Thursday, May 21, 2009

The Odd Economics of Maintenance Choice

Thank you for posting so many thoughtful and detailed reactions to yesterday's post (Reality Check on Mail Economics). I appreciate your trust in allowing Drug Channels to be a forum for open discussion of complex topics in the industry.
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.

  • However, I have some unanswered questions with the underlying logic:

  • 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.
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?


  1. AnonymousMay 21, 2009

    Keep in mind that CVS Caremark requires payers to implement either 'mandatory mail' or significant copayment penalties on retail maintenance drugs to qualify for Maintenance Choice. So some of the risk on mail vs. retail margin is being offset by an overall increase in market share.

  2. AnonymousMay 21, 2009

    Central fill is BS. You should read what walgreens pharmacists think about this brilliant corporate move:

  3. AnonymousMay 21, 2009

    Although the economics may be close to a wash for CVS, it seems to me that maintenance choice is more of a marketshare play and business preservation strategy. If the CVS retail is filling the Rx versus mail, they are more capable of preserving marketshare, even when/if the PBM is changed. It is also a disruption threat to strengthen renewal chances.

  4. AnonymousMay 22, 2009

    Cost of Goods Sold is calculated differently for retail than for mail order by CVS-Caremark as well as others like Medco or Walgreen.

    For retail, COG is ingredients + allocated shipping and handling cost ala 263a. Pharmacy Labor and pharmacy facilities costs are SG&A. This is typical for how all retail companies account for COG --only items purchased for resale.

    Mail order is treated more like a manufacturing operation where COG includes both ingredients (items for resale) but alo direct and manufacturing indirect labor plus facilities allocated to manufacturing.

    Thus, nominal comparisons of COG and margins of retail pharmacy -- generally around 22% to 24% to mail order pharmacy -- generally around 8% to 10% -- really is an apples to oranges comparison.

    Setting aside the anomolies of GAAP accounting, the question of true margin differences comes down to differences in fill costs as it is likely that reimbursement revenue and ingredient costs are the same across channel for maintenance choice.

    See the following from CVS-Caremark's 10-Q noting how they only say "operating costs" apply to mail.

    Gross profit includes net revenues less cost of revenues. Cost of revenues includes (i) the cost of pharmaceuticals dispensed, either directly through our mail service and specialty retail pharmacies or indirectly through our national retail pharmacy network, (ii) shipping and handling costs and (iii) the operating costs of our mail service pharmacies, customer service operations and related information technology

  5. re: Gross profit calculation

    I did not realize how CVS was defining "cost of sales" - very interesting. It suggests that the gross margin comparison makes retail profitability look better than it should versus mail. I'll have to investigate further.

    Thanks for the comment,

  6. AnonymousMay 22, 2009

    Remember, the mail model requires mail. Just this week the CEO of a company with a mail component offered the comment that it costs approximately $8 to mail an Rx. That makes the "cost" differentail on the pie charts more understandable.

  7. Al GodleyMay 25, 2009

    I find this debate very interesting. Having been to a mail/central fill facility I was amazed at what they could crank through! No way the real/comparable costs are more than retail unless it is vastly under utilized and overhead is killing them. I think the post on "cost" calculation shared good insights. Thanks for keeping us informed!

  8. The CVS maintenance program seems to border on the illegal. They are forcing their Caremark insured customers to order all their maintenance drugs from CVS otherwise the cost of the drugs will not be covered under the Caremark insurance plan. If this is not stopped it will drain all persons with maintenance drug requirements such as Lipitor, Toprol etc. from all other pharmacies both large and small.

  9. AnonymousMay 17, 2010


    No mention of cost of goods via "class of trade". Mail order as a "closed" pharmacy is able to purchase inventory at an advantage over a "retail"
    pharmacy. The product dispensed should have a higher cost in the retail pharmacy