Walgreen and Express Scripts Play Chicken

Ah, summer! The weather is warm, the birds are chirping, the sun is shining, and Walgreen (NYSE:WAG) is playing chicken with a major PBM.

Yup. Walgreen announced its intention to drop out of Express Scripts’ (NASDAQ:ESRX) retail pharmacy network, citing a “breakdown in contract renewal negotiations” in this announcement: Walgreens Planning to Move Forward Without Express Scripts, Inc. Pharmacy Provider Network in 2012

Express Scripts responded coolly in Express Scripts Strives to Make Prescription Drugs Affordable and Accessible to American Families. Kudos for not escalating the battle.

This isn't a rerun of last year’s CVS Caremark (NYSE:CVS)-Walgreen Brouhaha. Express Scripts has less to lose than CVS Caremark did last summer, especially because there's no need for Express to "prove" the value of its business model. However, the outcome is likely to be similar. Express Scripts can’t live without Walgreen, and vice-versa. Cluck!

Read on for more on the dispute and my best guess at the likely outcome.

I recommend the earnings call for lots of Q&A with Walgreen's management about their move.

• Webcast

• Transcript

Walgreen still likes to play hardball. Express Scripts' chairman and CEO George Paz said: "It is shocking to us that Walgreens would back away from the table with six months to go in the current agreement.” Actually, it’s not too shocking given Walgreen’s penchant for pushing back against payers when it feels undercompensated. Examples (in the public domain) include Washington’s Medicaid program, Michigan HMO Midwest Health Plan, Caremark (in 2007), and Caremark again in 2010. Walgreen still has the unusual habit of negotiating by press release. Is Charlie Sheen giving them PR advice?

Walgreen has a lot to lose. Walgreen disclosed that Express Scripts represents $5.3 billion in annual sales and about 90 million annual prescriptions. See chart below from yesterday’s earnings call. I wonder about credibility here. Walgreen pulled this same stunt with Caremark last year. How many times can they do it? Tune in June 2012 for my post on the Walgreen-Medco dispute?

Express Scripts will be hurt without Walgreen. EXRS stated: “On average, another pharmacy within the Express Scripts network is within one-half mile of a Walgreens pharmacy. Even without Walgreens in our network, we meet all client guarantees for access.” While perhaps technically true, Walgreens has 40%+ market share in many major cities—Chicago, St. Louis, Milwaukee, Houston, Phoenix, Manhattan, Denver, etc. Note the qualifier in the sentence. (“On average, an American child is a boygirl.”) And how could Express Scripts service a client where Walgreens has a work-site pharmacy? Assuming that Walgreen remains in the networks of other PBMs, then Express Scripts would be at a competitive disadvantage in the upcoming selling season.

Another vote for narrower networks? The growth of preferred pharmacy networks is one of the four major trends in The 2010-11 Economic Report on Retail and Specialty Pharmacies. Express Scripts has not really pushed hard for preferred or restricted network models despite the conceptual and economic advantages. However, I note the following prescient comment on page 5 of April's Express Scripts Drug Trend report:

“However, as retail chains consolidate, plan sponsors cannot count on achieving pricing concessions from pharmacies without tightening the network they use. To achieve maximum savings, retail networks must be organized and carefully managed over time.”

HANDICAPPING THE OUTCOME

Despite Express Script's somewhat better negotiating position, I still expect a resolution within a month. My current prediction:

• Reconciliation with no financially meaningful changes: 75%

• No Agreement—Walgreen leaves the Express Scripts network: 15%

• Express Scripts meets Walgreen's demand for better reimbursement: 10%

Stay tuned for more drama!