What The UnitedHealth-Catamaran Deal Means For Walgreens

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Yesterday, we laid out some reasons for why Walgreens (NASDAQ:WBA) might consider acquiring Rite Aid (NYSE: RAD) (Read the article here). Within a few hours of publishing the article, a leading healthcare company announced what could be another, potentially stronger, reason for such a transaction. UnitedHealth Group (NYSE:UNH) announced its acquisition of Catamaran Corporation (NASDAQ:CTRX) in a $12.8 billion cash deal. Together, these companies will form the third largest pharmacy benefit manager with a market share of around 20%. From a total of about 100 companies in the PBM market in 2008, it will come down to just 3 companies controlling almost three-fourths of the market, after the completion of this transaction (expected by the end of fourth quarter of 2015, pending regulatory approvals).

View our analysis for Walgreens

Some Context To Start With

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Today, there are very few pure play pharmacy retailers remaining. To mitigate risks arising from factors such as high drug prices and low reimbursement rates, traditional drugstores such as CVS Health (NYSE: CVS) entered adjacent markets, namely pharmacy benefit management. By doing so, the company reduced its dependency on external benefit managers who would make profits by retaining a margin of drug reimbursement for themselves. While this helped CVS’ core pharmacy business, PBM in itself turned out to be a growth driver, as revenues from the division doubled in the last five years. Walgreens, however, had its own (contrasting) way of mitigating these risks.

The Business That Walgreens Once Dumped, Now Poses A Potential Threat

While CVS entered the PBM market in 2006 with the acquisition of Caremark, Walgreens exited the same market in 2011 by selling its benefit management business to Catalyst Health Solutions [1], which was later acquired by SXC Health Solutions Corp to form Catamaran. Now four years later, it turns out that the same company (Catamaran) could be the cause for some course correction by Walgreens. It, instead, decided to focus on upgrading its drugstores and further expanding its retail footprint by opening more stores and acquiring independent pharmacies as well, all to increase its negotiating power.

The PBM market was already controlled by few players, with CVS and Express Scripts Holding Co. (NASDAQ: ESRX) together controlling about 50% of the market. With this deal, another similar sized company is formed resulting in more than 70% of the market to be controlled by just 3 players.  The creation of larger healthcare enterprises gives them greater bargaining power, which in turn results in greater pricing pressures for drug retailers. This is why we think this acquisition and, hence large the large benefit managers, could be a potential threat to Walgreens’ profits in the future. Furthermore, history supports this possibility.

Dispute With Express Scripts Led To Billions In Prescription Sales Losses

At the end of 2011, Walgreens decided to not participate in Express Scripts’ pharmacy networks. Reportedly, the primary reason for making this decision was that the latter’s reimbursements to the company’s national chain of pharmacies were so low  under the terms of a proposed new contract  that the company thought it more reasonable to risk losing an estimated $5.3 billion in prescription revenues from plans that Express Scripts manages.  ((In Walgreens Dispute, Express Scripts Seeks Knockout Blow to Pharmacies – and Patients))  About 9 months later, following severe losses in market share, Walgreens resolved the dispute in mid-2012 and signed a multi-year agreement which would again make it a part of Express Scripts’ preferred pharmacy network.

Even after the dispute was settled, regaining lost customers was an uphill task and the company continued to see significant profit declines in subsequent quarters [2]. This highlights how pharmacies, even as large as Walgreens, and their patients are hugely dependent on pharmacy benefit managers (PBMs), who use scale to their advantage, in many ways.

Conclusion

Walgreens, in the recent past, has taken various steps to protect itself from external risks. It entered into distribution agreements to hedge spikes in drug prices, went global through the acquisition of Alliance Boots to achieve more scale, etc. However, it still relies on PBMs to negotiate better prices with drug makers. Therefore, the fact that PBMs are getting larger and stronger could likely convince the company’s management to act and protect themselves from external risks sooner than later. And one possible way of doing that is by buying itself a benefit management business. While, it could acquire a standalone PBM, acquiring Rite Aid would also help them expand their retail footprint, which has historically been its growth strategy.

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Notes:
  1. Walgreen Goes For Retail Store Growth In Dumping PBM Business []
  2. Walgreen Slowly Winning Back Customers Lost In Express Scripts Dispute []