CVS Sees Big PBM Disappointment

For Gilmartin's thoughts leading up to the call, click here.

CVS Caremark (CVS - commentary - Trade Now) reported third-quarter financial results this morning, with revenue of $24.642 billion slightly beating expectations of $24.6 billion, and the adjusted earnings per share (after adjusting for an 11-cent tax benefit) or actual operating EPS of 65 cents was better than the 64-cent estimate. Total revenue grew 18% year over year, while EPS grew just 8%. Operating income of $1 billion grew 25% from the year-ago period.

By segment, pharmacy benefit management (PBM) revenue grew 23% to $13 billion, while claims processed improved 9% year over year, about in line with estimates. The retail drug store segment increased 18% to $13.6 billion. Same-store sales grew 5.7% year over year, while pharma comps rose 8% and front-end comps looked to be a little weak at 0.8%.

At first blush, CVS' report looked to be in line and pretty much on target with what was expected coming into the results, but on the conference call, management said the PBM lost about $4 billion in business contracts and that the PBM operating profit margin will decline in 2010. (According to our internal spreadsheet, CVS' PBM profit margin is roughly 6%, or $800 million, on roughly $13 billion of PBM revenues this quarter. Management said that the PBM profit could decline 10% to 12% in 2010. Some quick math suggests that the PBM's operating profit is about $2.5 billion a year, and thus a 10% haircut would be $250 million. There are roughly 1.4 billion shares outstanding, meaning that 2010 EPS estimates could get shaved to the tune of 15 to 20 cents a share -- and that is without any impact to the retail side of the business.)

As I detailed in the preview, the PBM is half of CVS's total revenue but operating profit has swung between 35% and the low 50% range over the last three years. The PBM operating margin, given its history, is already volatile.

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At the time of publication, Gilmartin was long CVS and WAG, although positions may change at any time.

Brian Gilmartin, CFA, founded Trinity Asset Management (TAM) in 1995, where he is currently a portfolio manager. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gilmartin appreciates your feedback; click here to send him an email.