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CVS Caremark Should Acquire Walgreen

It would be a way to defend against the Express Scripts-Medco merger.

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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.

While Walgreen isn't often mentioned as an acquisition target, Rite Aid is. However, we think a merger between CVS Caremark and Walgreen would make more sense than either company acquiring Rite Aid. Rite Aid comes with $6 billion in debt. After years of underinvestment, its stores (and customer relationships) are in significant disrepair. Worst of all, with sales per square foot more than 30% below peers and same-store sales consistently lagging, it would be nearly impossible for Rite Aid to improve efficiency enough to be competitive over the long run. What Rite Aid needs is more customers, but it's hard to see how CVS or Walgreen could expand Rite Aid's market share without cannibalizing its own business. Furthermore, with current share barely above 6%, adding Rite Aid's customers would be unlikely to have a meaningful impact on the acquirer's bargaining power relative to PBMs. We would actually expect cost "dis-synergies" as Rite Aid's acquirer would have to increase investment in customer service.

Would Regulators Ever Allow a Merger Between These Retail Pharmacy Giants?
The potential benefits of a CVS Caremark-Walgreen merger seem obvious. The question then becomes: Would regulators allow it? While our first inclination would be to say no, we had similar skepticism about the Express Scripts-Medco merger. Those PBMs clearly believe the odds are in their favor or they wouldn't be risking the disruption of pursuing a deal. We remain doubtful, assigning only a 40% probability of regulatory approval.

Assuming the Express Scripts-Medco merger falls through, there would be much less urgency for consolidation among retail pharmacies. Smaller-scale consolidation would probably continue among PBMs, and competitive and reimbursement pressures would remain. However, Walgreen wouldn't be facing the imminent loss of a second large PBM contract, and CVS Caremark would retain a comfortable market share lead in the PBM industry. In this case, a continuation of the recent trend of prescription file purchases and smaller tuck-in acquisitions is likely.

However, if regulators allow the Express Scripts-Medco merger to proceed, it would seem hypocritical to subsequently deny a merger between CVS Caremark and Walgreen. CVS Caremark-Walgreen's 37% prescription dispensing market share would be in line with or slightly below Express Scripts-Medco's estimated PBM market share. More important, the rest of the market beyond the top player would be much more competitive for retail pharmacies than for PBMs. There are more than 40,000 retail pharmacies other than those owned by Walgreen and CVS in the U.S., compared with just seven PBMs (including Medco and Express Scripts) that account for 95% of the pharmacy benefit management industry.

One could argue that PBMs will use their scale to push down health-care costs through lower reimbursements, while more powerful retailers would use their scale to push up health-care costs through higher reimbursements. However, CVS Caremark and Walgreen could just as easily make the case that by increasing patient engagement, achieving administrative synergies, and driving a harder bargain with drug manufacturers, health-care spending would actually be lower as a result of the merger. There is surely more to be saved by keeping patients healthy and out of the hospital and by negotiating down the economic rents of branded drugmakers than there is in squeezing the margins of retail drugstores.

Regulators almost certainly would examine a proposed CVS Caremark-Walgreen merger on a market-by-market basis. Here the retailers also might have an advantage in winning approval, in that they would be able to sell specific assets (stores or prescription files from highly concentrated markets) to appease regulators. It would be nearly impossible for Medco and Express Scripts to make material divestitures, as they have few physical assets and it is hard to see regulators forcing clients to switch to a different PBM. If too many divestitures were required, though, it could significantly diminish the synergies from the transaction.

A merger between CVS Caremark and Walgreen remains a long shot. However, the same could have been said about the pending merger between Medco and Express Scripts. If the latter deal proceeds, we think CVS and Walgreen will be evaluating their strategic options. A combination of the two could greatly strengthen both retailers' competitive position--stabilizing retail margins while enhancing the differentiated value proposition of the PBM.

Matthew Coffina has a position in the following securities mentioned above: ESRX. Find out about Morningstar’s editorial policies.