Express, Medco Antitrust Issues Could Be Bitter Pill

(Express Scipts, Medco deal story updated with analyst commentary)

NEW YORK ( TheStreet) -- Aside from the antitrust issues posed by a merger between Express Scripts ( ESRX) and Medco Health Solutions ( MHS), the deal also would impact drug companies and distributors.

The companies said on Thursday morning that the $29 billion deal, which would create the largest pharmacy benefits manager by far in the U.S., would be great for Americans and reduce pharmacy costs.

Anthony Vendetti, health care analyst at Maxim Group, said distributors and drug companies will line up against the deal.

The impact of the deal on drug distributors was evident on Thursday, as Medco's main distributor, AmerisourceBergen ( ABC) declined by 6% on heavy volume, and based on the belief that its position will be weakened if the deal goes through, because Express Scripts' main distributor is Cardinal Health ( CAH). Shares of Cardinal Health rose by 2% on Thursday.

"Express Scripts will work more with their preferred distributor or in the least play the distributors off each other, forcing distributors to give more pricing concessions. It 's a market where margins are already thin and my sense is that the distributors will complain," said Vendetti.

The drug companies won't be happy that this PBM behemoth has much more leverage. "'Every drug company will be against this, and that's a powerful lobby," Maxim Group's Vendetti said.

Analysts say the companies may have signaled how significant the extent of the antitrust issues are in the transaction terms: There will be no breakup fee if the deal fails for regulatory reasons, the companies said in a release explaining the deal terms.

"That's somewhat unusual and an acknowledgment of the risk," said Gabelli Securities health care analyst Jeff Jonas.

Ultimately, analysts say the U.S. Department of Justice and Federal Trade Commission review of the deal will hinge on how the category for these companies is defined: Is this a deal that is taking place within the larger pharmaceutical industry, or is the corporate pharmacy benefit manager market an industry that deserves a narrower definition for the purposes of reviewing this deal?

"The question for this deal is are we talking about a marketplace for the PBM that serves corporate employers, or the broader pill market in the U.S.? The threshold for this deal is how the market is defined, and if it is defined narrowly as the PBM market for corporate employers, the deal might be nixed by the FTC," said Dave Shove, health care analyst at BMO Capital Markets. Shove added, "My bias is that the corporate PBM argument fails as a definition, and the FTC will look at the pill marketplace. I don't think Medco and Express Scripts together move the price of generics."

Shove noted that there have been deals in the pharmaceutical industry of a much larger size that have passed antitrust review without a hitch. Additionally, he doesn't believe a compelling case can be made that a combined Medco and Express Scripts would move the market in terms of pricing of generics.

Gabelli's Jonas is not as certain.

"It's a coin flip," he said.

He contends that Medco and Express Scripts could in fact influence the pricing of a generics giant such as Teva Pharmaceuticals ( TEVA), and the generic drug companies will be one of the interest groups likely to lobby against this deal. He also said that within the pharmaceutical industry there is a much broader competition between small, medium-sized, specialty biotech and Big Pharma companies, making the comparison between PBMs and drug companies less relevant.

In addition to the generics, the community pharmacists industry is likely to lobby against the deal. "This would be a PBM that could dictate rates and move people to mail order," Jonas said.

If the deal goes through, the combined company would be far and away the largest PBM in the U.S. Gabelli estimates that the company would have annual sales of $110 billion, with CVS Caremark's ( CVS) PBM a distant second at $60 billion, and UnitedHealth's ( UNH) PBM third at $30 billion in revenue. UnitedHealth has operated both a proprietary PBM unit, OptumRX, and an outsourced PBM managed by Medco, a deal Medco said it would lose in 2013.

"This is a fairly well-defined industry, and the FTC has reviewed a number of deals in past that has provided it with the experience to define the PBM market narrowly," Jonas said. The deals include Catalyst Health Solutions ( CHSI) buying Walgreen's ( WAG) PBM, and Express Scripts buying the PBM of WellPoint ( WLP) and CVS Caremark.

"With CVS Caremark, there were still three equal competitors, but with this deal we would have one huge player and a distant second and third," Jonas said. Although the larger presence of UnitedHealth's PBM in the market, without a portion of its business outsourced to Medco, was one development that could argue in favor of the deal passing antitrust review.

The companies only laid out a very broad case on Thursday, stating that the deal would not present antitrust issues because there are already a significant number of diverse competitors in the space, and diverging PBM business models continue to emerge.

Yet analysts said that the companies were only willing to lay out a political case on Thursday rather than a legal case.

"It matters whether they change the competitive nature of the market, not whether prices are lower. Monopolies lower prices of products most of the time," BMO Capital's Shove said.

The Maxim Group analyst Vendetti said he is betting that the deal receives approval, but with significant caveats. He believes there's at least a 30% chance that the deal is rejected. Second, even in handicapping the deals odds of approval at 70%, he thinks approval could hinge on asset divestitures in certain markets, or contract bidding restrictions imposed by the FTC on the combined company.

Vendetti said that there isn't any precedent to help identify where divestitures could be made, or if the government would even have the legal right to limit the combined company's right to bid on certain contracts. However, the high level of scrutiny that he expects the deal to receive may force significant concessions from Express Scripts deviating from current deal structure.

"There's no precedent here, and if the government can't find a way to restrict it, they may scuttle the deal," Vendetti said. "Express Scripts could do everything to get the deal done including making concessions and it still might not be enough," he said.

The analysts expect the government review to take at least nine months to a year.

One important statistical measure of anticompetitive markets used by the government, the Herfindahl-Hirschman Index (HHI) could argue in favor of the deal receiving approval from the government, according to a report from TheStreet sister site RealMoney.

Analysts noted that one political development that could work in favor of the deal is the recent departure of Justice Department's top antitrust official, Christine Varney, who returned to private legal practice. Varney, appointed by President Barack Obama in 2009, increased the scope of antitrust enforcement by the government and retracted Bush administration policies on monopolization, which she viewed as fostering anticompetitive practices.

-- Written by Eric Rosenbaum from New York.

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