By Matthew Coffina
Retail drugstore chain Walgreen (WAG) and pharmacy benefit manager (PBM) Express Scripts (ESRX) remain locked in a contract dispute. If the two sides can't make a deal by the end of the year, millions of Express Scripts' members could be forced to fill their prescriptions elsewhere. Both companies stand to lose from this fight, which we see as evidence of a broader trend of increasing animosity between health-care payors and health-care providers over reimbursement rates.
The Walgreen-Express Scripts spat comes about one year after a similar disagreement between Walgreen and another pharmacy benefit manager, CVS Caremark (CVS). In that case, Walgreen and Caremark reached an agreement in 11 days, preventing any serious disruption to either party. While there is no way to know exactly what the final contract terms were, we suspect that the resolution in that case was favorable to Walgreen and that Walgreen hopes to repeat the experience with Express Scripts.
We believe that Walgreen had the upper hand in its negotiations with CVS Caremark. At the time of the dispute, CVS Caremark was in the early stages of a critical selling season. The company had recently lost significant market share to Medco (MHS), and the value of its integrated retail-PBM business model was being called into question. CVS Caremark risked losing many more members if it had to present clients with a retail network that excluded Walgreen. Calls from analysts and investors for CVS to spin off Caremark were growing louder. We believe the speedy resolution was facilitated by CVS Caremark's relatively desperate situation, which encouraged the PBM to concede to Walgreen's reimbursement demands.
Let's fast forward to June 21, 2011, when Walgreen announced that it plans to exit Express Scripts' pharmacy network at the end of this year. While it would be in both companies' interest to resolve this dispute quickly, as of this writing no resolution has been achieved. Importantly, we believe Express Scripts is in a much stronger bargaining position than CVS Caremark was at the time of its standoff with Walgreen, which could lead to a more protracted battle.
Unlike CVS Caremark, Express Scripts is not currently experiencing any strategic or financial difficulties. In fact, the company's relatively stable customer base could be a key advantage in discussions with Walgreen. About half of Express Scripts' revenue is derived from two long-term contracts that extend more than five years. The remainder of the company's client book is on three-year contract cycles, leaving only a midteens percentage of revenue up for renewal in any given year.
Clients choose a PBM for many reasons other than just its retail pharmacy network, and given an increasing focus on health-care costs, we suspect that a decent number of clients will be willing to stand by Express Scripts even if Walgreen is not in its network. Assuming a resolution isn't reached, retained PBM members will need to be transitioned to alternative pharmacies. According to Express Scripts, the company's network includes another pharmacy within half a mile of Walgreen's stores, on average. Since pharmacy customers tend to be relatively sticky, members that transition to another pharmacy may never return to Walgreen. This would also mitigate concerns about patient disruption during Express Scripts' future client contract renewals.
On the other hand, the hit to Walgreen if an agreement cannot be reached would be immediate and severe. Prescription sales to Express Scripts' members account for a little over 7% of Walgreen's total sales. However, the potential earnings impact of losing Express Scripts would likely be greater for two reasons. First, these patients may also be making purchases in the front of Walgreen's stores. Second, pharmacies have relatively fixed expense structures--costs such as rent and pharmacist salaries. This level of sales decline would likely result in some major negative operating leverage. Additionally, if an agreement is not reached, we suspect that this would leave Walgreen vulnerable to demands for lower pricing from other PBMs. While Walgreen may be able to get along without Express Scripts, it would be disastrous for the company to lose a second large PBM such as Medco, which puts Walgreen in a difficult negotiating position.
We believe the recent disputes between Walgreen and the PBMs are indicative of a larger trend of increasing hostility between payors (such as government agencies, managed-care organizations, and pharmacy benefit managers) and health-care providers (such as doctors, hospitals, and pharmacies). Due to a combination of health reform and the economy, regulators and businesses are now more focused on health-care costs than they have been in decades. Payors have an incentive to curb cost growth, while providers generally want to maximize their own revenue. The outcome of this fight could determine both the future rate of growth in health-care spending and the relative competitive advantages of payors and providers.
Also underlying the greater animosity is consolidation in the PBM industry, which has given the leading companies unprecedented bargaining leverage. Express Scripts' bargaining power could be greatly enhanced if the company's recently announced acquisition of Medco receives regulatory approval. Additionally, with the approaching peak of the generics wave, PBMs are being forced to consider new methods to create savings for clients, including tighter management of pharmacy networks. Finally, we see an increasingly competitive pharmacy marketplace. Patients now have more cheap and easy options for filling prescriptions, including nontraditional dispensing outlets such as mail-order, Wal-mart (WMT), and other diversified retailers.
The ultimate impact of the Walgreen-Express Scripts dispute on our fair value estimates will depend on how the disagreement is resolved. If a new contract can be agreed on quickly, as occurred with Walgreen and CVS Caremark, we are likely to maintain all fair value estimates. On the other hand, if an agreement is not reached before the end of the year, we are likely to lower our fair value estimate for Walgreen, perhaps significantly. The extent to which we lower our fair value estimate for Express Scripts will depend on how many clients, if any, the company loses as a result of not having Walgreen in its network.
The real winners from this dispute are competitor PBMs Medco (assuming its acquisition by Express Scripts falls through) and CVS Caremark. These companies stand to gain in two ways. First, they could gain bargaining leverage over Walgreen, which will likely be desperate not to lose a second large PBM. Second, they could steal PBM market share from Express Scripts.
Looking at the big picture, payors' increasingly aggressive stance toward reimbursements is a potential negative for all health-care providers, particularly those that lack scale. Walgreen is better positioned than most to stand up to the PBMs because of its large market share. Smaller pharmacy chains like Rite Aid (RAD) have much weaker bargaining positions.
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