CVS Leads Pharmacy Plunge

Shares across the sector drop 3%-8% as a big deal backfires.
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Updated from 2:24 p.m. EST

Shares across the pharmacy sector plunged Wednesday after

CVS

(CVS) - Get Report

confirmed plans to buy

Caremark

(CMX)

.

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) - Get Report

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.

Still, Banc of America analyst Robert Willoughby senses no desperation on the part of PBMs.

"We do not ascribe to the view that Wal-Mart or other industry issues are forcing PBMs to seek exit strategies," Willoughby wrote on Wednesday. "Our call has been PBM consolidation is inevitable, but we do not view a transaction with a retail pharmacy as likely. Rather, we believe another PBM would be involved."

Specifically, he adds, "if Caremark is in play -- as the

New York Times

article suggests -- you have to believe

Express Scripts

(ESRX)

and

Medco Health Solutions

(MHS)

are looking."

Willoughby has buy recommendations on all three PBM stocks. His firm has investment-banking ties to all three of them as well.

Robert Garis, an associate professor of pharmacy at Creighton University, seemed surprised by the deal. On the one hand, Garis says, the merger "makes very good sense for CVS" since the company has entered the PBM business already. But on the other hand, he asks, why would Caremark sell itself now -- and at such a low price?

"I can't help but wonder whether Caremark knows something" that others don't, Garis says. "Maybe the heat is on, and they've decided that now is a good time to get out. ... The heat has been on the industry for a while, but the industry has been thriving" nonetheless.

To be sure, Caremark would come with plenty of baggage. The company faces multiple government investigations. The company has paid a big fine already for a PBM it acquired in the past.

Caremark also faces government scrutiny for past stock options that could have been backdated. For his part, CEO Mack Crawford has denied that any backdating took place. Still, another high-profile CEO --

UnitedHealth

(UNH) - Get Report

leader William McGuire -- recently got the boot after defending his own stock option grants.

For his part, Crawford made $63.84 million through stock option transactions last year alone, the

New York Times

reported, and continues to sit on nearly $249 million worth of options even today.

Some people wonder if Crawford could now float off with a big golden parachute and leave all of his troubles behind.

"Caremark has real problems, and those problems aren't going away," Patrick Burns of Taxpayers Against Fraud insists. Moreover, "it's not even clear to me that America needs PBMs, as they currently operate. They didn't exist 15 years ago, and I don't think they will exist 15 years from now, either."

Burns feels that PBMs face major changes -- which have already started surfacing -- and could emerge as less popular investments as a result.

"When they become fully transparent, they're going to have profit margins like Safeway," he concludes. "And by and large, Wall Street will not love them as much because of that."