A pharmacy benefit manager (PBM) negotiates prices with the drug manufacturers and provides prescription medicines at discounted prices. Costco (NASDAQ:COST) recently started its own PBM program known as Costco Health Solutions, which fills out prescriptions for small and midsize business customers and their employees. 
With this program, Costco advances into a new market of handling drug plans, which is already dominated by players such as CVS Caremark (NYSE:CVS) and Express Scripts Holding Co. The primary strategy behind this move is to improve the store traffic and generate higher sales. The retailer is also making a bet that its the employees of its business accounts might end up becoming Costco members. 
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On Its Own, Pharmacy May Not Help Costco
Costco’s gross margins are already razor thin due to its business structure and pushing into a low-margin pharmacy business will not help them. Moreover, the retailer has to compete with big players such as CVS Caremark and Express Scripts Holding Co. Costco is less likely to have a competitive advantage because the retailer is not known for its pharmacy business and is new to the market.
Even if Costco gets good results from its PBM program, the impact on the retailer will be minimal due to low revenue share of pharmacies. Pharmacy is one of the seven subcategories of Costco’s ancillary businesses, which constitute only 18% of overall revenues.  Assuming even contribution from all the subcategories, we estimate pharmacy revenues to be around 2.5% of Costco’s overall revenues. Quite clearly, pharmacy alone does not make a material difference to Costco’s sales.
However, Costco Can Target $1.5-$4.5 billion In Additional Revenues With More Store Traffic
Costco’s PBM program focuses on signing contracts with small and medium-sized businesses located in its vicinity.  The retailer will provide discounted prescription medicines to their employees through its in-store pharmacies and 64,000 independent pharmacies. Hence, the employees of these businesses may become familiar with the cost benefits of shopping at Costco and might end up becoming its members. The customers may be reluctant to sign up for Costco’s membership as they look to tackle the tough economic environment.
As of fiscal 2012, the retailer had around 10 million business members. Assuming that about 10%-15% of the existing business members joining this program, there will be around 1 to 1.5 million businesses taking advantage of Costco Health Solutions. If we further assume that a contract with each of these businesses results in 1 to 2 employees becoming Costco’s members, we are looking at close to 1 to 3 million additional members. Given that Costco earns $1,500 per member annually in revenues, there is an opportunity to grow total revenues by roughly $1.5 to $4.5 billion if its PBM takes off.
Our price estimate for Costco stands at $111, implying a premium of about 10% to the market price.Notes: