Another set of earnings and another solid performance from drug store and pharmacy services company CVS Caremark (NYSE:CVS). The company raised its earnings guidance, and suggested its participation in public and private health care insurance exchanges would make it a net beneficiary of the Affordable Care Act, or ACA. There is a lot to like about CVS and its rival Walgreen (NASDAQ:WBA), and despite strong share price appreciation this year, they both look like good values.
CVS gets healthier
After delivering better-than-expected performance in 2013, CVS raised its full year EPS forecast to $3.94-$3.97 versus a previous estimate of $3.90-$3.96. In addition, it kept its free cash flow forecast at $4.8 billion-$5.1 billion, and pledged to return $5 billion in dividends and share buybacks to its investors.
How the Affordable Care Act is good news for CVS
While this year's performance seems assured, Foolish investors will want to look forward to see how CVS might fare in the new health care environment. Essentially, public and private health insurance exchanges are marketplaces set up in accordance with the ACA. They are being created to offer personalized health care plans in a standardized and regulated way. CVS is the second biggest pharmacy benefits manager, or PBM, after Express Scripts (NASDAQ:ESRX). One possible concern with both companies is that they may lose some business as a consequence of employers moving their employees to the new exchanges.
In its earnings presentation, however, CVS outlined why it sees itself as benefiting from the ACA.
- In the public health exchanges, it will participate as a PBM via its health plan clients, where the client offers pharmacy benefits as part of an integrated plan.
- It will act as a PBM via its health plan clients within private health exchanges as well.
- It will act as a stand-alone PBM where it can offer direct prescription offerings in other situations.
- CVS is already the leading player in managed Medicaid, so any expansion of that program should allow it gain business.
In other words, CVS is positioning itself to benefit from health care reform.
In any case, it may not turn out to be as big of a shift as many think. For example, CVS and Express Scripts are both forecasting that employers will be reluctant to shift employees to the private exchanges.The thrust of the argument, as outlined by Express Scripts CEO George Paz, is that employers will not want to make the shift because they won't want to pay the cost of risk coverage.
Employers have to pay 60% of the total cost of medical services in order to avoid a tax penalty. This means that the employer's risk goes up because it could losing control of what plans its employees are buying. If the cost of the plan goes up over time, possibly because the employee didn't buy a suitable plan, then the employer will still have to meet 60% of the rising cost.
Express Scripts predicts that "private exchanges represent less than 0.25% of prescriptions in 2013 and are projected to reach approximately 2% by 2016." CVS management forecasts:
Well, the fact is that less than 1% of covered lives are expected to move to private exchange products in 2014. And based on conversations we have had with our PBM clients and private exchange partners, we believe that most large employers are taking a wait and see approach to private exchanges, particularly with their active employees.
In other words, CVS and Express Scripts are positioning themselves to benefit should there be wide-scale shifts from employees. Even if this shift doesn't take place, they can benefit from lower income groups getting insurance.
Walgreen and CVS set to benefit
Unlike CVS, Walgreen doesn't have a PBM operation anymore. There is another catalyst to growth from the ACA, however. The reforms are likely to lead to more people being insured, and this should drive prescription demand for the drugstores.
Walgreen is aggressively transforming its business in preparation for these reforms. A big part of Walgreen's plans is to offer services whereby they administer ongoing treatments for indications like diabetes or rheumatoid arthritis, and CVS is doing the same with its MinuteClinics. Again, if more people are covered for these kinds of treatments (recall that the exchanges require standardized coverage) then CVS and Walgreen will benefit.
The bottom line
All these stocks look attractive from a valuation perspective. CVS may seem expensive in the following chart, but consider that this is a trailing chart and CVS is expecting to generate 37% of its free cash flow for the year in its fourth quarter.
Moreover, all of these companies have double-digit earnings forecasts for 2014. With Obamacare looking set to provide them with opportunities, they all look like good values.