CVS Caremark (CVS) has taken a step forward with respect to its proposed acquisition of Universal American’s (UAM) Medicare Part D business with the clearance from the Federal Trade Commission. The transaction is expected to close by the second quarter of 2011.

At the end of December 2010, CVS had announced its decision to acquire the Medicare Part D business of Universal American for $1.25 billion, which caters to about 1.9 million Prescription Drug Plan (PDP) members.

This is significant since the company’s pharmacy benefit management (PBM) business has been posting disappointing results for the past few quarters. However, CVS is confident of achieving operating profit growth in 2012.

One of the primary reasons for this assumption is the huge potential of generic drugs. The amount of branded drugs expected to come off-patent in 2012 is more than double that of the past five years. Moreover, benefits from the company’s streamlining initiatives are expected to outweigh related costs in 2012.

During the third quarter, the company had launched its PBM streamlining initiative, which would result in cost savings of $1 billion in the next 4 to 5 years. The contract with Aetna should further boost this segment. CVS has received a 12-year contract from Aetna to provide PBM services to Aetna customers.

The company also expects continued growth in Specialty Pharmacy and Medicare Part D Businesses, especially after its decision to acquire the Medicare Part D business. On completion of the deal, the number of covered lives is expected to more than double in one of the fastest growing segments in the PBM space.

Recommendation

CVS has been recording a drop in revenues since the second quarter of 2010, primarily due to the disappointing performance by the PBM segment, which is impacted by the loss of contracts in 2009.

Although the streamlining initiatives are expected to exert pressure on 2011 margins, we are confident about the company’s longer-term potential, based on its retail execution, deployment potential and the strong 2012 generics cycle. Furthermore, the decision to acquire Universal American’s Part D business should generate further growth in the PBM segment.

We maintain our Neutral recommendation on the stock.

 
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