CVS - CVS Health Corporation

[fisch777]

My impression is that MCOs originally "carved out" the drug benefit itself from the rest of the main medical plan, as the Rx benefit used to be simply lumped in.  At first, the "carved out" benefit was basically just processing drug claims, which could be done more efficiently/broadly with PBMs, who built networks to process claims at drug stores on behalf of MCO payors.  As Rx claims grew, the pharmacy benefit significantly gained in complexity, and the role of PBMs grew.  As PBMs grew in size, the role expanded beyond a 3rd party processor and they began to leverage their buying power to obtain lower drug pricing, which helped their payor clients (employers, MCOs). 

Some PBM activities do appear to be in potential conflict of end patient and/or payor, but PBMs do take cost out of the entire supply chain, so I don't get the argument that they don't add value and shouldn't exist. It is clearly not simple or easy to negotiate with the scale and expertise that these big PBMs operate.  As recently as 2009, Wellpoint (now Anthem) sold NextRx to ESRX for ~$5B.

Why is the integrated Rx/PBM model (CVS/Caremark) superior to the standalone (ESRX, recently Catamaran) model?

[DooDiligence]

My impression is that MCOs originally "carved out" the drug benefit itself from the rest of the main medical plan, as the Rx benefit used to be simply lumped in.  At first, the "carved out" benefit was basically just processing drug claims, which could be done more efficiently/broadly with PBMs, who built networks to process claims at drug stores on behalf of MCO payors.  As Rx claims grew, the pharmacy benefit significantly gained in complexity, and the role of PBMs grew.  As PBMs grew in size, the role expanded beyond a 3rd party processor and they began to leverage their buying power to obtain lower drug pricing, which helped their payor clients (employers, MCOs). 

Some PBM activities do appear to be in potential conflict of end patient and/or payor, but PBMs do take cost out of the entire supply chain, so I don't get the argument that they don't add value and shouldn't exist. It is clearly not simple or easy to negotiate with the scale and expertise that these big PBMs operate.  As recently as 2009, Wellpoint (now Anthem) sold NextRx to ESRX for ~$5B.

Why is the integrated Rx/PBM model (CVS/Caremark) superior to the standalone (ESRX, recently Catamaran) model?

Thanks - I didn't realize the history of the PBM (seems like they created a bunch if Frankensteins that got free & ate each other up & now the creators are gobbling up the resultant bigger monsters.)

I totally missed the United Health / Catamaran deal (did it go through & did they rename it Optum?)

I'm no expert but it seems logical that having PBM in house would be beneficial (albeit not for a pharma manufacturer as Merck found out.)

ESRX stands alone (will they eat their maker or be consumed & if so by whom?)

[ABM]

Why is the integrated Rx/PBM model (CVS/Caremark) superior to the standalone (ESRX, recently Catamaran) model?

I am spending a lot of time thinking about this myself. My best guess is that a scaled PBM returns profile is more attractive than the pharmacy business. It is a asset light negative cash conversion cycle business that has very high returns on tangible net assets.  This may explains why CVS entered the vertical which could have also been considered a low cost source of financing for its retail business inventory. I mean the amount of working capital ESRX has released over the past 10 years while growing EBITDA at high teens is astonishing and will be remembered in the same vein as AZO. 

Now from the perspective of ESRX, it is more difficult to understand rational incentives.  On the one hand, independent scaled PBM sounds ideal as it can serve multiple customers reinforcing network effect and widening its moat as the low cost producer.  On the other hand, disintermediation remains a threat as pharmaceuticals increase adoption rates of using direct to consumer rebates or "coupons" as they are known.  This is apparently a fast growing but real threat that could one day displace the PBM function as we know it.  So you can see ESRX maybe wanting to partner with a scaled payor to ensure its business remains relevant and well funded to face the shifting challenges of the industry.

To the comment earlier about why insurers let the PBMs out of the box to begin with, I believe it was due to the industry structure at the time which was fragmented; as such, a scaled PBM made sense for the benefit of all MCOs.  Now with the consolidated/consolidating MCO industry it likely makes less sense to outsource the PBM function if you underwrite 20% of all scrips int he country like UNH. 

[DooDiligence]

Why is the integrated Rx/PBM model (CVS/Caremark) superior to the standalone (ESRX, recently Catamaran) model?

I am spending a lot of time thinking about this myself. My best guess is that a scaled PBM returns profile is more attractive than the pharmacy business. It is a asset light negative cash conversion cycle business that has very high returns on tangible net assets.  This may explains why CVS entered the vertical which could have also been considered a low cost source of financing for its retail business inventory. I mean the amount of working capital ESRX has released over the past 10 years while growing EBITDA at high teens is astonishing and will be remembered in the same vein as AZO. 

Now from the perspective of ESRX, it is more difficult to understand rational incentives.  On the one hand, independent scaled PBM sounds ideal as it can serve multiple customers reinforcing network effect and widening its moat as the low cost producer.  On the other hand, disintermediation remains a threat as pharmaceuticals increase adoption rates of using direct to consumer rebates or "coupons" as they are known.  This is apparently a fast growing but real threat that could one day displace the PBM function as we know it.  So you can see ESRX maybe wanting to partner with a scaled payor to ensure its business remains relevant and well funded to face the shifting challenges of the industry.

To the comment earlier about why insurers let the PBMs out of the box to begin with, I believe it was due to the industry structure at the time which was fragmented; as such, a scaled PBM made sense for the benefit of all MCOs.  Now with the consolidated/consolidating MCO industry it likely makes less sense to outsource the PBM function if you underwrite 20% of all scrips int he country like UNH.

Nice thought process!

I'm looking into this because I own NVO, BBH & XBI & I'd like to have something that will counterbalance the risk of lower drug prices.

I like CVS but it seems a bit expensive & I don't like (but don't hate) ESRX & it seems cheap (lots of overhang from potential loss of Anthem contract & the proposed Cigna/Anthem merger, competition from UNH & CVS & the point you raised about possible future irrelevance of ESRX in the whole process...)

[ABM]

Further to my comment above, I found this excerpt from a buyside long report for ESRX posted on Sumzero defending the independent PBM argument

"There is in my mind a rational argument that the PBM business should remain independent of the HMO or the Retail pharmacy businesses because their interests are not necessarily aligned. By way of example, it seems to me inconceivable that Anthem would offer their PBM contract to UnitedHealth – there largest competitor. Similarly it seems likely that Walgreens would be more predisposed to dealing with Optum (Untied Health) or Express Scripts – as opposed to CVS (their largest competitor. To this extent and going forward, it seems reasonable that ESRX and United/Optum should have the upper hand over CVS/Caremark, when negotiating with pharmacies such as Walgreen, Target, Walmart, etc. Similarly ESRX and CVS/Caremark should have the upper hand over United/Optum when negotiating with HMO’s such as Anthem."

[KCLarkin]

Down 15% today.

http://www.bloomberg.com/news/articles/2016-11-08/cvs-says-slowing-prescriptions-will-hurt-profits-next-year

CVS Health Corp. earnings forecasts for 2016 and 2017 came in below analysts’ estimates as more prescriptions are being filled outside of its drugstores, sending the shares plunging Tuesday.

[fisch777]

Appears that most of the issues plaguing CVS today trace back to the PBM having superior leverage in the Rx supply chain, which allows PBM and respective client to steer lives away from specific retail pharmacy networks as it sees fit, to control payor costs.  The same thing happened in 2012 (on an ever larger scale) with ESRX dropping WAG from its network.

Again, I ask why is the integrated Rx/PBM model better?

[rogermunibond]

When it was about choice and consumer convenience having retail/PBM made sense.  When it's about cost reduction, well then...  that argument vaporizes.

[DooDiligence]

Appears that most of the issues plaguing CVS today trace back to the PBM having superior leverage in the Rx supply chain, which allows PBM and respective client to steer lives away from specific retail pharmacy networks as it sees fit, to control payor costs.  The same thing happened in 2012 (on an ever larger scale) with ESRX dropping WAG from its network.

Again, I ask why is the integrated Rx/PBM model better?

Good point...

If ESRX manages to stay independent, how do you think it will affect the competitve dynamic if at all?

Will politicos continue grinding at pharmas or payers or both?

[KCLarkin]

CVS is down 33% form all-time highs. It is now trading at under 12x FCF. This is remarkable for such a steady growth company when markets are at all time highs.

Ignoring the general malaise around drug prices and PBM business models, here is my theory.

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There is an epic battle brewing between Walgreen's and CVS.

CVS owns a PBM, pharmacy, clinics, specialty pharmacy, etc. Ultimately, it is hoping that this integrated approach allows it to offer cheaper and better PBM services to payers (employers, insurance companies, government). CVS is also using the PBM to drive traffic to the retail stores. As part of this strategy, CVS is de-emphasizing general merchandise sales. Ending sales of cigarettes, for example. In recent years, this strategy is winning. CVS was winning market share at both pharmacy and PBM.

Walgreen's is following a very different strategy. It is using prescription sales to drive traffic to stores, where it hopes to sell very high margin beauty products. Because the goal is to drive traffic, it is willing to sacrifice pharmacy margin to become the "preferred network" for PBMs and payers. Basically, Walgreens offers discounts on drugs and payers steer traffic to Walgreens beauty products.

CVS and Walgreen's retail stores are both heavyweights. CVS is slightly larger. But with Walgreen's acquisition of Rite Aid, they are basically the same size with excellent coverage across the U.S. Normally, you would expect CVS to respond aggressively to win its own share of "preferred networks". The negative impact on margins would encourage the duopoly to compete less vigorously.

But the brilliant owner of Walgreen's is playing some mean judo. Because PBMs compete with CVS Caremark, they are unlikely to select CVS as a preferred network. So CVS is unable to compete for a large chunk of business. Walgreen's can move aggressively knowing that CVS can't retaliate.

Pharmacies have high fixed costs. Any loss of market share has a big impact due to this operating leverage. In the past few years, CVS has been gaining share but now the tides are turning. Even relatively modest share losses could be a big hit to earnings.

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To respond, CVS is hoping to use its integrated model to win even higher share of the PBM business. So there is an interesting dynamic here. CVS retail will lose share of scripts from 3rd party PBMs. But win more share in the PBM business. The PBM business is a better business, so CVS might still grow despite headwinds in the retail business.

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This is an epic showdown worthy of an HBS case study.

It is really hard to predict how this battle shakes out. I'm using LEAPs to buy CVS. If CVS can stabilize its retail business, it is worth much more than 12x FCF. But there is also a risk that hyper-competition from Walgreen's could decimate FCF. (There are also regulatory risks that make the protective features of the LEAPs attractive).

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Some articles discussing these dynamics:
http://www.drugchannels.net/2015/04/walgreens-boots-alliance-analysis-of.html
http://www.drugchannels.net/2016/10/walgreens-tricare-win-tracking-wbas.html
http://www.chaindrugreview.com/brindley-walgreens-is-reinventing-beauty/