.9% EBIT Margin [pre-Caremark Synergies] - Retail 6.5% 30bp increase from Savon integration synergies EBIT Margin [pre-Caremark Synergies] - PBM 5.5% 20bp decrease to be conservative D&A Forecast 1,290 Memo Pharmacy EBITDA Buildup Total EBITDA $ 7,199 Total Pharmacy Sales $ 44,455 $ 47,167 Consensus EBITDA 7,333 % growth 6.1% % Difference -1.8% Pharmacy EBITDA (core, no synergies) 3,969 % margin 8.4% PBM EBITDA Buildup PBM Sales $ 38,545 $ 38,962 Loss of some government contracts included % growth 1.1% PBM EBITDA (core, no synergies) 2,530 % margin 6.5% 11
  • 13. DCF Analysis DCF analysis with conservative projections indicates meaningful upside Projected Year Ended 12/31 Normalized 2008E 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Residual Yr. Retail Pharmacy - Rx Sales Revenue $ 32,111 $ 34,519 $ 37,022 $ 39,613 $ 42,287 $ 45,036 $ 47,850 $ 50,721 $ 53,638 $ 56,588 $ 59,559 $ 62,537 $ 64,413 % Growth 7.5% 7.3% 7.0% 6.8% 6.5% 6.3% 6.0% 5.8% 5.5% 5.3% 5.0% 3.0% EBIT $ 1,846 $ 2,036 $ 2,240 $ 2,456 $ 2,622 $ 2,792 $ 2,966 $ 3,144 $ 3,325 $ 3,508 $ 3,692 $ 3,877 $ 3,993 Margin 5.7% 5.9% 6.0% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% Retail Pharmacy - Front-End Sales Revenue $ 15,056 $ 15,508 $ 16,128 $ 16,934 $ 17,781 $ 18,670 $ 19,604 $ 20,584 $ 21,613 $ 22,694 $ 23,828 $ 25,020 $ 25,770 % Growth 3.0% 4.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 3.0% EBIT $ 1,640 $ 1,712 $ 1,805 $ 1,920 $ 2,043 $ 2,173 $ 2,311 $ 2,458 $ 2,613 $ 2,778 $ 2,952 $ 3,138 $ 3,232 Margin 10.9% 11.0% 11.2% 11.3% 11.5% 11.6% 11.8% 11.9% 12.1% 12.2% 12.4% 12.5% 12.5% PBM Sales Revenue $ 38,962 $ 42,858 $ 47,037 $ 51,506 $ 56,270 $ 61,334 $ 66,701 $ 72,370 $ 78,341 $ 84,608 $ 91,165 $ 98,003 $ 100,943 % Growth 10.0% 9.8% 9.5% 9.3% 9.0% 8.8% 8.5% 8.3% 8.0% 7.8% 7.5% 3.0% EBIT $ 2,423 $ 2,772 $ 3,160 $ 3,460 $ 3,712 $ 3,971 $ 4,236 $ 4,508 $ 4,784 $ 5,063 $ 5,343 $ 5,624 $ 5,793 Margin 6.2% 6.5% 6.7% 6.7% 6.6% 6.5% 6.4% 6.2% 6.1% 6.0% 5.9% 5.7% 5.7% Total Sales $ 86,129 $ 92,885 $ 100,187 $ 108,053 $ 116,338 $ 125,040 $ 134,155 $ 143,676 $ 153,592 $ 163,890 $ 174,553 $ 185,559 $ 191,126 Growth 7.8% 7.9% 7.9% 7.7% 7.5% 7.3% 7.1% 6.9% 6.7% 6.5% 6.3% 3.0% Total EBIT $ 5,909 $ 6,521 $ 7,205 $ 7,837 $ 8,376 $ 8,936 $ 9,514 $ 10,110 $ 10,722 $ 11,349 $ 11,988 $ 12,639 $ 13,018 Margin 6.9% 7.0% 7.2% 7.3% 7.2% 7.1% 7.1% 7.0% 7.0% 6.9% 6.9% 6.8% 6.8% Taxes (Benefit) @ 40.0% $ 2,364 $ 2,608 $ 2,882 $ 3,135 $ 3,351 $ 3,574 $ 3,806 $ 4,044 $ 4,289 $ 4,539 $ 4,795 $ 5,055 $ 5,207 Net Operating Profit after Taxes $ 3,545 $ 3,913 $ 4,323 $ 4,702 $ 5,026 $ 5,361 $ 5,708 $ 6,066 $ 6,433 $ 6,809 $ 7,193 $ 7,583 $ 7,811 Cash Flow Net Operating Profit after Taxes $ 3,545 $ 3,913 $ 4,323 $ 4,702 $ 5,026 $ 5,361 $ 5,708 $ 6,066 $ 6,433 $ 6,809 $ 7,193 $ 7,583 $ 7,811 Plus: D&A $ 1,290 $ 1,396 $ 1,498 $ 1,607 $ 1,705 $ 2,224 $ 2,363 $ 2,505 $ 2,649 $ 2,795 $ 2,942 $ 3,089 $ 2,597 Less: Capex (1,851) (1,995) (2,151) (2,313) (2,479) (2,300) (2,300) (2,505) (2,649) (2,795) (2,942) (3,089) (2,597) Less: Dec/(Inc)Inc in Working Capital (88) (473) (511) (551) (580) (609) (638) (666) (694) (721) (746) (770) (390) Available Cash Flow $ 2,897 $ 2,840 $ 3,159 $ 3,445 $ 3,672 $ 4,677 $ 5,134 $ 5,399 $ 5,739 $ 6,088 $ 6,446 $ 6,813 $ 7,421 Present Value Factor @ 8.5% WACC 0.92 0.85 0.78 0.72 0.67 0.61 0.56 0.52 0.48 0.44 0.41 0.38 Present Value of Available Cash Flow $ 2,670 $ 2,412 $ 2,473 $ 2,486 $ 2,442 $ 2,867 $ 2,900 $ 2,811 $ 2,754 $ 2,693 $ 2,628 $ 2,560 Company Valuation Residual Calculation Sum of PV of Available CF During Projection Period ('08 - '19) $ 31,695 Residual Cash Flow $ 7,421 Plus: PV of Residual Value 50,692 Divided By: Cap Rate (r-g) 5.5% Fair Market Value of Business Enterprise (Marketable, Controlling Basis) 82,387 Residual Value $ 134,926 Less: Interest Bearing Debt (9,160) Mult. By: PV Factor 0.38 Plus: Cash and Cash Equivalents 755 PV of Residual Value $ 50,692 Implied Equity Value 73,982 Number of Outstanding Shares (in millions) 1477 Implied Price per Share $50.09 12
  • 14. Potential Risks s Potential re-set of drug spread pricing reimbursement benchmarks could affect PBM margins s PBM contracts with insurance payors typically have renegotiation clauses built in to safe guard against this. Drug reimbursement resets would impact all PBMs equally, and thus the entire industry would use its clout to maintain margin s Integration risk in combining two industry giants s Both companies have experience in integrating large transactions (CVS acquired Savon/OSCO in 2006 and Caremark acquired AdvancePCS in 2005) s Management has already increased guidance on cost synergies twice, and introduced prospect of revenue synergies. Integration appears to be on track s Threat of Walmart’s $4 generics program and plans to launch its own captive PBM s Most CVS generic copays range from $5-$10, so not materially different from WMT. More CVS locations also cuts down travel costs for most customers s WMT’s PBM announcement drove down shares of CVS. However, this is a much longer term risk, as it takes time to build this business. Customers are sticky (>90% retention rate for CVS), so stealing business will be difficult s WMT also has few of the necessary “service” components in place that are critical to winning non-government contracts s Sustained downturn in economy would hurt CVS, but less so than many other retail operators 13