Let's take a look at the mail versus retail tradeoff as framed by CVS Caremark. Frankly, I remain puzzled by the economics of CVS Caremark's Maintenance Choice program even after last Friday's 2009 Annual Analyst/Investor Meeting. Maintenance Choice may be a profitable business strategy for CVS Caremark, but I have a hard time understanding how retail dispensing is more profitable than mail dispensing. As always, I'd welcome your thoughts on what I'm missing here.
CVS Caremark CFO Dave Rickard spent a lot of time at last week's meeting explaining Maintenance Choice. Download the "2009 Annual Analyst/Investor Meeting Presentation Part Two" from this page and start reading on page 32 of the PDF file.
He presented the following "illustrative example," which raises more questions for me than it answers.
Here is my take on the underlying assumptions baked into this slide.
- Assumption 1: Gross margin percent is equal at both the retail and mail facility. This is probably true for employers that opt for Maintenance Choice because CVS Caremark is agreeing to receive the same reimbursement at retail and mail. Note that this situation appears quite different than the typical arrangement described in Reality Check on Mail Economics. (I know you don't believe me, but it seems to be true on average.)
- Assumption 2: If a CVS pharmacy is working below its maximum capacity, then the cost of dispensing extra scripts from the retail store is very low because most costs are fixed. This assumption also seems reasonable. Store-based retail pharmacies have high fixed costs relative to the incremental (marginal) costs of dispensing. Certain factors are required regardless of volume – a pharmacy license, pharmacists, insurance, rent, etc. Thus, filling the first prescription is very expensive, while filling the second prescription is not. An underutilized pharmacy that fills more prescriptions will see average cost per prescription go down, even as the low marginal cost remains constant. IMO, this logic also explains why Wal-Mart Stores' (WMT) $4 generic program is not necessarily a loss leader.
- Assumption 3: Regardless of capacity utilization, the incremental costs of dispensing a mail script are all variable. This is the crucial assumption because it leads directly to CVS Caremark's claim that shifting maintenance scripts from mail to retail is a profitable strategy.
- If mail is more expensive, why is Walgreens (WAG) expanding central fill as part of its POWER program? A central-fill mail facility is subject to the same type of fixed/variable cost analyses as a store-based retail pharmacy. The volumes are much, much higher at each facility compared to a typical store. Given the automation of a central-fill pharmacy, I believe that the incremental cost to fill a script would be lower than a store. The average cost to fill a mail script is also much lower than a store script.
- Why won't Maintenance Choice reduce the mail facility's capacity utilization, thereby unfavorably altering Caremark's average cost of dispensing? On the flip side, the loss of a single script will not make much difference to a mail facility that's dispensing millions of prescriptions. Yet CVS also claims that nearly half of all Maintenance Choice scripts shift out of mail to retail within three calendar quarters. (See the chart at the bottom of Debate Over CVS Caremark's Tactics Heats Up.)
- Why doesn't the slide allocate higher average physical distribution costs to retail scripts? The fully-allocated operating expenses for moving a product to the store for dispensing must be higher than dispensing from the mail warehouse. If the product is going to a store, then the product must be picked from inventory (in cases or units); packaged; shipped; delivered to a store; received by the store; held in a store's inventory; and then dispensed. If the product is dispensed at mail, then the product can be kept in bulk form; moved within the site to an automated pharmacy filling area, and then dispensed by machine.
However, I have some unanswered questions with the underlying logic:
One more curious factolito. Despite representing 70% of pharmacy revenues, CVS still considers detailed financial data (like gross margin) about the retail prescription business to be "not material." The "illustrative example" suggests a margin of 25%. Did we just see a financial disclosure?