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Why Obamacare Won't Stand in the Way of CVS Caremark in 2014

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CVS Caremark (NYSE: CVS  ) recently announced its partnership with Cardinal Health (NYSE: CAH  ) in a deal that saw the creation of the largest generic sourcing entity in the U.S. This was just one of the numerous mergers and partnerships taking place between large companies in the space. Express Scripts (NASDAQ: ESRX  ) and Medco Health merged in 2012. Walgreen (NASDAQ: WBA  ) also shuffled the decks after it announced it was planning to move its employees into a private health exchange.

These larger-than-life mergers and partnerships, coupled with the new industry developments such as Obamacare, have drastically altered the traditional PBM landscape. It's only fair to expect CVS investors to wonder where the company stands in the midst of all these changes, and what to expect both in the near-term and long-term.

CVS Caremark: Continuing to thrive in 2014 and beyond

CVS operates as an integrated pharmacy services provider, acting both as a drugstore chain and a pharmacy benefit manager, or PBM. The company gained this enviable status after the merger between CVS Corporation and Caremark RX in 2007. CVS's biggest rival in the space, Express Scripts  merged with Medco Health, another PBM, in 2012 to form the largest PBM in the country with 37% share of the market.

Both Express Scripts and CVS are expected to account for a whopping 60% of PBM revenue in 2013, according to a recent CVS report. Meanwhile, the drug distribution landscape is undergoing a major evolution, with new developments such as the planned implementation of the Affordable Care Act, aka Obamacare, in 2014, the entry onto the scene of private health exchanges, numerous patent expiries of major branded drugs in the next three years, and the increasing adoption of generic drugs in preference to branded drugs.

CVS specialty drugs offering to drive new growth
CVS released a report in October 2013 wherein it pointed out how the market for specialty drugs is expected to grow in leaps and bounds in the coming years, quadrupling by 2020 to cross the $400 billion mark. Specialty drugs are used to treat complex diseases including multiple sclerosis, hepatitis C, various types of cancers, rheumatoid arthritis, and many more.

Although only about 4% of patients are currently on specialty medication, the drugs account for a good 25% of total health care costs. CVS Caremark is currently focusing very strongly on specialty drugs through its pharmacy service management business, which accounts for 60% of its revenue. The firm commands a respectable 15% of the specialty drug market.

CVS Caremark recorded a healthy 22% growth in its specialty drugs segment compared to the same period in 2012. The specialty drug business has been benefiting from tailwinds coming from various quarters, including drug price inflation, new product launches, utilization, and new PBM clients.

The market for specialty drugs is driven by the same trends that drive traditional markets. The segment is, however, more complex and costly to manage. Employers are typically concerned about managing their specialty spending through pharmacy and medical benefit programs. The cost of these drugs, as well as the methods employed in their administration, can vary greatly depending on where patients receive the infusions. CVS offers programs that help payers to increase the utilization of cost-effective health care sites that patients visit for infused therapies. This makes the PBM attractive for cost-conscious employees.

Probably the biggest reason why Express Scripts merged with Medco Health in 2012 was the need to bolster its position in the specialty drug market. Before the merger, Express Scripts had a slightly larger market share than CVS at 17%. Medco Health had more than double Express Scripts' market share at 35%. After the merger, Express Scripts now controls 52% of this important market.

High retention of Walgreen customers
Investors still avidly remember the 2011 showdown between Walgreen  and Express Scripts. During the standoff, Walgreen customers gradually shifted to rival pharmacies. CVS gained an estimated 6.5 million-7 million new prescriptions from former Walgreen clients in 2012. Although Walgreen claims that a good chunk of these customers have been moving back, CVS expects to retain at least 60% of them. This will help the company to sustain the market share gains it has already made.

Strong growth in PBM business
CVS's PBM revenue improved 7.8% to $19.5 billion in the third quarter, aided by better-than-expected claims volume through the Maintenance Choice Program, and a robust specialty drugs business. CVS boasts a unique position as the only retail drug store chain that is also a PBM, an attribute which helps the company to offer benefits of scale to its clients.

CVS has a 30% share in the managed Medicaid market. The firm will continue to benefit from the expansion of the Medicaid program, which is expected to grow by a roaring 40% annual clip through 2016.

Lower generic substitution
The total generic dispensing rate grew to 78.5% in 2012 from 74.1% in 2011, and 71.5% in 2010. The general trend is that generic drugs have gradually been making up a higher proportion of patients' prescriptions.

Although generic drugs are lower priced than their branded counterparts, they enjoy approximately 50% higher gross margins. The lower prices, however, impact negatively on PBMs' revenues.

The good news for CVS investors is that the negative impact of generic drugs on the company's revenue has been slowing down. The negative impact was 6.7% in the second quarter of 2013, but it fell to 3.2% in the third quarter.

Branded drugs worth about $15 billion are expected to come off patent in the next three years, which will open these drugs to generic competition. This will likely water down CVS's top-line growth a bit, but at a slower pace going forward.

Bottom line
The expected negative effects of Obamacare and private exchanges eroding market share from PBMs are probably overblown at this point. Express Scripts predicts that private exchanges will make up less than 0.25% of prescriptions in 2013, and just 2% by 2016. CVS forecasts that private exchanges will represent less than 1% of covered lives in 2014.

These two behemoths of the space have continued to make strategic mergers and acquisitions that have helped them gain the necessary heft to make their presences felt, as Walgreen knows only too well. Although the drug distribution landscape is rapidly shifting, these two PBMs will continue to be dominant players and great investments for many years to come.

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