$CVS on earnings conference call this morning highlighted that $CVS expects $4.5Billion in PBM contract losses. Big customer losses are Chrysler, State of NJ, and Coventry. Further, the company expects $1.7Billion loss from Medicare Part D.
There are significant implications here presenting themselves to long term investors.
Clearly $MHS (Medco Health) and $ESRX (Express Scripts) are taking share away from $CVS. The perception in the market place is that scripts costs more from a retail/mail PBM model. Theoretically retail/PBM model of $CVS should offer competitive advantage over pure mail PBM model of $ESRX and $MHS. Our ZYX Change Analysis validates the theoretical advantage. The ZYX Change Analysis also shows that to capture the theoretical advantage $CVS needs to differentiate itself in the market place in a manner that adds value. Clearly $CVS is failing to execute such a model of differentiation.
Our ZYX Method’s Quantitative Analysis Screen shows that at $27.00 per share, PBM business of $CVS is being priced at 50% discount. In the long run either the present management at $CVS will either start to execute to capture the theoretical advantage or it will be ousted and the new management will either execute better or simply separate PBM business from the retail business. In any case the value will be unlocked.
The investors with long term horizon may consider scaling in $CVS stock if the stock falls further. We will use ZYX Method’s Technical Analysis Screen and Fund Flows Screen to pinpoint exact entry points.
Those interested in hedging or pair trades may consider a short on $WAG (Walgreen). Today $WAG is going higher as the money coming out of $CVS is going into $WAG. $WAG will continue to post good numbers for the next two quarters because of H1N1 flu season. We see the flu season only as a short term advantage and expect $WAG to disappoint on the downside in the summer of 2010. Thus if $WAG goes higher it will be appropriate to consider a short for long term accounts.
The next question is what to do with $MHS and $ESRX stocks. $MHS and $ESRX are clearing capturing market share by being aggressive on price. There is the age old question, how do higher volumes at lower margins work out. At this time we do not have enough data to construct a model that we can be confident of. However, we can not run away from the simple twin realities. First the Wall Street is uniformly bullish on these stocks and believes there advantage will continue forever. Second if Obama’s health care IT vision comes true, and all medical records are electronic and everyone in the business is interconnected, the next step is for the technology to disintermediate the likes of $MHS and $ESRX. In a nut shell, we agree with the Wall Street in the intermediate term but see Wall Street’s bullishness as an opportunity to short these stocks in the very long term.