Financial Analysis of a CVS Caremark Break-Up

I have a real treat for you today.

Regular readers know that I expect CVS Caremark (NYSE:CVS) to split up. Well, Deborah Weinswig, George Hill, and their colleagues at Citi Investment Research & Analysis have gone far beyond my idle speculations and crunched the numbers behind five different ways it could happen. Their conclusion?

“We believe a spin-off is the most likely way CVS would divest its Caremark business, as it provides tax benefits and allows the two companies to continue to partner on certain initiatives.”

While I can’t provide the full report to the Drug Channels readership, they have given me permission to share a few key nuggets from their fascinating and creative analysis below, including their expectations of the potential stock price impact of a transaction.

Hint: It’s worth more apart than together.

Citi analyzes two basic options for CVS: 1) a spin-off of the Caremark business, or 2) an asset sale to another PBM or a private equity firm. See the figure below for the five scenario alternatives, all of which are analyzed in the report.

The Citi analysts identify four reasons why a spin-off would be the best way to unlock the value of the pharmacy services segment’s value.

• Tax-Free Transaction—Apparently, a spin-off transaction could be considered tax-free after five years. The CVS/Caremark deal closed in March 2007, so a transaction would make teh most sense after March 2012. Interesting.
  
  
• Continued Partnership with Caremark to Maintain Purchasing Synergies—I have long pointed to generic drug purchasing as the one clear example of synergies. Citi believes that a joint purchasing agreement could maintain those savings even if the companies split.
  
  
• Ability to Continue to Execute Maintenance Choice—The Maintenance Choice program has proven to be the other winner from the CVS/Caremark transaction, although CVS retail stores have benefited more than the Caremark PBM business. (See Still Searching for Synergy.) I’m more skeptical that separate organizations could continue the program because the PBM and retail business would always be battling to dispense the incremental prescription per The Odd Economics of Maintenance Choice. But perhaps the mail-pricing-at-retail movement (a la Walgreen) would make collaboration feasible.
  
  
• Allows Management to Focus on Core Business—I completely agree.

In a spin-off, CVS Caremark would create a new legal entity and then distribute a pro-rata amount of shares in the “New Caremark” to existing shareholders. So, what would the two separate entities be worth compared to the current combination?

The figures below show the potential upside at various valuation (stock price) levels. Citi projects a 27% increase in total shareholder value and possibly as much as a 45% premium! Put another way, 1 plus 1 equals about 1.6 today, but could be worth 2.0 after March 2012.

Kudos to Citi for a superb piece of analysis. And a special thank you for letting me share the highlights on Drug Channels.

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