CVS Caremark Should Acquire Walgreen

By Matthew Coffina

Walgreen (WAG) needs a new strategic direction. Its services are becoming increasingly commodified, as its convenience advantage is eroded by cheap prescriptions offered through the mail and many other retailers. On its current trajectory, we think the company is likely to be on the losing end of a major change in payer/provider dynamics. If the merger of Express scripts (ESRX) and Medco (MHS) receives regulatory approval, both Walgreen and CVS Caremark (CVS) should look for a countermove. A combination of the two companies could be the ideal solution.

A fundamental shift is occurring in the relationship between health-care payers and providers in the United States, thanks to a combination of health-care reform, the prolonged economic slump, and an increasing awareness of the unsustainability of health-care spending growth. We see two paths.

On the one hand, traditionally adversarial relationships between payers and providers are becoming ever more contentious, leading to public reimbursement disputes and providers exiting or being kicked out of provider networks. The most prominent example is the contract termination between Express scripts and Walgreen, but smaller-scale disputes have boiled to the surface between managed-care organizations and hospitals. With narrower networks, payers gain bargaining leverage and can direct patients away from the highest-cost providers.

On the other hand, we also see increasing cooperation between some payers and providers. Rather than trying to control costs through more aggressive negotiations--a tactic that generally has failed for the past 50 years--some payers and providers are partnering with each other to keep patients healthier and to encourage cost-effective health-care consumption decisions. Examples include the CVS-Caremark merger, recent acquisitions of provider groups by managed-care organizations, and the emerging accountable care organization model.

It's an open question as to which approach has the better chance of actually slowing health-care spending growth. Employers, governments, and individuals seem increasingly willing to accept restricted access to providers in exchange for lower costs. Combined with consolidation among payers, this should boost payer bargaining power, perhaps allowing them to squeeze providers on reimbursements. But providers are also consolidating, improving their own bargaining position. Over the long run, vertically integrated providers, including CVS Caremark and ACOs, threaten to disintermediate third-party payers. In a best-case scenario (for consumers), this could greatly reduce administrative costs across the health-care system and result in improved health-care outcomes.

Either way, CVS Caremark and Walgreen would be better off together than apart. If the relationship between payers and providers remains adversarial, the combined company would have much greater bargaining power against third-party pharmacy benefit managers. If enhanced cooperation between payers and providers turns out to be the best way to control costs, CVS Caremark-Walgreen could provide a highly differentiated offering to both PBM and retail clients.

We see both firms as motivated to do a deal. While CVS Caremark stands to gain modestly from the Walgreen-Express scripts dispute in the short run, the same long-term threats facing Walgreen are also concerning for CVS. The Express scripts-Medco merger is particularly dangerous, as that would result in a PBM around 50% larger than Caremark. With its greater bargaining leverage and stronger competitive position, Express scripts-Medco could steal market share on the PBM side and pressure margins on the retail side.

Despite Its Potential, CVS Caremark Has Much to Prove
We think CVS Caremark holds tremendous potential. It is unique among PBMs in its ability to seamlessly integrate mail-order and retail prescription dispensing. Caremark is also the only PBM that can offer face-to-face interactions between patients and pharmacists, which may improve patient engagement and therapy adherence. In the future, the company will probably combine primary care and disease management with pharmacy services through MinuteClinic, offering a superior platform for helping clients keep members healthy and out of the hospital.

However, CVS Caremark still has much to prove, in our view. PBM margins are set to fall again in 2012, marking the fourth consecutive year of declining profitability. Since 2008 (the first full year following the merger of CVS and Caremark) the Caremark PBM has massively underperformed its independent peers in both EBITDA per adjusted prescription and overall operating profit dollars.

We continue to believe that if clients really saw value in the integrated retail PBM model, CVS Caremark would be able to charge a premium for its services, rather than having to sacrifice margin to maintain and win market share. However, management is making the case that only now, with a few years of experience, is it beginning to gather the quantitative evidence to back up its claims about improved health-care cost-containment. It projects PBM operating profit dollars to increase 11%-15% in 2012, which is a major improvement on the declines of the past two years but is still only about in line with peers.

Acquiring Walgreen would allow CVS Caremark to take its integrated model to the next level. Currently, around 28% of CVS' retail prescription drug sales come from Caremark PBM members, while around 19% of PBM claims are fulfilled by CVS retail stores. These percentages have steadily increased, but CVS is still far from having the capacity to fill a majority of its PBM members' prescriptions. Adding Walgreen's stores would greatly reduce CVS Caremark's reliance on the third-party pharmacy network and increase engagement with the majority of members who aren't CVS retail customers.

CVS Caremark-Walgreen Would Be Better Positioned to Defend Retail Margins
While CVS Caremark fills more prescriptions than any other company, Walgreen is larger when considering just the retail stores. Walgreen has more locations (7,800 drugstores compared with 7,300 for CVS) and larger stores and generates slightly higher sales per square foot.

But despite $72 billion of sales in fiscal 2011 compared with around $59 billion for CVS' retail segment, Walgreen is the less profitable retailer. Walgreen's operating margin fell from 5.9% in 2007 to 5.1% in 2009, before improving to 5.4% in the most recent year. While the weak economy and reimbursement pressure have contributed to this result, CVS was affected by the same headwinds, yet managed to steadily improve its retail margin during this period.

We attribute CVS' superior retail profitability to better execution. For example, the company's earlier shift to a customer-centric store format may have contributed to lower administrative costs, while its ExtraCare rewards program may be enabling more effective promotions. The presence of the PBM may also be resulting in stronger margins through enhanced bargaining power with suppliers and lower customer acquisition costs. It is also possible that CVS Caremark's intrasegment accounting decisions have boosted the appearance of the retail segment at the expense of the PBM.

Retail pharmacies face an ongoing margin headwind from increasing competition and reimbursement pressure. While CVS Caremark and Walgreen are already better positioned than most, the combination of the two companies would create a retail powerhouse that in 2011 would have dispensed around 37% of all prescriptions by revenue. While PBM clients may be willing to exclude one large pharmacy chain from their networks, excluding both CVS and Walgreen would be a tough sell. This would shift bargaining power in CVS Caremark-Walgreen's favor, allowing the combined retailer to extract preferential reimbursements from payers. Combined with CVS' already superior margins, we see the potential for significant synergies from a deal. Just bringing Walgreen's margins closer to CVS' level could generate well over $1 billion in additional operating income. While we currently rate Walgreen as having a narrow economic moat, a merger with CVS would widen that moat.