Drugstores or Benefit Managers: Who’s Holding the Cards?

by James Brumley | November 7, 2012 6:30 am

Last year, Walgreen (NYSE:WAG[1]) and Express Scripts (NASDAQ:ESRX[2]) made headlines as the two were unable to come to an agreement after their prior contract expired. CVS Caremark (NYSE:CVS[3]) enjoyed the dispute, though, picking up their defecting customers.

In fact, CVS reported that former Express Scripts/Walgreen customers translated into earnings 4% better than what they would have been without the two companies quarreling.

But that dynamic is just a small piece of the puzzle here. The bigger questions surrounding CVS’ win at Walgreen’s expense is whether the pharmacy benefit management (PBM) business model or the pharmacy itself is the investment-worthy part of drug-dispensing business.

Let’s take a look.

Then and Now

Prior to 2008, the pharmaceutical industry was the Wild West — where pharma companies charged what they wanted and insurance companies paid it, no questions asked. In those days, the need for pharmacy benefit management organizations like Express Scripts was clear. A good PBM could whittle down an insurer’s prescription costs by as much as 30%.

But what if $90-billion worth of those drugs start to fall off a patent cliff? And what happens if the Federal government basically mandates how insurance will work going forward? For that matter, what about when insurance companies and pharmacies finally figure out they can act as their own PBMs? Oh, and what happens when a huge chunk of the workforce is no longer covered by a benefits plan?

I think you get the point. All of a sudden, pharmacy benefit management outfits would lose much of their relevance. And … well … that’s basically what’s happening now.

Express Scripts’ 13% plunge Tuesday could be a testament to this fact. To give credit where it’s due, though, the company didn’t do nearly as badly last quarter as the stock’s movement would indicate. The acquisition of Medco Health earlier in the year helped grow the top and bottom line, and some synergies have been realized.

Had it not been for the pickup of Medco though, growth may not have been seen. The stock’s selloff is the result of concerns about the future; there’s no end to the headwinds in sight.

CVS Caremark, on the other hand, organically topped Q3 earnings estimates of 83 cents with operating earnings of 85 cents. Revenue was up 13%, reaching a record $30.2 billion. Of that per-share earnings figure, just under 4-cents worth stemmed from customers that left Walgreen during its dispute with Express Scripts.

Big mistake — CVS expects to keep 60% of that new business Walgreen lost to its competitor.

Do It Yourself

At the same time, it’s easy to forget that CVS Caremark isn’t just a chain of drugstores; Caremark is its own PBM as well.

Walgreen used to own a pharmacy benefit management called Walgreen Health Initiatives, but sold it to Catamaran (NASDAQ:CTRX[4]) in 2011. In retrospect though, one has to wonder if Walgreen would have been better served by staying in and expanding that business rather than being forced into disadvantageous negotiations (with few alternatives) with PBM Express Scripts earlier this year.

Now, though, Walgreen is getting back into the PBM business with its partial purchase of United Kingdom-based pharmacy benefit management company Alliance Boots. The buzz is that Alliance Boots and Walgreen are positioning to enter the domestic PBM market.

What It Means

Even if Alliance Boots isn’t coming to America, the fact that Walgreen wants to get back in the business — especially in the shadow of frustration with Express Scripts — doesn’t exactly scream it’s a bad business to be in. Plus, the fact that CVS Caremark is making such a union work only bolsters the argument.

Still, that’s not necessarily a good sign for a company that’s exclusively a PBM — like Express Scripts. Given the whole picture, CVS’ and Express Scripts’ third-quarter earnings are apt to be a glimpse of the future: As pressure for more profits is applied, middle-men like pharmacy benefit management organizations get squeezed out simply because drug stores become their own middle-men. And Obamacare is only going to fuel that pressure.

While this reality slightly raises the possibility of acquisitions in the PBM space, it mostly inspires drugstore chains to make alternative arrangements in search of wider margins … which they will do.

In the end, drugstores indeed seem to be holding the better hand.

As of this writing, James Brumley did not own a position in any of the aforementioned securities.

Source URL: https://investorplace.com/2012/11/drugstores-or-benefit-managers-whos-holding-the-cards/

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