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CVS Acquires Target Pharmacies: An “Evolving Duopoly”
Jun 16, 2015 04:59 pm
Following
last months acquisition of Omnicare, in a deal valued at $12.7 billion,
CVS Health announced Monday that it will be acquiring Target’s pharmacy and clinic business for an estimated $1.9 billion. The 1,600 stores acquired from Target in the deal will be branded CVS Pharmacy, marking the first use of the “store within a store” model by CVS.
The deal will make CVS Health the largest retail pharmacy chain in the United States with an estimated 9,200 stores. Walgreens will now have the second largest retail pharmacy footprint with 8,200 stores.
News of this acquisition should be concerning to pharmacy owners, beneficiaries, and the Medicare Part D program as a whole.
An “Evolving Duopoly”
In their 2013 report titled Pharmacies and Drug Stores in the U.S.,
IBISWorld described the state of the industry as follows:
The industry is primarily an
evolving duopoly, with major players Walgreens and CVS dominating the industry. This trend is expected to continue, and these two companies are the primary beneficiaries of ongoing consolidation. The top three industry players (i.e. Walgreens, CVS and Rite Aid) generate more than half of total industry revenue. As these major players grow in size, it becomes more difficult for potential entrants and independents to compete with the resources and brand recognition of these companies.
Today’s announcement represents a further evolution of this growing duopoly as CVS Health will now control a 23% share of U.S. retail pharmacy revenue (according to non-mail order
pharmacy revenues in 2014).
“Lack of Scale” and an Inability to Compete
Rite Aid, which accounts for 8.3% of retail pharmacy revenues and operates 4,600 stores, has expressed their concerns about the impact this duopoly will have on their business. In their 2014 10-K filing1, Rite Aid discusses their position in the retail pharmacy market:
We face intense competition with local, regional and national companies, including other drugstore chains, independently owned drugstores, supermarkets, mass merchandisers, dollar stores and internet pharmacies. Competition from discount stores has significantly increased during the past few years. Some of our competitors have or may merge with or acquire pharmaceutical services companies, pharmacy benefit managers, mail order facilities or enter into strategic partnership alliances with wholesalers, which may further increase competition.
We may not be able to effectively compete against them because our existing or potential competitors may have financial and other resources that are superior to ours. In addition, certain of our competitors entered into the pharmacy benefit management industry before us, and there is no assurance that we will successfully compete with entities with more established pharmacy benefit management businesses. Further, we may be at a competitive disadvantage because we are more highly leveraged than our competitors. The ability of our stores to achieve profitability depends on their ability to achieve a critical mass of loyal, repeat customers. We cannot assure you that we will be able to continue to effectively compete in our markets or increase our sales volume in response to further increased competition.
A retailer with 4,600 pharmacy locations expressing concern about its ability to compete in the retail pharmacy market is a red flag. However, these concerns are not isolated to Rite Aid and appear to have motivated Target.
The New York Times writes that “on a conference call with analysts, Brian Cornell, Target’s chief executive officer, said that while the CVS deal would reduce the retailer’s sales by more than $4 billion annually, it would also significantly reduce its costs, which were high because of the retailer’s lack of scale in the pharmacy business.”
In the same article, the New York Times also points out that “Target’s pharmacies earned favorable marks from consumers, performing above the average for mass merchandisers in a
2014 J. D. Power study of customer satisfaction with pharmacies. CVS, by contrast, scored below average for chain drugstores.”
After Target, Who Will Be Next?
Back in March of this year, Stefano Pessina, CEO of Walgreens Boots Alliance,
spoke of Walgreens’ pharmacy-related merger and acquisition strategy and said “the next big one will probably be in the U.S. because it is such a big market. It is a fascinating market. It is similar to what we had in Europe 20 years ago because the intervention of the government changes all the rules.”
These comments, along with the pattern of market consolidation we have seen in recent months and years, have fueled numerous suggestions that Walgreens will acquire Rite Aid2 (and, to a lesser extent, Express Scripts3).
We do not seek to speculate on the merger and acquisition strategy of CVS and Walgreens. However, we
can say that the acquisition of Rite Aid, its $18.3 billion of pharmacy revenue last year, and its 4,600 stores, would increase Walgreens market share to nearly 31% of 2014 retail pharmacy revenue and roughly 12,800 stores. Of even greater significance, such a move would give over 51% market share to two firms.
Implications for Part D Plans
The CVS and Target deal does not specifically impact Medicare Part D, but the general pattern of vertical (and in this case horizontal) integration certainly does. Without eliminating barriers to entry for, or providing guarantees to protect, small-business pharmacies, the economic theory supporting preferred pharmacy networks quickly erodes. As we’ll discuss, the longer CMS waits to support small business protections in Part D, the harder it will be to undue the damage.
The Economics of Preferred Networks
In a widely cited study from 2013 titled
Selective Contracting in Prescription Drugs: The Benefits of Pharmacy Networks by Joanna Shepherd, the author outlines the economic theory behind preferred pharmacy networks. The paper specifically addresses “any willing pharmacy” legislation at the federal and state level, and concludes that such efforts restrict the ability of plan sponsors to negotiate discounts that “guarantee” greater volume to a narrow segment of pharmacies.
The author concludes that:
When drug plans have the ability to exclude pharmacies from their network and steer patients elsewhere, pharmacies compete aggressively for selective contracts by offering price discounts for filling prescriptions. In general, more exclusive networks produce greater competition because they promise to channel more patients to network pharmacies. As a result, more exclusive networks generate even steeper price discounts.
Let’s accept that as true and then consider analysis by the Congressional Budget Office (CBO) in their 2014 report titled
Examining the Number of Competitors and the Cost of Medicare Part D. One aspect of Part D competition examined by CBO was “Interactions with Plan Size”, or how the number of beneficiaries enrolled in a plan affects how aggressively the plan will pursue lower costs.
CBO found the following:
We observe that as a plan becomes larger, it becomes less sensitive to competition (among plans that do not primarily serve low-income beneficiaries). One additional plan sponsor in an 18-firm market is associated with a bid 0.06 percent lower ($0.05 for a plan that bid $85) for a plan sponsor enrolling 5 percent of the regional beneficiary pool, all else being equal. Conversely, the bid of a plan enrolling only 0.25 percent of the regional beneficiary pool is 0.6 percent lower ($0.56 for a plan that bid $85), all else being equal.
In their conclusion, CBO goes on to estimate that “the loss of four plan sponsors, as occurred between 2007 and 2010, is estimated to have cost the government between $27 million and $68 million each year.” But what about the plan sponsors lost since 2010 (when Part D offered 1,576 plans)? This year Part D offers 1,001 stand-alone prescription drug plans, which is down from 1,875 in 2008 and the lowest number ever offered. While the prevalence of preferred pharmacy networks and the market consolidation trend have grown, the bidding environment has become less competitive.
Cost Increases: Do Beneficiaries Respond?
Let’s consider one final variable: the rate at which beneficiaries switch plans.
In the study
Selective Contracting in Prescription Drugs: The Benefits of Pharmacy Networks, which we discussed above, the author examines the issue of “convenient access” via data provided to her by Express Scripts. She concludes the following:
Express Scripts’ customers that choose more exclusive network options pay less for the prescription drug costs of their covered individuals. Moreover, concerns about access to care are largely unfounded: far more individuals covered under Express Scripts’ networks have convenient access to network pharmacies than would be required under governmental standards. This result demonstrates how
the intense competition among PBMs for sophisticated clients ensures that PBMs will offer the accessibility that consumers want in their pharmacy networks.
But does this really happen? For the most part, no.
In a 2013 report titled
To Switch or Not to Switch: Are Medicare Beneficiaries Switching Drug Plans to Save Money? the Henry J. Kaiser Family Foundation found that 7 out of 10 Medicare beneficiaries enrolled in Part D from 2006 to 2010 did not voluntarily switch plans in any of the four enrollment periods, even though those who switched plans often lowered their out-of-pocket costs as a result. Most beneficiaries whose premiums increased $10 or more per month did not change plans.
The Big Picture
The implications of the market consolidation taking place in the U.S. retail pharmacy industry are enormous. But they are especially pronounced in Part D. Let’s consider the big picture.
- With CVS and Walgreens now operating nearly 17,400 U.S. pharmacies, these two firms are one acquisition away from eclipsing the number of stores operated by all independent, small business pharmacies. Small businesses are typically guaranteed 23% of federal contracts or 36% of contract revenue, but CMS has chosen not to apply these requirements to Part D.
- As more and more plans and plan sponsors disappear from Part D, those with the greatest share of beneficiaries bid less aggressively, increasing costs to the federal government.
- With so few beneficiaries responding to cost increases and changing plans, the consequences of an insufficiently aggressive bid are reduced.
- The economics of Part D require new plan sponsors interested in entering the market to bid lower than large, existing plans.
- As the market share of CVS and Walgreens grow, there are fewer and fewer pharmacy chains that can participate in new plans to create pharmacy networks with great access for beneficiaries.
- New Part D beneficiaries have fewer choices as a result of the above (not to mention the bandwagon effect enjoyed by the largest plans).
The incorporation of
small business contracting requirements, which the Secretary of Health & Human Services may apply to Medicare Part D with the regulatory authority they are granted under the law, is the best way to promote competition, guarantee adequate levels of access, and protect Part D and its beneficiaries in today’s concentrated pharmacy market.