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Good Medicine at Caremark Rx

By Phillip Seligman Amid widespread concern over rising health-care costs, we at Standard & Poor's Equity Research think the prospects are bright for the pharmacy benefit management (PBM) industry -- especially for our favorite name in the group, Caremark Rx (CMX). We like Caremark also because its stock trades at a discount to the S&P 500-stock index, despite having significantly faster and, in our view, more sustainable earnings growth than the index. Caremark carries Standard & Poor's highest investment recommendation of 5 STARS, or buy.

We think several factors will drive Caremark's growth, some of which relate to its industry and others that are company-specific. Runaway growth in spending on prescription drugs, partly caused by drug price inflation, rising utilization, and the introduction of new, high-price specialty compounds, creates a continuing need, in our view, for the cost-management tools PBMs provide.

Looking ahead, we think the recent passage of the Medicare drug proposal will intensify that need. The legislation has the potential to add a large and expanding senior population into a possible future Medicare-sponsored drug-cost-saving program -- and as that group continues to age, drug usage should increase accordingly. Still, we believe Caremark, like its PBM peers, would be unwilling to participate in the program if doing so requires it to absorb the risk for covering seniors in places where Medicare managed care is nonexistent.

PROVEN SAVERS. The regulatory environment for the PBM industry also appears to have become more favorable, particularly as the federal government has recognized its usefulness in helping control health-care costs. In January, 2003, the General Accounting Office issued a report confirming that the PBMs it reviewed produced savings for health plans participating in the Federal Health Benefits Program. Moreover, in an April, 2003, report outlining guidance for pharmaceutical manufacturers' marketing practices, the Health & Human Services Dept.'s Office of Inspector General (OIG) recognized the value of PBMs in controlling drug costs.

Caremark has a number of competitive advantages, in our view. One is having four large, automated mail-service facilities. In addition, it operates a network of 19 smaller mail-service pharmacies located around the U.S. that are used to deliver specialized medications to individuals with chronic or genetic diseases and disorders. Caremark also has a number of established, advanced, technology-based systems and services. However, if it's ahead of its industry peers in some respects, we think that it won't be too long before these competitive advantages are erased by its rivals' tech investments.

And the competition in the PBM industry continues to intensify. Caremark believes that at least 60 PBMs are operating in the U.S. The industry consists not only of independent outfits but also of PBMs that are divisions of large health plans or managed-care organizations -- or that operate as joint ventures between them. Moreover, some PBMs owned by big health-benefits providers service businesses other than their corporate parent's, making them direct competitors to the independents. Some large retail pharmacy chains also offer PBM services.

SAVVY DEAL. Still, Caremark has been able to hold its own. About 60% to 65% of the net new business it sees for 2004 is expected to come at the expense of its largest independent competitors and approximately 20% from smaller PBMs -- not that much different from the book-of-business mix gained in 2003. Moreover, management sees its customer retention rate for 2004 at 97% to 98%, which, in our view, speaks well of Caremark.

And its position should be further solidified by its pending acquisition of AdvancePCS, which has roughly double Caremark's revenues, yet lower earnings before interest, taxes, depreciation, and amortization (EBITDA) in a transaction valued at $5.6 billion (90% stock, 10% in cash). We expect eventual Federal Trade Commission approval of the deal, since the combined company will cover only an estimated 25% of the PBM market in terms of lives -- an industry term for the number of end users.

Caremark expects $125 million in annual cost savings from the merger, 75% of which will be derived from purchasing efficiencies and the remainder from eliminating administrative redundancies, achieved within the first 12 months after closing. It also sees earnings accretive to Caremark earnings per share in the near term.

LITTLE OVERLAP. The acquisition would combine companies that we think will complement one another. In terms of customer mix, AdvancePCS built a large base of managed-care customers, while Caremark focused on the employer marketplace. Significant cross-selling opportunities exist, as neither company's key specialty and disease-management programs overlap.

In addition, Caremark sees significant upside potential to AdvancePCS's mail-order service penetration rate, which stands at only 9% vs. Caremark's 45%, the PBM industry's highest. Moreover, we see this transaction creating enhanced growth opportunities stemming from significantly improved cash flow.

Although failure of the pending AdvancePCS acquisition would be a letdown to shareholders, if the merger doesn't go through, Caremark's stand-alone prospects remain bright, in our view.

WIDER MARGINS. On its own, we believe Caremark is capable of generating 2004 operating revenues of $11.1 billion, up 22.5% from the slightly more than $9 billion we expect for 2003. As of September 30, 2003, it had garnered approximately $700 million in net new business for 2004, an impressive amount on top of $1.3 billion in net new business in 2003.

At the time, Caremark was still getting requests for proposals, or bids from prospective customers, suggesting that additional net new business in 2004 was possible. In addition, revenues from existing accounts should experience growth from new branded drugs and higher prices for existing branded and generic drugs.

Caremark's EBITDA margins should continue to widen in 2004, aided by an improving revenue mix, with higher-margin generic-drug revenues and the mail-order and specialty pharmaceutical businesses growing as a percentage of total revenues, and by infrastructure investments. In comparing Caremark's EBITDA margin with those of its peers, because of the accounting differences between them, we believe the best way to view such a measurement is by EBITDA per adjusted script, with each mail-order prescription counted as three retail prescriptions. Caremark boasts the highest EBITDA per adjusted script among its peer group, a figure that we expect to continue to climb for years to come.

HEALTHY SPENDING. All told, our 2004 EPS estimate, based on generally accepted accounting principles, or GAAP, is $1.37, vs. $1.10 we see for 2003. Our earnings model excludes future acquisitions, including the pending deal to buy AdvancePCS.

In the first nine months of 2003, Caremark's cash flow from continuing operations increased 40%, to $432 million, from $308 million in the year-earlier period, as the addition of deferred income taxes, absent in 2002, compensated for the increase in the effective tax rate to 40% from 7.5%.

Capital spending in the first nine months was $39 million, while cash spent on discontinued operations was $60 million. On its October 28, 2003, third-quarter earnings conference call, management indicated that it expected capital outlays for full-year 2003 to be $60 million to $65 million. Because much of that was slated for the expansion of its Westin (Fla.) mail facility, we don't believe the figure will grow in 2004 for Caremark on a stand-alone basis. Meanwhile, management pegs spending for discontinued operations at $70 million to $80 million in 2003 and $20 million to $25 million in 2004.

FINANCIAL FLEXIBILITY. We believe Caremark has a strong cash position on its balance sheet. As of September 30, 2003, cash and short-term investments totaled about $692 million, while total debt was about $696 million, yielding a net debt position of less than $4 million. This is down by $387 million from yearend 2002 and by $167 million since June 30, 2003.

Caremark expects to report a positive net cash position at the end of 2003, the first time it has been in such a position. Moreover, the recognition of the deferred tax asset in 2002 helped shareholders' equity, which had been gradually improving, to leap into positive territory for the first time since 1997.

In our view, Caremark's healthy cash position and free cash flow provides it with wide financial flexibility. We believe that whether or not the acquisition of AdvancePCS occurs, it will pursue small acquisitions that would increase its expertise in the expanding, high-margin areas of specialty pharmaceuticals and disease management. Also, we estimate that as of September 30, 2003, Caremark had about $125 million left in its existing share-repurchase authorization.

P-E PREMIUM. We believe Caremark has exceptionally high earnings quality. Based on our proprietary Standard & Poor's Core Earnings methodology, we see 2003 EPS of $1.07, 2.8% below our GAAP estimate, and 2004 EPS of $1.34, a difference of 2.4%. The S&P Core EPS estimates assume stock-option expense, under accounting standard SFAS 123, of 3 cents per share and no defined pension plan in both years.

Utilizing S&P's proprietary

discounted cash-flow model, and making what we regard as conservative assumptions about the stock's beta and free cash-flow growth, we have calculated an intrinsic value of about $39 a share.

We note, though, that the intrinsic value is what we calculate the stock's current value should be in terms of the discounting of future cash flows and is not necessarily representative of our 12-month target price, which is $34, or around 25 times our 2004 EPS estimate of $1.37. This p-e multiple is at a premium to that forecasted for the S&P 500, but it matches our projected, long-term EPS growth rate. We believe it is merited, based on significantly faster earnings growth seen for Caremark than for the S&P 500.

Risks to our investment opinion include legislation or regulations affecting company operations, increased pricing pressure from states and managed-care providers, broad weakness in the pharmaceutical sector, and unfavorable conditions within U.S. equity markets. Analyst Seligman follows managed-care stocks for Standard & Poor's Equity Research

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