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The Battle Of The Rx Titans Begins

A watershed moment in the drug benefits management trade came April 2, when the Federal Trade Commission waved through Express Scripts' (ESRX - News) $29 billion acquisition of Medco Health Solutions.

The merger — hotly contested by many consumer and industry advocates — quickly closed the same day, collapsing the industry's Big Three into the Big Two. CVS Caremark (CVS - News) moved up from No. 3 to No. 2.

Many in the industry saw the FTC's no-strings-attached approval as a green light for additional mergers. On April 18, fast-growing drug-benefits firm SXC Health Solutions (SXCI - News) said it would pay $4.4 billion for rising star Catalyst Health Solutions (CHSI - News).

If approved, the deal would lift SXC's volume to 362.5 million prescriptions a year. At 8%, that would be the third-largest share of the pharmacy benefit management market's total prescription volume, according to researcher AIS Health and its affiliate Drug Benefit News.

UnitedHealth's (UNH - News) pharmacy benefits subsidiary OptumRx would rank a close fourth.

Express Scripts dominates more than 30% of U.S. prescription drug volume. It has an estimated annual volume of 1.4 billion prescriptions, according to AIS, almost twice the volume of CVS Caremark, the hybrid retail pharmacy/PBM.

"The (Express Scripts/Medco) merger absolutely changed the landscape of the PBM industry," said drug industry consultant Adam Fein, president of Pembroke Consulting.

Business SXC Health and Catalyst Health each have several years of acquisitions under their belts, including deals pending in the first half of this year.

"Both (SXC and Catalyst) were doing well independently, and together they make a powerful combination," said Anthony Vendetti, an analyst with the Maxim Group.

SXC's well-regarded technology platform also gives it a competitive edge. Many PBMs use its software, including Catalyst.

SXC, Catalyst and Express Scripts have helped lift the Medical-Services industry to a No. 4 ranking in Friday's IBD, up from No. 92 on March 1. The group also includes medical laboratory consolidators such as Quest Diagnostics (DGX - News) and Laboratory Corp of America (LH - News). Omnicare (OCR - News) supplies drugs to nursing homes. VCA Antech (WOOF - News) is an animal hospital chain, and Air Methods (AIRM - News) is an air ambulance service.

Consolidation has stepped up the drumbeat for PBMs to control drug costs, which have been rising about 10% annually.

PBM clients are chiefly employers and managed care companies. The customer list also includes government employee plans, unions and any other entity that offers drug benefits to their employees or members.

"This is a business where scale matters," said Morningstar analyst Matthew Coffina.

PBMs are middlemen, negotiating better prices with drug manufacturers and retail pharmacies on their clients' behalf.

The larger a PBM, the more leverage it has to negotiate better rates. They also try to steer members to lower-cost, higher-margin generic drugs and mail-service programs.

PBMs are generally paid based on prescription volume and how much money they save clients. Contracts typically include incentives for exceeding certain savings benchmarks.

"Our job is to take the waste out of the system," Express Scripts CEO George Paz said in a recent conference call.

Market Conditions The so-called "patent cliff" is what the drug industry calls the wave of brand-name-drug patents expiring over the next several years. For drugmakers, it poses steep challenges. For PBMs, it opens the door to more high-margin generic business.

"The largest number of brand patent expirations in the history of the pharmaceutical business is occurring this year and next year," Vendetti said. "That major catalyst is going to be a significant driver of earnings over the next two years.

Another growth opportunity: specialty drugs that target patient populations as small as 5,000 to 10,000, but can cost upward from $10,000 a year.

"Traditional drug utilization has been slack, but specialty drug use is growing dramatically," Fein said.

Use of traditional drugs has been sluggish largely because consumers have ratcheted down health care use in a tough economy. That pullback has actually helped PBMs, Fein said.

"In a flat market, pharmacies have to compete more for business," he said. "PBMs are able to drive better deals with pharmacies.

The benefits aren't always clear-cut. A key example: Express Scripts' negotiations last year with retail-pharmacy giant Walgreen (WAG - News). Walgreen left Express Scripts' network Jan. 1.

"Walgreen walked away with the intention of trying to extract better terms. But Express Scripts let it happen; it didn't give in," said Coffina.

Express Scripts shares jumped 5% in the next trading session. And, despite the loss of a sizable retail partner, Express Scripts' first-quarter prescription volume grew 3.6% over last year due to new business wins. Quarterly profit rose 11%. Analysts expect full-year earnings to jump 21%.

Walgreen's earnings have, in the meantime, slumped, with consensus forecasts calling for more declines for the year.

"I'm baffled that Walgreen hasn't figured out a way to resolve this," Vendetti said. "Without one of the big PBMs, Walgreen just doesn't lose scripts — they lose some of the store traffic, which is critical to their success.

Walgreen's 8,000 stores make it a potent retail partner. The chain's prior contract with Medco — now part of Express Scripts — remains in effect. Express Scripts' Paz said in the recent call that several Medco clients "have already selectively chosen to drop Walgreens themselves.

One positive from Walgreen's withdrawal from Express Scripts' network, he told analysts, was that it has helped drive the firm's mail-order business higher.

The drugstore lobby is meanwhile fighting an uphill battle for legislation to keep prices from eroding further. A trade group that represents PBMs says Walgreen's exit has been a boon to local independent drugstore pharmacists.

"Our polling shows consumers have flocked to other pharmacies and are just as satisfied if not more," said Charles Cote, a spokesman for the Pharmaceutical Care Management Association.

Outlook Overshadowing all of this activity is federal health care reform legislation. If the Supreme Court upholds the health-coverage mandate, 32 million more Americans will likely have coverage in 2014.

"They will have more access to prescription drugs, which should mean more potential business for the PBMs," Vendetti said.

Meanwhile, the big wave of generics hitting the market will keep revenue and profits on a growth track for PBMs through at least 2015, observers say.

Then what? The "easy money" from switching users from brands to generics will taper off in 2015 and 2016, Fein says, so PBMs will need other growth platforms.

He thinks specialty drugs will provide one. Those drugs could account for roughly 40% to 45% of U.S. drug industry sales by 2016, up from less than 20% now, he says.

But growing that business will be challenging. Entrenched players with specialty drug pharmacies include large-scale drug distributors such as McKesson (MCK - News) and AmerisourceBergen (ABC - News).

Some large health plans such as UnitedHealth, Cigna (CI - News) and Aetna (AET - News) also have a head start.

Another challenge: About half of all specialty drug spending occurs in locations such as a doctor's office or at clinics, Fein says. PBMs don't typically manage much drug spending in those places, he says. But they view those areas as new opportunities.

Meanwhile, industry consolidation still has room to run.

"SXC is very well positioned to make many more acquisitions," Fein said. "It has the technology platform for about one-third of all the regional PBMs so it will be fairly easy for them to integrate some of those companies.

Morningstar's Coffina thinks the market hasn't fully valued the potential synergies in the Express Scripts-Medco merger. Management sees $1 billion in eventual savings.

Equally important "is the increasing bargaining power over suppliers," Coffina said. "The industry is getting smaller by the day."