Interpreting Caremark’s Big Win over Medco

Big news in the PBM world on Friday: CVS Caremark (NYSE:CVS) took the $3 billion Federal Employee Program (FEP) mail/specialty business away from Medco Health Solutions (NYSE:MHS) and will manage the entire contract starting in January 2012. Here’s the official press release: CVS Caremark Awarded Integrated 3-Year Blue Cross and Blue Shield Federal Employee Program (FEP) Contract.

This major win for Caremark—and surprising loss for Medco—reinforces my view that Per Lofberg is leading a successful rejuvenation of Caremark’s PBM business. However, there is limited evidence that the integrated PBM-Retail model was the deciding factor, beyond purchasing synergies that allow CVS Caremark to compete more aggressively on price.

Apparently, Medco lost the FEP contract for "financial" reasons. While bad news for Medco, it is consistent with my view that marketplace competition is better than government oversight in protecting the interests of plan sponsors.

Here’s my quick take on what this deal means for CVS Caremark, Medco, and the two drug wholesalers supplying each company. As always, Pembroke Consulting and Gerson Lehrman Group clients can schedule phone calls with me for additional insights beyond what I discuss in this public post.

A BIG WIN FOR CAREMARK

I have never viewed Caremark as fundamentally broken, Instead, I see it as an imperfect fit with a large retail chain. As I wrote last October in CVS Caremark: More Happy Talk, But Hard Work Remains: "Caremark is now clearly focused on competing as a top PBM, not just as a nice-to-have adjunct to a large retail chain. I credit Per Lofberg for this more aggressive and strategic posture."

Here’s the Wall Street Journal in CVS Beats Out Medco for Federal Contract:

CVS, which already provided drugstore services to the FEP, said it received the mail-order business by offering "the best overall value," leading observers to surmise that the company was aggressive with its pricing…"Per Lofberg is being very aggressive about trying to grow the top line of Caremark," Leerink Swann analyst David Larsen said Friday.

Caremark can afford to be more aggressive with pricing thanks to its significant purchasing synergies for generic drugs. In 2010, CVS Caremark was more than 20% of total retail and specialty pharmacy revenues (per 2010 Market Share of Top Retail and Specialty Pharmacies.)

Take a trip down memory lane with CVS' Channel Power from 2007. As I explain in that article, CVS Caremark filed suit against generic company Prasco, LLC, because Caremark was allegedly receiving a lower price than CVS prior to the merger.

Maintenance Choice is reportedly not in the 2012 FEP benefit design. That’s another reason why I think the win says more about Caremark’s bidding strategy than about the services of a combined retail/PBM entity.

Thus, the song remains the same. CVS retail pharmacies and Caremark’s PBM business may be able to live together without driving each other crazy, but that still doesn’t mean it permits the combined entity to command a price premium from plan sponsors. See my comments under “Synergy = Competing on price?” in CVS Caremark: Still Searching for Synergy. A strong Caremark will have many strategic options in 2012 and beyond.

A BIG LOSS FOR MEDCO

The news was a big surprise for Medco and its shareholders. Medco’s stock ended Friday down by 9%. Ouch.

FEP was entirely a mail and specialty contract. According to Medco’s 8-K filing: “The FEP contract generates nearly $3 billion in annual net revenues, including approximately 9.8 million mail order prescriptions, and represents less than ten (10%) percent of the Company's estimated 2011 earnings.”

Thus, FEP represents about 12% of Medco’s mail pharmacy revenues and about 9% of total mail claims, but was slightly less profitable than Medco’s other clients.

The Wall Street analyst reports that I read on Friday project that Medco’s earnings per share will be lower by 6% to 10% next year. Ouch again.

Does this contract loss have anything to do with the CalPERS situation? Probably not, but no one really knows.

THE WHOLESALER TANGO

The FEP contract will shift about $1.8 billion in revenue from AmerisourceBergen (NYSE:ABC) to McKesson (NYSE:MCK). However, the profit impact will be minimal for both companies because this business is extremely low margin.

For those who don’t follow such things, the large mail-order pharmacies purchase brand-name drugs—but not generics or specialty drugs—via drug wholesalers rather than buying directly from a manufacturer. Here are the key relationships:

• Medco: AmerisourceBergen (NYSE:ABC)
• Caremark: McKesson (NYSE:MCK)
• Express Scripts: Cardinal Health (NYSE:CAH)

Drug wholesalers earn operating profits of an estimated 20 to 40 basis points on this business. Yes, you read that correctly—profit margins of 0.20% to 0.40%. The profitability of this bulk business is much lower than that a wholesaler's non-bulk business with smaller pharmacies or non-self-warehousing chains. See The 2010-11 Economic Report on Pharmaceutical Wholesalers (pages 24-29) for a detailed explanation of why these sales continue to flow through wholesalers.

Medco purchased about $14 billion in brand-name drugs from ABC in 2010. This equals about 32% of ABC’s AmerisourceBergen Distribution Company (ABDC) business. If we assume that about 60% of FEP was traditional brand-name drugs, i.e., non-specialty and non-generic, then the FEP contract loss will reduce ABC’s revenues in 2012 by about $1.8 billion and increase McKesson’s revenue by the same amount.