Friday, November 06, 2009

CVS Caremark: Pharmacy Gain, PBM Pain

CVS Caremark disclosed unexpected problems in its PBM business yesterday, spooking investors and sending its stock down by 20%. See Dow Jones’ coverage: CVS' Pharmacy Benefit Struggles Renew Merger Benefits Debate

Judging by the financials, it sure looks like CVS Caremark has sacrificed its PBM business for the benefit of the retail pharmacy business. They are also having trouble explaining how a PBM customer gains when a brick-and-mortar pharmacy is paired with a benefit management business.

Adding insult to injury, CVS Caremark also disclosed that the Federal Trade Commission (FTC) has opened a formal inquiry into its business. Ouch.

Pembroke Consulting retainer clients and Gerson Lehrman Group customers should feel free to schedule phone calls with me for additional comments beyond what's in this post.

Here are the primary sources for your reading pleasure:

Despite the bad news about the PBM business, the retail pharmacy segment posted another quarter of above-market growth. CVS pharmacies’ same store sales grew by 8.0%. Maintenance Choice accounted for 250 basis points of this increase, demonstrating how the program is helping to grow the company’s retail pharmacy market share. See my recent pharmacy report for more on Maintenance Choice and its impact on the market.

The positive synergy for the pharmacy business is apparent from the growing share of CVS' retail prescription revenues coming from CVS Caremark’s PBM businesses. In two previous posts (here and here), I describe how to use the accounting construct called intersegment eliminations to measure this effect. The chart below shows how important the PBM business has become to the brick-and-mortar pharmacies.

The PBM share at CVS stores was fairly flat in the two years after the Caremark acquisition (2007 and 2008). Since 2008:Q4, we’ve seen PBM business at CVS pharmacies increase by 520 basis points to 21.4% of prescription revenues. In other words, more of CVS’ pharmacy revenues is coming from its own PBM businesses. CEO Tom Ryan even validated this fact on the earnings call, stating:
“PBM is helping the retail business. The retail business is taking share from other players in the business.”
Left unsaid is the risk that further losses in the PBM business could reverse this beneficial effect.

Two technical notes for those who care about such details:
  • To provide a clearer picture of the retail business, I compute the figure differently than CFO Dave Rickard because I use prescription revenues from CVS pharmacies as the denominator.

  • The intersegment figures from the most recent two quarters are artificially inflated because RxAmerica contracts were moved from "net" to "gross" accounting in Q2:2009. The dotted line in the chart above shows my estimate of an apples-to-apples comparison. The retail revenue synergy is still increasing but a bit less impressively.

How does patient care improve when a PBM owns a brick-and-mortar pharmacy chain? What are the hard-dollar cost-savings from Maintenance Choice for the payer? And how exactly does a payer benefit when CVS increases its pharmacy market share?

These are reasonable questions—and ones that CVS Caremark is apparently having a hard time answering to the satisfaction of payers. Listen to CEO Ryan from yesterday’s conference call:
“I think it’s fairly common knowledge that our message early on was not clear, to be honest. It was not simple for managers, benefit managers to understand. It focused a little too much on the retail side of the business as opposed to a coordinated effort…”
The company expects to lose PBM contracts worth $4.5B in revenue—more than twice the $2B figure disclosed in its last earnings call. CVS Caremark also lost $1.7B of Medicare Part D business as I highlighted in CVS' Losses in 2010 Part D Enrollment.

These contract losses are occurring despite what I perceive to be a profitability sacrifice baked into the combined offering. The company contends that its prescription profits increase when consumers move from a mail-order to a brick-and-mortar pharmacy. But the underlying economics don’t make sense (at least to me) as I explained last May in The Odd Economics of Maintenance Choice.

In other words, it looks like the company is effectively reducing its own profitability, yet not reaping the benefits of increased PBM market share.


CVS Caremark management faced very tough questions from investors and analysts on yesterday’s call. The combination has now moved from a “show me how you’ll make it work” situation to a “show me why you shouldn’t just spin off the PBM” story. It will be interesting to see how the FTC approaches this confusing situation.

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