SOLD! Thoughts on the Catalyst-Walgreen Deal

Yesterday, Catalyst RX (NASDAQ:CHSI) agreed to purchase Walgreens Health Initiatives (WHI), the PBM subsidiary of Walgreen (NYSE:WAG), for $525 million. Here are the respective press releases:

• Catalyst Health Solutions to Acquire Walgreens Health Initiatives for $525 Million
  
  
• Walgreen Co. to Sell Pharmacy Benefit Management Business to Catalyst Health Solutions, Inc.

This is a big move for Catalyst, which vaults ahead of its competitors to become the fifth largest PBM behind the Big 3 PBMs—CVS Caremark (NYSE:CVS), Express Scripts (NASDAQ:ESRX), and Medco Health Solutions (NYSE:MHS)—and United Health’s (NYSE:UNH) Prescription Solutions. Even so, Catalyst will have less than 5% of the total U.S. prescription volume vs. about 70% for the top four. The company’s stock price jumped 19% yesterday on the news.

I want to highlight a few implications of the transaction for the PBM and pharmacy industries:

• What does the deal mean for Walgreens?

• What does this signal about the PBM industry?

• What does the deal mean for CVS Caremark?

Walgreens: Back to Basics

I wrote about Walgreens decision to sell itself back in October in For Sale by Walgreens: One Small PBM, Slightly Used.

As I noted then, WHI lacked scale in negotiations with manufacturers and pharmacy providers—such as Walgreens! The only real options were divestiture or a mega-acquisition. WHI has 11 million members and 89 million equivalent scripts, a bit below my estimate reported six months ago in Business Week. Mail-order penetration is reportedly only 2.5% at WHI.

Walgreens has systematically been making a series of moves to refocus on its core retail and non-retail dispensing channels, which are the most diverse in the health care system. See Walgreens and Omnicare Play Switcheroo.

As part of the Catalyst deal, Walgreens will retain its mail-order and specialty pharmacies and remain the preferred provider for Catalyst mail fulfillment. IMO, Catalyst was always the most likely buyer given this existing relationship.

PBM Industry: Transparency Gaining Traction

Catalyst’s rapid organic and acquisitive growth shows how competition is remaking the PBM business model. The market is responding to the needs of plan sponsors without government intervention or regulation.

Catalyst differentiates itself from the big 3 PBMs by focusing on pass-through pricing to its customers for retail reimbursement rates, dispensing fees, and rebates. These contracts are sometimes referred to as “transparent” because the plan sponsor has visibility to prescription costs at the pharmacy.

In contrast, the big three PBMs are still primarily compensated by plan sponsors using spread pricing. In a spread pricing model, PBMs earn a portion of their revenues by handling the flow of drug payments from plan sponsors to network pharmacies.

Competition is fierce. According to Concerns delay state action on $2.3b drug contract, Express Scripts has offered to take over the State of Maryland contract from Catalyst Rx for $50 million less over five years. The article highlights the requisite controversy over "booting a local company from a lucrative contract” and the supposed role of Express Script’s past legal problems.

Perhaps there’s a lesson on competition for over-zealous anti-trust lawyers here…

Et Tu, CVS Caremark?

I’m already on the record suggesting that the strategic benefits of a combined PBM/pharmacy chain are small. I still believe that CVS Caremark will eventually spin-off Caremark so that the PBM business can compete more effectively. See When will CVS and Caremark split up? from last May.

Apparently, I’m not alone. Yesterday, Bob Willoughby at Bank of America Merrill Lynch wrote: “The deal is consistent with our view that the PBM unit was irrelevant from a competitive standpoint and consequently non-core to WAG.” Credit Suisse analyst Edward Kelly said: “While Walgreen's PBM sale is small, it should fuel the debate on a possible break-up at CVS.”

In CVS Caremark: Still Searching for Synergy, I interpreted comments In February by Larry Merlo to mean that the spin-off scenario is being actively considered. CVS Caremark spokeswoman Carolyn Castel told Dinah Brin at Dow Jones yesterday that “there are no plans to split up the company.” (source)

We’ll see.

FOR THE RECORD

In writing about Walgreens last Friday, I said: “Look for the spin-off of their PBM business soon.” This was purely speculation following Hal Rosenbluth’s departure and not based on any proprietary or non-public information. Please take note, SEC lawyers!