A WBA/RAD or CVS/RAD NEWCO as a Counterweight to Narrowing Retail Pharmacy Networks

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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


May 4, 2015

A WBA/RAD or CVS/RAD NEWCO as a Counterweight to Narrowing Retail Pharmacy Networks

  • This note updates our argument that US retail pharmacy networks are likely to narrow, compressing pharmacy dispensing margins – and in particular focuses on our belief that a WBA/RAD or CVS/RAD NEWCO is better able to withstand such margin pressures
  • If we assume no payor is willing to construct a retail pharmacy network that violates the TriCare/CMS standards for pharmacy proximity, then as of today 19.1% of the US population lives in a geography where WBA must be included in pharmacy networks (because to exclude WBA would require violating minimum access standards). For CVS this value is 17.6%
  • After controlling for divestitures, 28.8% of the US population lives in a geography where a WBA/RAD NEWCO could not be excluded from the pharmacy network, and 26.6% live in a geography where a CVS/RAD NEWCO could not be excluded
  • We reiterate our viewpoint that RAD is a highly valuable strategic asset to either WBA or CVS, and so is reasonably likely to be acquired. We further reiterate that either deal is likely to be highly accretive, despite RAD’s recent outperformance

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)


Previously we examined the drivers behind increasingly narrow retail pharmacy networks.[1] Total growth in retail prescription dispensing margins has outpaced growth in drug prices (Exhibit 1) as well as the gross profits of all other major retail settings (Exhibit 2) for the observable look-back periods. This cannot be attributed to a lack of willingly competitive entrants; over a third of US prescriptions are dispensed either by mail order pharmacies or by pharmacies located within mass merchants or supermarkets – pharmacy operators who presumably would be motivated to discount for either prescription volume (mail order) or front-store volume (mass merchants and supermarkets) – and, mass merchant/supermarket pharmacies have ample locations in close proximity of chain pharmacy outlets. Nor is the issue a scarcity of outlets; in gauging the adequacy of retail pharmacy supply by applying the CMS/TRICARE standard for access to outlets[2], we estimate that over a third of national outlets can be considered ‘surplus’, i.e. in excess of what is required to maintain acceptable access

Our theory is that pharmacy dispensing margins have grown in real terms not because of an excess of seller power, but because of unused buyer power. The vast majority (92%) of US prescriptions dispensed at retail are paid for by a third party, and until recently third party payors structured benefits in such a way that beneficiaries’ costs were the same regardless of which pharmacy they used. As a result, retail pharmacies had no reason to lower pharmacy dispensing margins (to insured customers), because it would have no effect on the prices customers paid. However with most highly elastic seniors and a growing number of commercially insured choosing prescription coverage based in large part on monthly premiums, the ever-large pie of retail dispensing margins represents a significant source of potential savings to PBMs and HMOs, accordingly the trend toward narrow retail pharmacy networks should at the very least continue, and will in all likelihood accelerate. For the sake of argument, if we assume that retail dispensing margins could be rolled back to their real year 2000 levels[3], the cost of the average commercial drug benefit and Part D benefit alike would fall by 7 percent (Exhibit 3) – nearly as much (+/- 8%) as PBMs and HMOs generate in average rebates per retail prescription – with great effort[4]

Greater market share can moderate pressures on dispensing margins

In the wake of last year’s gross margin warning signals from WBA and RAD, the traditional chains have variously sought to contain concerns about dispensing margins as having multiple causes, and being largely near-term in nature. In sharp contrast, we see narrowing retail networks as the main driver of margin compression, and believe the trend will only accelerate in the coming years[5]

As we previously argued[6], an obvious way for either CVS or WBA to mitigate the effects of narrowing retail networks would be to acquire RAD. Even after DOJ/FTC-required divestitures, as the next biggest kid on the block RAD would increase either suitor’s total number of outlets by over 40 percent and significantly grow either suitor’s (population-weighted) average market share – we estimate a 7.8 percent boost for WBA or 6.1 percent for CVS (Exhibit 4). The operating margin leverage from refining RAD’s relatively bloated cost structure would greatly aid accretion. Despite recent rumors we see little evidence that any substantial acquisition premium is already priced into RAD’s valuation

An alternative way to consider the benefit of becoming bigger through acquisition is to estimate how many people live in areas where a given chain’s outlets simply cannot be excluded from a network without violating the aforementioned Part D standard for minimum pharmacy access. Using zip code-level data on pharmacy counts and demographics, we estimate that 19.1 percent and 17.6 percent of the national population reside in zip codes where it’s presently infeasible to exclude WBA or CVS, respectively. In other words, omitting either WBA or CVS from a pharmacy network in those areas would leave those beneficiaries with an unacceptably small number of outlets to conveniently choose from, at least from the TriCare/CMS perspective

To quantify the benefit of acquiring RAD from this angle, we then simply calculate the incremental percentage of the population living in areas where the hypothetical WBA/RAD or CVS/RAD NEWCO would be un-excludable from networks. We can’t simply add up the acquirer’s and target’s existing outlets by zip code to reach revised inputs due to divestiture requirements; however FTC/DOJ precedent is for these requirements to be set at the broader MSA level. Therefore we conservatively assume the acquirer would have discretion in choosing which stores to jettison (by MSA) and logically would satisfy divestiture requirements by selling off stores with the lowest traffic[7]. This yields our estimates of WBA/RAD and CVS/RAD fully-divested NEWCO outlet presence by zip code. We again calculate the percent of the population living in areas that cannot afford to lose the NEWCO’s presence vis-à-vis the CMS standard; 28.8 percent of the country lives in areas where a WBA/RAD NEWCO is effectively immune from narrow networks, and 26.6 percent lives in areas where a CVS/RAD NEWCO would be protected (Exhibit 5)

  1. “WBA, CVS, RAD: There Are Simply Too Many Pharmacies & Now it Starts to Matter”, SSR Health LLC, February 25, 2015
  2. The TRICARE standard, which has been adopted by CMS, requires that 90% of beneficiaries have access to at least 1 network pharmacy within 2 miles of their urban residence, within 5 miles of their suburban residence, or within 15 miles of their rural residence
  3. The choice of 2000 is more or less random; however the notion that pharmacy dispensing margins could be rolled back to +/- year 2000 real values is entirely realistic, since the costs of operating a retail business arguably should have inflated at more or less the rate of CPI
  4. We estimate the average difference between list price sales for brands and net sales for brands is 30% (see “Outlook for Brand Drug Pricing, Part 1”, SSR Health LLC, January 20, 2015), and that brand sales are roughly 28% of retail dispensing; 30% x 28% = 8.4%
  5. “WAG/RAD: Pressure on generic dispensing margins likely to be much more permanent than guidance implies”, SSR Health LLC, October 14, 2014
  6. “CVS, MCK, RAD, WBA: How WBA or CVS can fight narrowing retail networks – buy RAD”, SSR Health, April 6, 2015
  7. Specifically, we assume the outlets prioritized for divestitures are those with the smallest population share as calculated by outlet share × zip code population. We also assume they would prioritize zip codes where there are at least three total outlets, otherwise our algorithm would unreasonably suggest completely exiting a number of smaller markets
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