Merger of Rivals Gives CVS Caremark Advantage in Drug Wars

The recently announced merger of Express Scripts (ESRX) and Medco Health Services (MHS), two of the largest pharmacy benefit managers (PBMs) provides an excellent opportunity for CVS Caremark (CVS) and their investors.

As I wrote previously, I think CVS is undervalued on a sum of the parts basis. The proposed merger adds credence to my case. ESRX is purchasing MHS for 13x EV/EBIT while by my estimates, the market is valuing the Caremark segment as low as 5x EV/EBIT.  If the merger is completed, ESRX-MHS will have a 40% market share compared to around 16% for Caremark.

While the emergence of a larger rival may seem like bad news for CVS, it does provide opportunity on several fronts. Earlier this year, CVS won several big contracts from MHS and the pending merger (and management attention focused on the integration) may drive clients to look elsewhere.

The best opportunity for CVS is the pressure the merger puts on their fiercest retail rival, Walgreen (WAG).  WAG is currently embroiled in a public dispute with ESRX, and if a deal isn’t worked out by year end ESRX clients and their employees will be unable to fill their prescriptions at WAG. With the pending merger and a 40% market share, ESRX now has a lot more leverage in the dispute.  No matter what the outcome, CVS should be able to pressure WAG for major price concessions.  The same holds true for small pharmacies as well, meaning the CVS retail stores could benefit from better pricing negotiated by the Caremark division.

The future looks bright at CVS with demographic trends and the competitive environment providing tailwinds. At a recent $37, there still looks to be some upside for investment gains.

Disclosure: None

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