In my view, this deal represents a logical vertical integration within the U.S. pharmaceutical infrastructure – the network of companies that facilitate dispensing and payment of pharmaceuticals. It’s also the coverage area for this blog (which I called “Drug Channels” because it had fewer letters than the “Pharmaceutical Infrastructure Blog.”)
I have been studying how channels evolve for over 15 years. The following two guiding principles, which have motivated my research and consulting in many sectors of the US economy, can help explain the current deal.
- You can remove an intermediary but not the services provided by that intermediary. I am skeptical of the “PBMs add no value” critics because it is at odds with the marketplace realities. The PBM’s success reflects many individual business decisions by payers and insurers. If PBMs really added “no value,” then sophisticated payers would simply bypass them and perform the activity themselves. There are situations where this has occurred, but there has not yet been a rush for the exits.
- The services of an intermediary eventually migrate to the lowest cost provider of those services. PBMs heritage was in transaction processing, which was at one time a valuable service. As it became commoditized, they moved on to more complex services, such as formulary design. Like all intermediaries, innovative services often become part of core expectations, so further innovation is needed or disintermediation is at hand. Matthew Holt of The Helath Care Blog suggests that Caremark is sneaking out at the top, presumably because PBMs have reached the end of the line innovation-wise. I don't agree, as evidenced by the spirited debate that he and I are having over on his blog.
The confusion and uncertainty about the transaction stems from an inherent division of labor within U.S. Drug Channels. There are three major activity sets within this infrastructure:
- Product Movement from Manufacturer to Patient
Key intermediaries: Wholesalers, Retail Pharmacies, Mail Pharmacies, Providers
- Payment flow from Patients/Payers to Manufacturers
Key intermediaries: PBMs, Insurers, HMOs, Government
- Product Selection from Manufacturers to Physicians
Key Intermediaries: PBMs, HMOs
There is still much we don’t know about this deal, such as how the combined entity will work with other pharmacies to complete their retail network. See my comments in CVS/Caremark Creates Powerhouse, Unites Rivals:
But Fein adds that the fit could be awkward in other areas. In June, CVS acquired 700 Sav-On and Osco stores from Albertson's Inc. for $2.93 billion. While that helped the company solidify its national footprint, it still doesn't operate in all the markets covered by Caremark's dispensing network, which includes 60,000 retail outlets across the country. That network also includes a number of key rivals for CVS, among them Wal-Mart Stores Inc. (WMT) and Walgreen Co. (WAG).
"Strategically, Wal-Mart and Walgreen are going to have to make some tough decisions," Fein says. "I don't think they can sever their relationship with Caremark, because they need those customers. But they're going to be very nervous that Caremark could design programs that could favor CVS versus other programs.
Although the stock market doesn’t seem to love the CVS-Caremark deal, I still believe that it represents an inevitable compression of the industry.