CVS Leads Pharmacy Plunge

Updated from 2:24 p.m. EST

Shares across the pharmacy sector plunged Wednesday after CVS (CVS Quote) confirmed plans to buy Caremark (CMX Quote).

The transaction, which the companies called a merger of equals, calls for Caremark holders to get 1.67 CVS shares for each Caremark share held. The deal values Caremark shares just north of $48.50 apiece.

Talk of the impending deal had sent the companies' shares into a frenzy Wednesday after it was first reported by The New York Times. Caremark shares, which earlier traded as high as $53.65, recently were down $1.67 to $47.60. CVS fell $2.62 to $28.77.

Retail drugstores like CVS and pharmacy benefit managers such as Caremark have been notorious enemies for some time. Drugstores pride themselves on offering personalized service -- including consultations with real-life pharmacists -- at convenient neighborhood shops. PBMs in turn compete by promoting cheaper mail-order service, which boosts their margins nicely but makes them seem almost invisible to the customers they serve.

But now, with Wal-Mart (WMT Quote) setting off a price-cutting frenzy in the generic drug business, the lines are being redrawn.

"The critical question is: 'What does this transaction do for CVS strategically?'" Goldman Sachs analyst John Heinbockel wrote on Wednesday. "In short, becoming the largest PBM would greatly improve the company's position to influence changes in the pharmacy marketplace."

Heinbockel highlights four opportunities in particular. First, he says, CVS could better promote 90-day prescriptions filled by retail pharmacies. At the same time, he says, the company could slow the growth of mandatory mail-order service, which focuses on those 90-day prescriptions right now. Meanwhile, he says, the company could seek to prevent Wal-Mart's $4 generic drug program from spreading into third-party channels. Finally, he adds, the company could use its new muscle to help shape positive changes to the "average wholesale pricing" system for brand-name drugs.

Heinbockel views the merger as a "modest positive" for CVS in the end. His colleague, Christopher McFadden, suggests that the deal -- perhaps at a higher price -- makes sense for Caremark as well.

"The merits of PBM/drug retailer vertical integration have been topical with investors for many years," McFadden noted on Wednesday. "Today's news suggests that the market growth opportunities presented by the Medicare Part D program and national employer contracting, as well as signs of market maturity for the PBM sector (end of vertical integration, growing scrutiny of pricing practices) may have reached an inflection point in which the traditional animosity between retailers and PBMs gives way to a mutual vision for industry growth."

Goldman Sachs has buy recommendations on CVS and Caremark alike. The firm has investment-banking ties to CVS and hopes to secure investment-banking business from Caremark in the future as well.