Can CVS and Express Scripts Sustain Their Rebound Relationship?

This post is syndicated at The Motley Fool Network:
http://beta.fool.com/malayappan/2012/11/06/can-cvs-and-express-scripts-sustain-their-rebound-/15827/

Express Scripts (NASDAQ: ESRX) and CVS Caremark (NYSE: CVS) report third quarter results on Monday, Nov. 5 and Tuesday, Nov. 6, respectively.  What they report should be interesting to watch because they are both apparently in a rebound relationship after Express Scripts broke up with Walgreen (NYSE: WAG) over contractual terms last year.  Unfortunately for Walgreen, Express Scripts apparently had the upper hand as patients migrated over to CVS and Rite Aid (NYSE: RAD).  Walgreen and Express Scripts kissed and patched up recently, and I wrote about how Walgreen perhaps turned out to be the loser.

Express Scripts is a Pharmacy Benefits Manager (PBM), and therefore the primary contract holder for drug benefits for millions of patients across the country.  Self-insured companies and Health Insurance plans negotiate with PBM’s like Express Scripts and Caremark (owned by CVS) to obtain the most cost effective rates for drug distribution.  Express Scripts, in turn, relies on Pharmacy networks such as Walgreen and Rite Aid to reach patients, in addition to operating its own mail order pharmacy. 

After the spat with Walgreen, Express Scripts tried aggressively marketing its mail order pharmacy as a convenient, cost effective and more efficient alternative to retail pharmacies. However, perhaps in order to lessen the pain, Express Scripts also pointed out to Walgreen customers the existence of alternatives, such as CVS Pharmacy and Rite Aid, within a mile of any Walgreen. 

Complicated Relationship

The relationship between a PBM like Express Scripts and a retail pharmacy network like CVSor Walgreen is complicated.  On the one hand Express Scripts depends on the retail locations that these pharmacy networks offer.  On the other hand, these networks themselves pose a threat to Express Scripts, since they themselves own PBM’s that pose a competitive threat.  CVS owns Caremark, which is a huge PBM.  Express Scripts took steps to counter the challenge, and became bigger by merging with another PBM, Medco Health Solutions, for $29.1 billion.

Walgreen does not currently own a PBM and therefore did not have the wherewithal to pose a threat in the PBM space to Express Scripts.  Walgreen did own a PBM before called Walgreen Health Initiatives that it sold to Catamaran .  No wonder Express Scripts had a vested interest in developing a close relationship with Walgreen versus CVS.  It was an open secret as to how much Express Scripts and Walgreen depended on each other. 

However, it appears that Walgreen might be preparing to create another PBM that could directly compete with Express Scripts.  In June 2012, Walgreen acquired a 45% stake worth $6.7 billionin Alliance Boots, the United Kingdom’s largest pharmaceutical distributor.  Walgreen has the option of acquiring the remaining 55% in the next three years.  Alliance Boots is not yet a Pharmacy Benefit Manager in the USA, but it appears that Walgreen is positioning it to become one by creating a new joint venture!  According to Walgreen this is part of the strategic partnership relationship program.  It appears that the love-hate affair between the two might be just heating up.

Migration of Customers to CVS and Rite Aid

Both Rite Aid and CVS reported that after the rift between Express Scripts and Walgreen they were able to pick up much of the approximately 60 million prescriptions that Walgreen lost as a result of the contract termination.  CVS especially reported in its Q2 earnings report that there was a “significant benefit” from the dispute.  Rite Aid reported in its Q2 earnings announcementin September that there was a benefit of additional prescriptions from the dispute.  Walgreenreported Q4 results on Sept. 28, and not surprisingly disclosed the negative impact of the dispute with Express Scripts.

It is important to note that standalone drugstores are not the only options available to a patient.  Supermarkets such as Wal-mart, Target and Kmart - owned by Sears Holdings have a pharmacy section as well.  Grocery stores such as Kroger, Publix and Super Stop and Shop have pharmacy sections also. In fact, pharmacy units of such stores offer extra incentives such as rock bottom $4 prescription refills for popular generics targeted towards customers without medical insurance.  Such discount drug programs build a loyal customer base by enrolling those without insurance who might later continue even after becoming insurance eligible.  Suffice it to say that there are plenty more alternatives out there than one might realize.

Different Expectations?

Now that Walgreen and Express Scripts appear to have patched up their differences and signed a new agreement, should we expect different results from Express Scripts and CVS Caremark next week?  I don't think so.  It is too soon to see the impact of the new agreement, and as I mentioned in my recent post there are aspects of the agreement that gives us pause.  Express Scripts claims that Walgreen is a member of its “broadest network of pharmacies.”  It neglects to mention that while this may be true, there might be several new networks that do not include Walgreen. 

Under the new agreement, former Walgreen customers like me are unable to switch back because my company chose a lower cost network that continues to exclude Walgreen.  The new contractual provisions of the agreement might not give patients any choice!  It is quite conceivable that CVS and Rite Aid might get to keep a substantial portion of their new customers from Walgreen after all.  CVS might report good results anyway since they have cannibalized Walgreen customers successfully for over two quarters.

Express Scripts is another story.  The only way they could show greater margins is if they have successfully steered away customers towards generics, which generate less revenue but more profits.  Additionally, it remains to be seen if they have also convinced more customers to try out their mail order pharmacy because that also generates greater revenue and profits by cutting out the retail pharmacy in the distribution chain. In addition, investors will need to figure out how the Medco acquisition affects the bottom line.  The forward P/E ratio for ESRX is 13.78, which is roughly halfway between that of competitors such as WellPoint (NYSE: WLP), which has a P/E of 7.6, and Catamaran, which has a P/E of about 28.

I rate Express Scripts a hold and CVS a buy.