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Bruce Frey's Analyst Insights

InvestorsObserver
Options Analyst Writer
Bruce E. Frey II
Author Bio


November 5, 2012 - CVS Caremark Has the Prescription for Higher Profits

The problems with healthcare are much bigger than a single election. Regardless of who wins in the election tomorrow, the U.S. healthcare system will still be in need of repair. Like the problem with railroad monopolies over a century ago, the issues facing our modern health system will be solved not by political manipulation or far-reaching legislation, but by circumstances as yet unseen. The birth of the U.S. automobile industry ripped the power from the railroad barons? hands and solved the monopoly issues almost overnight. In the process, it transformed our cities, our country and our way of life far beyond the imagination of those who tried to force change with legislation and political posturing.

We are, however, living in the present and the fact that over a hundred years from now the health care system will likely not be an issue is of little comfort. Health spending is rising at more than three times the rate of inflation. At the same time quality and safety are said to languish far behind other industrialized countries. Despite the questionable methodology used to make this determination, improvements can be made to advance the quality and quantity of care. Our current system has its flaws as well as positive points, and, regardless of who is in the White House, investors will continue to place strategic bets on all aspects of the system.

Pharmaceuticals currently present the best opportunity for investors interested in capitalizing on the rise in health costs. These costs are not likely to come down in the near future. For several years, spending on prescription drugs and new medical technologies has been cited as a primary contributor to the increase in overall health spending; however, in recent years, the rate of spending on prescription drugs has decelerated. Nonetheless, some analysts think the availability of more expensive, state-of-the-art medical technologies and drugs fuels health care spending for development costs and because they generate demand for more intense, costly services even if they are not necessarily cost effective.

The biggest issue for the investor is determining which company will hit the market with the next best-selling prescription or treatment. But, pharmaceutical companies are only as good as their next big drug. The 10th largest global pharmaceutical company, according to drug data firm IMS Health, Teva Pharmaceutical Industries? (TEVA) stock price was performing well until the company reported weak Copaxone sales and softness in European sales, sending the stock into a severe downtrend.

One way to invest in big pharma without the risk of picking the right company at the wrong time is to look at companies which generate profits from all the pharmaceutical companies without itself being a strictly healthcare company. CVS Caremark (CVS) fits this bill nicely. CVS Caremark benefited from the prolonged contract dispute between Walgreens (WAG) and Express Scripts (ESRX). The first half of the year saw CVS gaining market share in its pharmacy segment as a result of the dispute.

Both Walgreens and CVS Caremark have made a push to become more than just a pharmacy, but health and daily living destinations. Although both companies have made a push to expand their health care services, CVS has consistently been a step ahead on the innovation front. CVS started in-store health clinics, a rewards program, and consumer-friendly store layouts. CVS was also the first pharmacy to integrate in-store health clinics and they are winning the race in expanding health care services.

The contract renewal between Walgreen and Express Scripts should have a minimal impact on CVS Caremark's pharmacy segments? top and bottom line, as most clients will remain in CVS's network. If you have ever tried to transfer your prescriptions from one pharmacy to another you understand why the majority of customers who came over from Walgreens will not make the move back.

The optimistic outlook in the retail segment is, however, countered by a rough outlook for their pharmacy benefit manager (PBM) segment. Margins will continue to decrease in the PBM segment stemming from industry consolidation and pricing pressures. The company will benefit from the consolidation in the PBM industry and the introduction of several generic drugs replacing brand-name drugs over the next 5 years.

No matter which big or little pharmaceutical company makes a major advance or fails to produce expected results, the pharmacy will still be there. CVS Caremark has positioned themselves to benefit from any advances in pharmaceuticals as well as a more health conscious consumer.

CVS Caremark will be stepping into the earnings confessional this week but you don't need to wait for their announcement to generate some cash from the stock. A hedged trade to consider on CVS is the January 43/40 bull-put credit spread. This trade combines selling the January 43 puts while buying the same number of January 40 puts for a net credit of 25 cents or better. The stock would have to fall more than 7.3% to cause a problem. As long as CVS is above 43 when the January options expire the trade realizes its full profit for a 9.1% return (44.2% annualized, for comparison purposes only).

Be certain you fully understand the risk and reward profile of any trade before you put your hard-earned cash to work. If you have comments, concerns, praises or criticisms, please e-mail me at bfrey@InvestorsObserver.com.

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