CVS-Aetna: Less Than Meets The Eye?

On Tuesday night, CVS Caremark (NYSE:CVS) announced a 12-year contract to provide PBM services to Aetna (NYSE:AET). Here is the official press release: Aetna Awards Long-Term Contract to CVS Caremark to Provide PBM Services.

First, the upbeat spin.

• This is a bold move by CVS Caremark with enough positive strategic implications that it overshadowed the otherwise gloomy news from Q2 earnings.
• The contract supports my contention that there will be more PBM consolidation ahead. Scale matters in the PBM business, especially on the eve of major generic launches.
• It’s a great defensive move. Medco was rumored to be wooing Aetna last year, but now must shop elsewhere.
• The size of the deal will relieve pressure on CVS Caremark as it fixes the PBM business.

Yet, I have some nagging doubts. The deal seems much more like a very big administrative contract win rather than a game-changing consolidation. The transaction is neither as straightforward as the Express Scripts/NextRx combination nor will it be as profitable for CVS Caremark. The lack of detailed financial disclosure also makes me wonder how much CVS Caremark was willing to concede to make it all happen.

Plus, CVS Caremark is embarking on a long-overdue consolidation of its multiple PBM platforms while simultaneously ramping up the Aetna business, adding implementation risk.

As always, I recommend that you can get the spin directly from each company's management on their respective earnings conference calls:

• CVS Caremark Q2 2010 Earnings Call Transcript
  
  
• Aetna Q2 2010 Earnings Call Transcript
  

A VOTE OF CONFIDENCE?

A big question: Does this arrangement finally “prove” the value of an integrated PBM-Retail model? Dow Jones states unambiguously: Aetna Pact Seen as Vote of Confidence for CVS Caremark Model and quotes numerous analysts to support this headline.

I’m not so sure. Much of the synergy in the CVS Caremark combination to date has come from (1) boosting CVS' retail pharmacy and (2) leveraging buying power against suppliers—generic drug manufacturers and drug wholesalers for brand-name supply. Scale will be crucial on the verge of Lipitor et al losing patent protection and the prospects for reduced per-script profitability on generic prescriptions.

The Aetna contract doesn’t seem to take advantage of Caremark’s broader array of Retail/PBM services.

• CVS Caremark will be “managing purchasing, inventory management and prescription fulfillment” of Aetna’s mail order and specialty pharmacy. It will also provide administration of selected functions for Aetna's claim processing, customer service, retail pharmacy network contracting, and "physician engagement through e-prescribing."
  
  
• Aetna will continue to control medical and pharmacy policy, formulary design, pharmacy/medical benefit integration, rebate contracting, and many other core PBM functions. Aetna is even keeping technical ownership of pharmacy licenses and clinical functions.

Watch this short video with Aetna Chairman and CEO Ronald Williams, who emphasizes that CVS Caremark will help Aetna “purchase much smarter for our customers” and “administer the benefit cheaper as well as buy smarter.” Hmmm. (Click here if you can't see the video.)

Fun fact: Aetna apparently spent $50 to $60 million on financial advisers, consultants and legal advisers to get the transaction executed. Sweet!

GOOD BUT NOT GREAT ECONOMICS (I THINK)

Despite the apparent similarities, this deal appears to be much less beneficial to CVS Caremark than the Express Scripts deal with NextRx. Express Scripts estimates an incremental $1 billion EBITDA (Earnings Before Interest Taxes and Depreciation) from the acquisition of NextRx’ $16 billion in drug spending.

The EBITDA benefit to CVS Caremark will be much smaller on Aetna’s $9.5 billion in drug spending since there will be less integration and cost cutting given Aetna’s retention of core PBM functions. My back-of-the-envelope calculations suggest the deal will generate an incremental EBIDTA per Adjusted Script for CVS Caremark that is 75% lower than the incremental EBITDA per script that Express Scripts will get from NextRx.

Nonetheless, the economics of the deal are still murky. Yesterday’s conference call raised as many questions as it answered. The Wall Street Journal’s Health Blog has a good summary in Analysts Question Aetna on CVS Caremark Deal.

RANDOM THOUGHTS

McKesson will take a margin hit. As I discuss in The 2010-11 Economic Report on Pharmaceutical Wholesalers, the ongoing consolidation of the pharmacy industry will pressure wholesaler profit margins from drug distribution. The supply chain purchasing savings will come at the expense of drug wholesaler McKesson (NYSE:MCK), which supplies the mail pharmacies of both Caremark and Aetna. While there will be no volume movement between wholesalers because of the deal, CVS Caremark presumably buys at a bigger discount than Aetna, translating into lost margin for McKesson.

More evidence against the Transparency Myth. Independent pharmacies are lobbying for “PBM transparency” legislation that will purportedly help plan sponsors. Yet here we have an example of a large plan sponsor choosing to outsource a chunk of its PBM operations to an independent company. So, I presume NCPA will be contacting Aetna’s management to explain the foolishness of this transaction and how independent pharmacies know better than Aetna, right? (See Why do pharmacy owners care about PBM transparency? to understand why Aetna won’t take their call.)

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Any bold reader care to share their analysis or predictions?