The Real Winner from the Battle between Walgreen and CVS

In a bid to keep a lid on runaway prescription drug prices, many companies have turned to Pharmacy Benefit Managers (PBMs). These firms act as a middleman, handling all prescription-related paperwork and gently nudging consumers toward lower-priced generic drugs and an increased use of low-cost mail-order services. Over time, the PBMs have proved they can save clients lots of money, and as they grow ever-larger, scale economies kick in, making their compelling business models look even better.

PBMs have been in the news this week, as CVS Caremark (NYSE: CVS) and Walgreen (NYSE: WAG) embarked on a very public spat. Walgreen and CVS had a contract to provide mail order delivery for Walgreen’s customers. (Customers also have an option to simply pick up drugs at a Walgreen store). But CVS began to push Walgreen’s customers toward CVS’ “Maintenance Choice” program that allows for retail refills good for 90 days. The catch: drugs needed to be picked up at CVS stores, even though they were Walgreen customers.

Walgreen saw where that was going, and told CVS that it would no longer send new customers to CVS’ PBM. CVS responded by telling Walgreen to take its existing customers somewhere else as well. That public fight has left both companies bruised. CVS stands to lose that Walgreen business, and Walgreen risks its customer ire as they have to scramble to quickly sign up with another PBM.

The two sides may still amicably resolve this dispute, but one thing is clear: CVS’ hopes of being both a retail pharmacy chain and a PBM (though a 2007 acquisition of Caremark) was a bad move. Trying to compete with rival drug store chains while also supplying them with PBM services has created a clear conflict of interest, one that CVS foolishly exploited through its Maintenance Choice customer switching initiative.

As a result, CVS has started to lose PBM customers, and the trend is likely to continue. The clear beneficiaries: MedcoHealth (NYSE: MHS) and Express Scripts (Nasdaq: ESRX). And though both stocks are similarly valued, Medco, the biggest player, looks like the best investable play here.

In addition to any business it can pick up from defecting CVS customers, Medco should also uses its size and favorable demographic trends to keep pounding out impressive growth. As has been widely chronicled, the number of senior citizens is rapidly rising, and they are the biggest consumers of prescription drugs. That’s why analysts think prescription drug volumes will keep rising at a +5% to +7% clip each year for the foreseeable future.

But rising volumes doesn’t mean rising spending. Cost pressures are leading many organizations to emphasize generic drugs. And that trend should only accelerate. Branded drugs that generated roughly $100 billion in annual sales in 2008 are expected to lose patent protection during the next five years. Medco and the other PBMs actually make greater profits on cheaper generic drugs. That’s counter-intuitive, but the result of much better leverage in negotiations, as there are usually multiple providers of a generic drug.

Another plus: a number of managed care firms and large employers have begun to realize that PBMs can operate a lot more efficiently than they can. So the PBMs have been picking up about $5 billion in new business each year as PBM contracts get outsourced. There’s ample room for that trend to continue: at recent conferences, executives at Medco and Express Scripts have noted that they are signing new contracts at a robust pace for next year’s selling season. That’s why analysts think both hose firms can boost sales at least +5% next year, although a +10% growth rate could be the actual result.

And as they gain scale, these firms are able to show substantial profit gains. During the past decade, Medco’s earnings before interest, tax, depreciation and amortization (EBITDA) margins steadily grew from 3% to 4%, enabling profits to rise even faster than sales. The company is eyeing further savings to push EBITDA margins closer to the 5% mark.

Medco’s per-share profits have grown at least +20% in each of the past three years, and are expected to rise at least that much in 2010 and 2011 as well. Per-share profits have also been boosted by a massive $3 billion share buyback, which has taken the share count from 600 million in 2006 to a recent 475 million. Analysts suspect a similar fresh buyback will be put in place later this year, as long as shares don’t quickly move to new highs.

Action to Take –>
Even after a recent spike, shares of Medco still hold great appeal. Assuming the forward price-to-earnings ratio (P/E) rises back to its historical norm of 20, shares will rise to $80, representing +30% upside form current levels.