Tuesday, February 08, 2011

CVS Caremark: Still Searching for Synergy

Last Thursday, CVS Caremark (NYSE:CVS) reported another disappointing performance by its pharmacy benefit management (PBM) business.

I last checked in on CVS Caremark after their October 2010 investor day in More Happy Talk, But Hard Work Remains. In its latest results, the company was not even able to meet the lowered expectations for its PBM business that the company had set for itself just three months ago.

There were also some unexpected surprises. Caremark now has negative revenue synergy for CVS retail pharmacies, which is a reversal of previous trends. At the same time, a combined pharmacy chain/PBM apparently does not seem to generate enough value for plan sponsors, so Caremark has resorted to more aggressive price competition for PBM business. Details below.

The company has now lowered the bar further for its long-promised turnaround. Unless there is major progress, I still predict a 2012 Caremark spin off for the reasons outlined in When will CVS and Caremark split up? Comments by new CEO Larry Merlo suggest that this scenario is now under active consideration.

As always, Pembroke Consulting and Gerson Lehrman Group clients can schedule phone calls with me for additional insights beyond what I discuss in this post.

Background materials for 2010:Q4 for your reading pleasure:
Here are my observations on the latest quarterly results.

Caremark now has negative synergy for CVS retail pharmacies. CVS’ same-store pharmacy (prescription) revenue growth began outpacing Walgreen's (NYSE:WAG) growth in 2008 due to Maintenance Choice, which cannibalized the Caremark mail pharmacy in favor of CVS stores.

In contrast, CVS' same store pharmacy growth would have been negative in the fourth quarter of 2010 without Maintenance Choice. Caremark’s loss of momentum is now hurting the CVS retail business. As the chart above shows, same-store growth is now roughly equal at Walgreens and CVS.

The numbers:
  • CVS’s same store pharmacy growth was 2.0% (200 basis points).
  • Maintenance Choice increased same-store pharmacy growth by approximately 300 basis points on a gross basis (or 220 basis points on a net basis that accounts for cannibalization of existing 30-day CVS retail scripts).
  • Caremark represents about 23% of revenues at CVS retail pharmacies.
Synergy = Competing on price? Here’s a statement from Larry Merlo, speaking in a dialect called Corporate Doublespeak: “Now since that time, our estimates of the impact of renewal pricing became more clearly quantified, and have resulted in more margin compression than we expected.” In response to a question, Per Lofberg highlighted contract renegotiations that “reflect current competitive market conditions,” leading to “margin erosion.”

Adam's translation: Over the past three months, we have desperately cut price to prevent contract losses. Hmmm, if the combination of a large PBM and a large pharmacy chain is such a smashing success, why does CVS Caremark need to compete on price? Shouldn’t the PBM be commanding a price premium from plan sponsors?

Could Caremark compete more effectively without CVS? Many of the company’s combined offerings seem beneficial to patients and plan sponsors. So why can’t they be shared? Why can’t Pharmacy Advisor (~10 million lives) be rolled out to non-CVS network pharmacies?

Why can’t Maintenance Choice (~600 clients with 7.4 million lives) be opened up to any retail pharmacy that is willing to accept Caremark mail reimbursement levels? Yes, I know it’s the mail vs. retail profit trade-off, but Walgreens seems quite willing to accept mail-order reimbursement levels in their stores. (See Walgreens Joins the Attack on PBM Mail Profits.) If a program works, plan sponsors will want to expand availability.

The spin-off scenario is in play. Tom Ryan will be departing even earlier than last May's earlier-than-expected departure. Note Larry Merlo’s carefully worded statement on the earnings call: “one of my top priorities will be to ensure that the CVS Caremark merger is financially successful for our shareholders.” To my ears, it sounds like the door is clearly open for CVS to spin off Caremark because shareholders might make more money owning two independent companies. I wonder how many shareholders are holding the stock for this very reason.

Of course, it’s difficult for an outsider to get perspective on what’s really happening at the top levels of this organization. Perhaps management is honoring Ronald Reagan’s 100th birthday by continuing to look for the pony.


  1. Thanks for the great article. What will happen to the value of CVS stock if the spinoff occurs? What will be the result for the shareholders?

  2. First, let me remind you that I do not make investment recommendations, on this website or otherwise. So I will address your question in a general way.

    The market valuation of CVS Caremark together is less than the implied value of a peer PBM + a peer retail pharmacy. In other words, the stock market says 1+1<2.

    Assuming that (a) Caremark is not fundamentally damaged, then presumably the value of the two companies alone would be comparable to peers, so 1+1=2.

    However, the analysis is not so simple because there are some synergies, especially in generic purchasing and for CVS retail.


  3. Great post, as usual.

    Now for the important question. Do you own the cel of Daffy Duck shown in the latest Drug Channels?