Caremark/CVS and the Threat of Wal-Mart

Tuesday, November 7, 2006 | 0

By Peter Cohan

Sunday's merger between drugstore chain CVS Corp. (NYSE: CVS) and Pharmacy Benefit Manager (PBM) Caremark Rx, Inc. (NYSE: CMX) could raise your medical expenses and slam your stock portfolio. By eliminating competitors, the merger could result in higher drug prices for consumers and the stock market's reaction to the deal knocked 7.4% off of CVS and 2% from CMX.

This merger happened to coincide with a case I taught yesterday about Merck & Co.'s (NYSE: MRK) 1993 merger with PBM, Medco Health Solutions Inc. (NYSE: MHS). Thirteen years ago, Merck spent $6.6 billion to buy Medco with the idea of creating a new coordinated pharmaceutical care approach to health care, using data about patient medical outcomes to improve drug development. But the concept never happened and in 2003, after a botched IPO, Merck spun off Medco to shareholders.

The reasons for the failure of Merck-Medco provide useful insights into the challenges facing CVS and Caremark. Merck-Medco tried to combine two companies with different capabilities and cultures, but the two companies were never integrated and the intent of the merger was not achieved. CVS and Caremark could do a bit better on the integration front -- they forecast $400 million in cost savings -- but the combination is like having two competing business models under the same roof.

As this industry background reveals, PBMs represent a direct threat to pharmacies like CVS. And yet recently CVS has gotten into the PBM business itself and buying Caremark represents a huge bet on the future of the PBM industry.

A merger like this should be evaluated on the basis of three tests:

Industry attractiveness

The PBM industry is growing faster and has higher margins than the pharmacy business does. According to IMS Health, $36.9 billion of prescription drugs were bought through PBMs in 2005, a 7% increase from 2004. Pharmacies, which had $88.2 billion in sales, saw sales increase 5%. Moreover, PBMs have an average 5-year return on equity of 20% compared to 14% for drug stores like CVS. Mail-order prescriptions have been profitable for PBMs because they can dispense prescriptions at lower cost via automated mail facilities. But the threat of Wal-Mart offering $4 for a 30-day prescription of certain generic drugs at stores in the Tampa, Fla., area expanding to 27 states -- represents a threat to all industry participants.

Competitive position

The merger will create a company controlling the dispensing of one billion prescriptions a year -- 25% of the U.S. total -- with $75 billion in annual revenues. It would be bigger than any other PBM or pharmacy chain and could negotiate lower drug prices due to its higher purchasing volume.

Price

The aforementioned stock price declines in the wake of the merger suggest that the $400 million in combined cost savings are not worth the $21 billion price of the deal. Caremark also faces multiple government investigations -- including one pertaining to stock option backdating -- and has already paid a fine for a PBM it acquired. Moreover, a cut in branded-drug list prices, prompted by industry litigation could pressure revenues and profits.

Based on this analysis, I'd be wary of owning any of the PBM stocks for a while. The absence of a premium paid for CMX suggests that investors believe Wal-Mart Stores Inc. (NYSE:WMT) is going to be a significant threat to the industry's profitability. Whether mergers such as the CVS/CMX deal will offset Wal-Mart's power and the looming price cuts remains an open question.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, and a Professor of Management at Babson College. He has no financial interest in Bristol Myers Squibb, Caremark, CVS, Medco, Merck or Wal-Mart.

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