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CVS $25 Billion Benefit Looms as SunAmerica Agitates for Breakup: Real M&A

CVS Caremark Corp. (CVS), created in a takeover four years ago that has left investors with underperforming stock, could be worth $25 billion more if the company split itself up.

Shareholders SunAmerica Asset Management Corp. and Cambiar Investors LLC say Chief Executive Officer Larry Merlo, 55, may have to separate CVS Caremark’s drugstore and pharmacy-benefits units if the largest U.S. provider of prescription drugs doesn’t lift profit growth. Merlo last month replaced Thomas Ryan, 58, who orchestrated the purchase of Caremark RX Inc. in March 2007. Since then, the stock gained just 3.4 percent through yesterday, trailing a 14 percent advance for companies in the Standard & Poor’s 500 Index that sell consumer staples.

While the $27 billion acquisition, the largest ever by a drugstore, enriched banks from Evercore Partners Inc. (EVR) to JPMorgan Chase & Co., CVS Caremark is still valued at a discount to both Walgreen Co. (WAG) and Express Scripts Inc. (ESRX), according to data compiled by Bloomberg that includes net debt. Using its rivals’ valuations would give CVS Caremark’s two units a combined market capitalization of $73 billion in a break up, an increase of 51 percent from its equity value yesterday, the data show.

“They’re under the gun and need to turn this around,” said Maria Mendelsberg, a money manager at Denver-based Cambiar Investors, which oversees $8 billion and owns about 3.8 million shares of CVS Caremark. “They’re at a crossroads. People are just losing their patience. If they were separate, the combination would be worth more than where the stock is today.”

‘Uniquely Positioned’

The firm’s $1.6 billion Cambiar Opportunity Fund (CAMOX) in the past year has beaten 99 percent of funds that invest in the biggest U.S. companies which are undervalued relative to earnings or cash flow.

“There are no plans to split up the company,” Carolyn Castel, a spokeswoman at Woonsocket, Rhode Island-based CVS Caremark, said in an e-mail. “We are uniquely positioned to continue to develop and implement programs that meet our goals and enhance shareholder value.”

CVS Caremark rose as much as 4.1 percent on the New York Stock Exchange today, the biggest intraday gain since Sept. 24, 2010. The shares closed at $36.23, a 2.1 percent advance.

The current entity was created when CVS Corp. acquired Caremark after beating out St. Louis-based Express Scripts. Caremark investors received 1.67 CVS shares plus $7.50 in cash for each share owned, according to data compiled by Bloomberg.

The acquisition combined the CVS drugstore chain with Caremark’s pharmacy-benefit management business, which negotiates prices for prescription medicines with pharmacies and drugmakers on behalf of health insurers and their customers.

Medco, Express Scripts

Evercore and bankrupt Lehman Brothers Holdings Inc. of New York were financial advisors to CVS, while JPMorgan of New York and Zurich-based UBS AG (UBSN) provided advice to Caremark.

Since the takeover closed on March 22, 2007, CVS returned 7.2 percent including dividends through yesterday, versus a 29 percent gain from S&P 500 consumer staples stocks. While Deerfield, Illinois-based Walgreen, the largest U.S. drugstore chain, has lost money for investors in the same span, Medco Health Solutions Inc. (MHS) of Franklin Lakes, New Jersey, and Express Scripts, Caremark’s two biggest competitors, returned 58 percent and 168 percent.

John Massey, a money manager in Jersey City, New Jersey, for SunAmerica, which oversees $13 billion, says CVS Caremark would be worth more as two standalone companies.

CVS Caremark’s equity and net debt are currently valued at 7.5 times its earnings before interest, taxes, depreciation and amortization in 2010, data compiled by Bloomberg show.

‘Any Dispute’

The CVS drugstore business, which had $5.55 billion in Ebitda last year, would have an enterprise value, or the sum of its equity and net debt, of $44.2 billion based on Walgreen’s 7.95 times multiple, data compiled by Bloomberg show. Caremark, which generated $2.78 billion in Ebitda, would be worth $37.9 billion using Express Scripts’ 13.7 times valuation.

Excluding net debt, the two units as standalone companies would then have a combined market value of about $73 billion, more than $48.5 billion for CVS Caremark.

“We’re four years into this now, and it hasn’t had the success that CVS initially thought it would,” said SunAmerica’s Massey, whose firm owns about 1.2 million shares of CVS Caremark. “I don’t think there is any dispute that investors would believe that this company should be broken up.”

‘Realize More Value’

CVS Caremark lost contracts with large health-care insurers and had difficulty pricing bids for Medicare Part D, according to Jeff Jonas, a Rye, New York-based analyst at Gabelli & Co, which owned about 1 million CVS Caremark shares as of Dec. 31, according to data compiled by Bloomberg.

“The main reason to do it is to realize more value in the stock market,” he said.

CVS Caremark bids every year on the right to provide drugs to Americans covered by Medicare Part D, a federal program that subsidizes medicine for retirees. In 2009, it lost about 35 percent of its enrollees for 2010 after asking for higher prices than its competitors in some regions.

The company chopped its proposed prices for 2011 for some of the services to try to recapture business.

CVS said in March 2007 the combination would generate about $3.5 billion in free cash flow, or cash from operations after deducting capital expenses, in 2009. The company fell about $2 billion short of its target, the data show.

In February, CVS Caremark dropped the most in eight months after saying that full-year profit excluding some items will be $2.72 to $2.82 a share. Analysts surveyed by Bloomberg projected an average of $2.89 a share.

Operating Profit

While Caremark’s sales will increase as much as 26 percent this year, its operating profit will drop as much as 9 percent as margins shrink, according to the company’s February forecast.

CVS Caremark may still have the opportunity to impress investors as it spends about $500 million to help upgrade Caremark’s technology and $1.25 billion to purchase Universal American Corp.’s Medicare Part D business.

It may also benefit next year from the arrival of new generic drugs, which are more profitable for pharmacies than branded products, according to Cynthia Axelrod, an analyst at Glenmede Trust Co., which manages about $18 billion.

Drugs facing the loss of patent protection include the world’s two best sellers, New York-based Pfizer Inc. (PFE)’s cholesterol pill Lipitor and the blood-thinner Plavix from Bristol-Myers Squibb Co. of New York and Paris-based Sanofi- Aventis SA.

‘Host of Generics’

“There’s a whole host of generics that are coming up and a number of branded drugs that are losing protection within the next 12 months,” said Philadelphia-based Axelrod. “CVS would obviously be a beneficiary of that.”

Shareholders still haven’t been rewarded by management’s plan to boost earnings, which may make breaking up the company a more attractive alternative, said David Abella, a money manager at Rochdale Investment Management LLC in New York, which oversees about $4 billion.

“It just seems like the market never was on board with the combination and you can see the underperformance,” he said. “The company will argue they’re getting some business synergies out of it and cost reduction and that the future is brighter. But I’m sure the market would just prefer the two to be split.”

Overall, there have been 6,545 deals announced globally this year, totaling $653.3 billion, a 27 percent increase from the $515.5 billion in the same period in 2010, according to data compiled by Bloomberg.

To contact the reporters on this story: Tara Lachapelle in New York at tlachapelle@bloomberg.net; Cecile Vannucci in New York at cvannucci1@bloomberg.net.

To contact the editors responsible for this story: Daniel Hauck at dhauck1@bloomberg.net; Katherine Snyder at ksnyder@bloomberg.net; Robin Ajello at rajello@bloomberg.net.

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