A Strategic Look at CVS/TGT; Why We’re Still Bullish on RAD

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Richard Evans / Scott Hinds / Ryan Baum


203.901.1631 /.1632 / .1627

https://twitter.com/images/resources/twitter-bird-blue-on-white.png richard@ / hinds@ / baum@ssrllc.com


June 16, 2015

A Strategic Look at CVS/TGT; Why We’re Still Bullish on RAD

  • CVS’ acquisition of TGT’s pharmacies raises from 17.6% to 22.7% the percent of the US population living in areas where CVS cannot be excluded from a retail pharmacy network (at least one that complies with commonly-used proximity standards). And, the transaction also takes a major mass merchant out of the business of operating retail pharmacies
  • Both accomplishments are crucially important. CVS has reduced its exposure to markets in which it can be excluded from narrow networks, and eliminated a major competitor who likely would have priced aggressively as retail networks narrowed
  • This is a very clever strategy – but to work it must be pressed much further. Before the TGT transaction, persons living within a commutable radius of a CVS store could choose from an average of 9.2 supermarkets or mass merchants who operated pharmacies in that same radius – now the number is down to 7.9 – still a very large number. The average distance from a CVS outlet to a competing mass merchant or supermarket with a pharmacy was 1.9 miles, now it’s 2.0
  • Because of FTC/DOJ limits on pharmacy market share (generally 35%), CVS cannot acquire control of enough supermarket and/or mass merchant pharmacies to eliminate these outlets as a major source of pricing pressure. WBA also would need to get into the act, and potentially RAD as well (note that the effect of eliminating TGT as a pricing competitor benefits WBA and RAD just as much as CVS)
  • We can’t rule out that CVS and WBA will methodically seek control of the pharmacies that currently exist within supermarkets and mass merchants, and that they’ll pursue this strategy instead of acquiring RAD. If they do, RAD shareholders never benefit from an acquisition premium; however RAD shareholders would benefit (arguably as much as CVS and WBA) from the reduced presence of supermarkets and mass merchants – still a bullish outcome, just not so bullish as an outright acquisition

Where we’re BULLISH: Biopharma companies with undervalued pipelines (e.g. VRTX, BMY, SNY, ROCHE); Biopharma companies with pending major product approvals (e.g. ALIOF, ALKS, AMGN, BDSI, ENDP, HLUYY, HSP, ICPT, JAZZ, NVS, PTCT, RLYP, RPRX, TSRO, UCBJY, VRTX); ABBV and ENTA on sales prospects in Hep C; SNY on undervalued basal insulin franchise and sales potential for Praluent (alirocumab), in addition to its undervalued pipeline; AZN and LLY on the likelihood that excess SG&A/R&D spending must be reined in, in addition to pending major product approvals; CFN, BCR, CNMD and TFX on rising hospital patient volumes; XRAY and PDCO on rising dental patient volumes and rising average dollar values of dental products and services consumed per visit; CNC, MOH and WCG on bullish prospects for Medicaid HMOs; and, DVA and FMS for the likely gross margin effects of generic forms of Epogen

Where we’re BEARISH: Biopharma companies with overvalued pipelines (e.g. GILD, ALXN, SHPG, REGN, CELG, NVO, BIIB); PBMs facing loss of generic dispensing margin as the AWP pricing benchmark is replaced (e.g. ESRX, CTRX); Drug Retail as dispensing margins are pressured by narrowing retail networks and replacement of AWP (e.g. WBA, CVS, RAD); Research Tools & Services companies as growth expectations and valuations are too high in an environment of falling biopharma R&D spend (e.g. CRL, Q, ICLR); and, suppliers of capital equipment to hospitals on the likelihood hospitals over-invested in capital equipment before the roll-out of the Affordable Care Act (e.g. ISRG, EKTAY, HAE)

CVS’ acquisition of TGT’s pharmacies increases CVS’ share of US retail outlets by 3.3%, raising CVS’ share from 15.4% to 18.7%. WBA is next-closest at 16.1%, followed by RAD at 9.2% (Exhibit 1)

We’ve been arguing for several months that chain pharmacies are under mounting pressure from narrowing retail networks[1]. We’ve further argued that the chains’ best response to narrowing networks is to increase their market shares in whatever US markets they operate, ideally to a point at which networks cannot be designed that exclude a given chain[2]

We’ve also argued that pharmacy outlets located in mass merchants and supermarkets are a particular problem for the chains. This is because the mass merchants and supermarkets arguably should be willing to dispense prescriptions at or near cost, since these businesses make the vast majority of their sales from the ‘front’ store. Conversely the retail pharmacy chains obviously cannot afford to dispense at or near cost, since the majority of the chains’ sales come from the prescription counter

The CVS/TGT transaction is clever in that it both raises CVS’ market share, and eliminates TGT as an otherwise highly probable source of price competition – the problem is that both effects are somewhat limited; and, that the benefit of eliminating TGT as a source of price competition accrues to everyone, not just CVS

Before the CVS/TGT transaction, the average distance from a CVS outlet to a mass merchant or supermarket that operates a pharmacy was 1.9 miles; after the deal the average distance is 2.0 miles. And, the average beneficiary living within a commutable distance of a CVS outlet also had on average 9.2 supermarket or mass merchant operated pharmacies to choose from before the transaction. That number is now down to 7.9 – but that’s still an awful lot (Exhibit 2). So while taking control of TGT’s pharmacy outlets is a very clever way to both raise share and mitigate TGT as a competitor that leads with price, the problem of mass merchants and supermarkets who operate pharmacies and are likely to lead with price remains very real. Notice also that the benefits of eliminating TGT as a likely pricing-based competitor accrue to WBA and RAD, not just to CVS (Exhibit 2, again)

Shifting our focus to market share – rather than thinking simply in terms of share of outlets, we find it useful to think in terms of the percent of the population that lives in markets where a given chain, because of its large share of outlets, cannot be excluded from a compliant[3] retail pharmacy network. Before the TGT transaction, 17.6% of the population lived in areas where it was impossible to build a compliant network without including CVS; after the transaction, this figure rises by 5.1% to 22.7% — a respectable gain. By way of comparison, if CVS had instead acquired RAD, the percent of lives in areas where the CVS NEWCO could not be excluded from compliant networks would have jumped 9.1% to 26.6% (Exhibit 3)

We’re bearish on CVS and WBA, and we’re bullish on RAD. We’re bearish on the former because we believe gross margin pressures from narrowing networks are not fully reflected in current valuations; and we’re bullish on the latter because we believe acquiring RAD is the best single step either WBA or CVS could take to counteract the effect of narrowing networks

The CVS/TGT transaction arguably is consistent with our view of the mounting pressure on retail pharmacies from narrowing retail networks. The question is what the CVS/TGT transaction says about our bearish stance on CVS and WBA, and our bullish view of RAD

IF CVS and WBA could gain control of a critical mass of supermarket and mass merchant pharmacies, and IF this could be done at reasonable costs, these two leading chains would simultaneously gain market share as a counterweight to narrowing retail networks, and greatly reduce the prevalence of pharmacies whose operators are willing to dispense at or near cost – a highly attractive strategic outcome – in theory. In reality, our best guess is that FTC/DOJ limits on market share are the rate-limit to this strategy – i.e. we doubt CVS and/or WBA (and/or RAD) could (without exceeding FTC/DOJ thresholds) gain control of enough mass merchant and/or supermarkets to truly offset the impact of the remaining outlets’ presumed willingness to dispense at or near cost. Ultimately this is an empirical question, which we intend to answer using the relevant data

With respect to RAD, we remain bullish. The CVS/TGT deal raises the possibility that instead of purchasing RAD, WBA and CVS embark on a ‘store-in-store’ campaign of taking over the pharmacies that currently exist within mass merchants and supermarkets. Such a campaign presumably lowers the likelihood that either company bids for RAD, reducing the odds of RAD shareholders receiving an acquisition premium. However because this strategy reduces price competition from mass merchants and supermarkets, and because this benefits all remaining pharmacies (including RAD’s), we believe this too is a bullish outcome for RAD

  1. “WAG/RAD” Pressure on Generic Dispensing Margins”, 10/14/14; “WBA/CVS/RAD: There are Simply Too Many US Pharmacies”, 2/25/15; “WBA/CVS Can Fight Narrowing Networks by Buying RAD”, 4/6/15; “WBA/CVS/RAD: A NEWCO as Counterweight to Narrowing Retail Networks”, 5/4/15
  2. The Tricare / CMS standard requires that 90% of beneficiaries have an in-network pharmacy within 2 miles for urban beneficiaries, 5 miles for suburban beneficiaries, and 15 miles for rural beneficiaries. Conversely, the FTC/DOJ threshold for challenging pharmacy mergers is anything in excess of 35% market share at the MSA level
  3. To the Tricare / CMS standard
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