ESRX-MHS Part 1: Last stand of the PBM pure play: observations on the Medco-Express combination

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UNH’s decision to take the commercial PBM business in-house did not force MHS into ESRX’s arms: I would argue that it removed the major roadblock to what the companies wanted to do anyway. MHS and ESRX had been talking about a merger off and on for few years (per WSJ reporting) and the logic (laid out below) is compelling but FTC concerns must have kept getting in the way. UNH’s decision doubled the size of its PBM subsidiary in terms of lives (somewhat less in terms of scripts because the legacy Medicare business has a lot more scripts per life) and committed UNH market muscle to compete in the pharmacy benefits space – thereby graduating Prescription Solutions to the PBM big leagues and creating a viable argument to the FTC. (MHS recent commercial stumbles and declining relative market cap also probably helped settle another key barrier to a deal – which team was going to get the corner offices…)

The deal vastly expands the generic purchasing scale at a critical moment. While MHS has been aggressively growing other margin source (services, specialty, etc.), mail generics still drive 50% of the gross profit (see below for Medco) and critical to get right.

The CVS-CMX combination introduced a new level of purchasing scale which neither MHS nor ESRX could match. That kind of purchasing clout may matter less when most generics are mature and the most important drugs have 5 to 8 manufacturers. But it becomes critical at the early stages of going off-patent when there may be just 1 or 2 generic manufacturers: scale determines who gets access to the (initially limited) supply and can use leverage to get a good price before suppliers proliferate. The upcoming generics wave would have provided CVS-CMX with a chance to really display their purchasing muscle. ESRX-MHS has to combine to be able to remain competitive. Even so, the combined organization will still have only a little more than half the purchasing scale of CVS-CMX (see table below: note that CVS retail scripts do not provide as much leverage as the mail scripts because the mix is more acute than chronic and the 90 day retail script program blurs the distinctions a bit but the order of magnitude remains clear…no doubt relative purchasing scale will be one of the arguments advanced by ESRX-MHS at the FTC).The deal also marries complementary capabilities. The ESRX “Consumerology” story about influencing consumers towards cost-effective choices is well positioned to address the next big thing in pharmacy benefits (the looming generics wave). MHS, on the other hand, is well positioned two steps down the road with its clinical depth and capabilities in personalized medicine (which I am guessing have had a relatively marginal impact on costs to date but I think will become critical in managing the future headache of specialty). Bringing the two organizations together provides a clear near-term step one (generics), medium-term step two (personalized medicine) path for the medium term.

The deal creates some opportunity to optimize the mail capacity. I estimate that MHS is running mail capacity at 65-70% utilization even before the recent losses. Recent MHS losses are not enough to justify taking out one of their three main mail facilities, especially with reform’s coverage expansion looming around the corner. If MHS stayed as a stand-alone, it would be stuck running at a lower level of capacity utilization for next 2-3 years. On the other hand, I estimate that ESRX is operating at 90%+ utilization and has little room to meet demand just as Rx demand is picking up (see Wellpoint reporting uptick in pharmacy utilization in Q2) and ESRX is getting to work driving mail penetration in the acquired WLP book (which I estimate at 15% vs. the ESRX legacy rate of 25%). Together, MHS+ESRX could close one of the older mail facilities (or close two older ones and open a new one) and still have enough capacity to meet medium-term demand. (Note: I will put out more detail on scenarios for the mail facilities in a separate post.)
Finally, the deal reinforces the ability of pure play PBMs to preserve the wide retail network as the market standard. Narrow networks play into the hands of smaller PBM players by substituting scale for share as the currency of leverage. (Recall it was the biopharma rebates being driven by script share which encouraged health plans to forward integrate into the PBM business through various hybrid models in the early 2000’s and it was the rise of transparency contracting – removing the script share-rebate issue from PBM economics — that helped drive them divest out of it recently. In this context, it is interesting by the way to note that Prescription Solutions is exploring a narrow network offering). Narrow networks are also not the kind of games a stand-alone PBM wants to play vs. CVS-CMX which can exploit the vertical synergies. Had WAG left the ESRX network, one of two things would happen: ESRX would lose accounts in droves or ESRX’s 20% of lives figured out they could make do and narrow networks might become much more acceptable to a market hungry for savings — neither good for the big pure-play PBM. However, ESRX+MHS is too big for WAG to walk away, and the combined entity can protect the wide network as the market standard – and reinforce the value of its core advantage in scale.
Implications:
The PBM landscape increasingly diversified: ESRX-MHS will be the last major pure-play PBM. Despite speculation, CVS-CMX still appears committed to the combination of PBM and retail pharmacy and continues to innovate distribution models and leveraging bricks and mortar into addressing healthcare cost. Prescription Solutions, on the other hand, nestled in the Optum world will likely lead with integration of broader health management capabilities of OptumHealth and OptumInsight with the pharmacy benefits; perhaps driving hard on outcomes risk funded by the deep pockets of the parent. Diversified suppliers should help break open a marketplace accustomed to 95%+ retention rates.
UNH’s Prescription Solutions will need to bulk up fast. They fall far behind in purchasing scale and will need to make it up fast if they are going to make a serious play for business outside the UNH book. Acquisitions are the way to get there quickly in time for the generics wave. Look for SXC, Catalyst and other small PBM deals to get there. Prescription solutions will also need some mail facilities. I estimate that their capacity at Overland Park, KS and Carlsbad, CA will be tapped out absorbing the commercial business and there won’t be room to grow with reform or even with cyclical demand growth as the economy improves. Available mail capacity may help prioritize acquisitions.
ESRX-MHS will need to hold the line vs Prescription Solutions health management gambit in order to be able to outflank with purchasing scale. This may lead MHS-ESRX to dig deeper into building out its own health management capabilities or seeking stronger ties with incumbent vendors to make its willingness to be play nicely with all health management vendors come across as seamless not just agnostic.