Analyst: CVS Caremark should buy pharmacy rival Walgreen

Walgreen Co. and CVS Caremark are far and away the largest drugstore chains in the United States, with Rite Aid a distant third. Woonsocket-based CVS fills more prescriptions annually, while Walgreens has more stores (7,800 to CVS’s 7,300).

Most discussions of their rivalry focus on whether one should buy Pennsylvania-based Rite Aid to get a leg up on the other. But Morningstar analyst Matthew Coffina thinks the smartest move would be for the two leaders themselves to pair up – with CVS buying Walgreens to create “a retail powerhouse.”

“CVS Caremark and Walgreen would be better off together than apart,” Coffina wrote in a report issued Friday. They face the same “long-term threats” from pharmacy-benefit manager (PBM) consolidation, and by combining they’d gain bargaining power and make it harder for PBMs to exclude them from their networks, he said.

Coffina’s suggestion sounds outlandish at first blush. Regulators and law-enforcement agencies already keep a close eye on CVS – why would they allow the two leaders to merge into a single behemoth, especially since the National Community Pharmacists Association and consumer groups would likely howl in protest?

Coffina himself admits a merger is “a long shot,” but argues another development in the pharmacy sector – the pending merger of top PBMs Express Scripts and Medco, which compete with CVS and Walgreens – would make regulators look “hypocritical” if they block a CVS-Walgreens tie-up, though they might need to divest stores in certain markets.

CVS and Walgreens dispensed a combined 37% of all prescriptions sold in 2011, which “would be in line with or slightly below Express Scripts-Medco’s estimated PBM markets share,” Coffina said. There would still be more than 40,000 U.S. drugstores not owned by CVS-Walgreens after a merger, he said.

“If the relationship between payers and providers remains adversarial, the combined company would have much greater bargaining power against third-party pharmacy benefit managers,” Coffina wrote. “If enhanced cooperation between payers and providers turns out to be the best way to control costs, CVS Caremark-Walgreen could provide a highly differentiated offering to both PBM and retail clients.”

Coffina thinks CVS should take over Walgreens, and not the other way around, because CVS retail executives have shown “better execution” in recent years. Walgreen posted more revenue but less profit than CVS last year, and he sees “tremendous potential” in CVS Caremark’s integration of retail and mail-order pharmacies as well as its growing MinuteClinic franchise.

“However, CVS Caremark has much to prove,” Coffina wrote. The Caremark PBM unit “has massively underperformed its independent peers” since their 2007 merger, he said, and “CVS is still far from having the capacity to fill a majority of its PBM members’ prescriptions” at a physical drugstore.

Coffina isn’t a fan of either company buying Rite Aid, the usual subject of drugstore merger speculation. The No. 3 chain has $6 billion in debt and its stores have fallen into “significant disrepair.” Neither CVS nor Walgreens would likely be able to get much benefit out of Rite Aid without cannibalizing their existing stores, he said.

CVS spokeswoman Carolyn Castel declined to address Coffina’s suggestion. “As a matter of policy, we don’t comment on rumors,” she told WPRI.com.

CVS had 61 locations in Rhode Island and 356 in Massachusetts as of Dec. 31, according to regulatory filings. Walgreens had 29 locations in Rhode Island and 180 in Massachusetts as of Aug. 31. Rite Aid had 46 locations in Rhode Island and 157 in Massachusetts as of last February.

• Related: Warren Buffett makes bigger bet on RI’s CVS with $290M stake (Feb. 16)

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