Parnassus Digest - October 2011
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Research Insight
Two important factors we consider when analyzing a retail investment are the company’s brand and customer experience. These two intangible factors represent the competitive moat around a retailer, fostering repeat customers and ensuring lasting intrinsic value. An economic moat is a long-term competitive advantage that allows a company to earn returns on capital well in excess of its cost of capital. Our recent investment in CVS Caremark, an integrated pharmacy health care provider, reflects this approach, specifically with regard to its retail segment. We think this investment has a defensive, asymmetric risk-reward profile and fits well with our investment philosophy.
Before I explain why we like this investment, consider these key facts about CVS Caremark:
With over $100 billion of annual revenues, the company is #21 on the Fortune 500 list; 3/4 of the U.S. population lives within three miles of one of its 7,200 locations; CVS’s leading retail loyalty program has over 65 million active members; and, the company fills or manages 20% of all U.S. prescriptions, the largest share in the industry.
Convenience and trust reinforces CVS’s retail brand and unique customer experience. Not surprisingly, the company’s non-pharmacy sales (30% of total retail sales) are primarily convenience driven. On the pharmacy side, convenience also plays a role, but so does trust. Customers value their relationships with CVS’s pharmacists and feel reassured that their prescriptions are filled and checked by qualified professionals. For these reasons, customer stickiness increases with each prescription filled.
The company’s Caremark segment (45% of total company sales) is a leading pharmacy benefits manager (PBM). PBMs reduce healthcare costs by negotiating lower drug costs, operating mail-order pharmacies and providing special services to health plan sponsors. The top three PBMs in the U.S. control over 50% of the market, and there’s a significant drop off in size for the smaller competitors. The moat in this business is driven by purchasing economies of scale; mail-order infrastructure; and the networked ecosystem of patient, provider and sponsor relationships that PBMs work with in providing their services. Evidence of this moat is the fact that Caremark’s retention rate is 98%.
By now, you probably understand CVS Caremark’s competitive moat, but what about its relevancy, management, and valuation – the other key pillars of Parnassus’s investment philosophy?
The company’s relevancy is increasing for four reasons: 1) an aging population, 2) the increasing prevalence of chronic conditions, 3) a focus on lower-cost health solutions and 4) the advent of ever-busier lives. CVS Caremark benefits from demographic shifts because older Americans consume as much as three times the medications as compared to younger Americans. Chronic diseases like cancer and diabetes that require continuous treatment and medication are also on the rise. Because of its leading share of U.S. prescriptions, CVS Caremark plays an important role in reducing healthcare costs by transitioning patients to lower-cost generic drugs, helping individuals adhere to their prescriptions and facilitating better communication between patients, physicians and pharmacists. Lastly, modern day Americans have less free time and are willing to pay for convenience.
As for management and valuation, in the case of CVS, these factors are interrelated. In 2007, CVS acquired Caremark, scaling its PBM operations significantly and fundamentally changing the overall company. While the deal had several benefits, many investors didn’t like it because it complicated CVS’s pure-play story and presented a potential conflict of interest as CVS and its drugstore competitors are large suppliers to Caremark. Making matters worse, CVS’s management team didn’t integrate the two companies very well, and soon after the deal, Caremark started experiencing significant customer losses. In response to these issues, the company promoted Larry Merlo to CEO, and recruited Per Lofberg to run the Caremark division. Larry had been with CVS for 13 years and was previously COO, while Per had an admirable 20 year track record in the PBM industry. Under this new leadership, Caremark has reversed its losses and won a series of large contracts. Meanwhile, the Board of Directors has announced increased dividends and share buybacks, so that shareholders now collect a greater portion of the company’s more than $4 billion of annual free cash flow.
The final piece of our CVS thesis is the defensive characteristics and asymmetric risk-reward profile of the company. In 2010, the drugstore portion of the business grew just under 4% during the toughest economy since the Great Depression and has grown every year for the last 10 years. Even in a down economy, customers still continue to take their medications and make convenience purchases. With almost $60 billion in revenues and producing consistent gross margins around 30%, the retail business is a strong free cash flow generator. In addition, the PBM business has historically been very consistent with the majority of customers engaging in long-term contracts or renewing every few years. We think that CVS Caremark’s PBM business is on the right track and will generate good earnings and free cash flow going forward.
Another interesting part of the investment thesis is that CVS Caremark may split apart if the combined entity does not garner an appropriate valuation. This serves as additional downside protection because the market may assign higher values to a pure-play drugstore chain (CVS) and independent PBM (Caremark) than it does to the combination. We think both segments are undervalued and have great prospects, and would be happy to own them on a combined or separate basis.
Percentage of Parnassus Funds represented by CVS Caremark Corp., as of September 30, 2011 is 0.38% of the Parnassus Fund, 2.68% of the Parnassus Equity Income Fund, and 1.57% of the Parnassus Fixed-Income Fund as a corporate bond.
The views expressed in this Parnassus Digest are subject to change at any time in response to changing circumstances in the markets and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or the Parnassus Funds. Any specific securities discussed may or may not be current or future holdings of the Funds.
Inside Parnassus
Romahlo I. Wilson joins the Parnassus Investments research team. Romahlo joined the team as a Senior Research Analyst after completing his internship in September 2011. His prior experience includes work at Cleantech Approach and Houlihan Lokey’s Mergers and Acquisitions Practice. When asked about his new position at Parnassus, Romahlo replied, “My role is to identify compelling investment opportunities for our portfolio managers, funds and, most importantly, our investors. I plan to contribute to the investment team in any way that I can. Each of us brings different perspective, expertise and experiences to the role. This is important in creating a whole that is greater than the sum of its parts. Individual idea generation can be sparked by some of the compelling themes we hash out as a group.” Director of Research Ben Allen added, “Rom relies on common sense to think differently than the crowd and explains his recommendations clearly and directly. We’re very excited that Rom chose to join our team.”
All returns greater than one year are annualized.
a The inception date for the Parnassus Fund is December 31, 1984. The inception date for the Parnassus Equity Income Fund and Parnassus Fixed-Income Fund is August 31, 1992. The inception date for the Parnassus Mid-Cap Fund, Parnassus Small-Cap Fund and Parnassus Workplace Fund is April 29, 2005. The inception date for the Institutional Shares of the Parnassus Equity Income Fund is April 28, 2006.
bAs described in the Fund’s current prospectus dated May 1, 2011, Parnassus Investments has contractually agreed to limit the total operating expenses (exclusive of acquired fund fees and expenses) to 0.99%, 0.99%, 0.77%, 1.20%, 1.20%, 1.20% and 0.75% of the net assets of the Parnassus Fund, the Parnassus Equity Income Fund–Investor Shares, the Parnassus Equity Income Fund–Institutional Shares, the Parnassus Mid-Cap Fund, the Parnassus Small-Cap Fund, the Parnassus Workplace Fund, and the Parnassus Fixed-Income Fund, respectively. These limitations may be continued indefinitely by the Adviser on a year-to-year basis. Without these fee waivers and/or expense reimbursements, the Funds’ returns would have been lower.
Performance shown for the Parnassus Equity Income Fund – Institutional Shares prior to the inception date of April 28, 2006 reflects the performance of the Parnassus Equity Income Fund-Investor Shares and includes expenses that are not applicable to and are higher than those of the Institutional Shares.
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