10.13.15 | Forbes
By Steve Brozak
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Insurance companies have a major stake in the national discussion on the cost of drugs. They’re usually pitted against big pharma and biotech, looking for ways to save money on care and drugs. One recent savings trend has been a push by major insurance companies to divert members from going to brick and mortar pharmacies like CVS Health Corporation (CVS) and Walgreens Boots Alliance , Inc. (WBA) and place them into mail-order pharmacies. By having drugs delivered to doorsteps instead of picked up at pharmacies, insurance companies can leverage their buying power and exercise even better control over what brands of drugs are utilized through a single, preferred distribution network. This could result in hundreds of millions of dollars in savings, cutting out countless middlemen who all play transactional roles in a fractured healthcare system. It could also tear the foundations of traditional brick and mortar pharmacies around the nation.
Insurance companies have long tried to convert as many members as possible to the mail order model to achieve true scale, but many people today still prefer the brick and mortar experience, even though it’s outdated and inefficient. Now with rising costs for insurance premiums and copays, the insurance companies may have to incentivize its members more than ever. For instance, insurance companies may offer lower or even no copays for certain drugs if members utilize a preferred mail order pharmacy, passing some of the savings experienced by the insurers to their membership. Now the U.S. government is pushing a similar approach.
TRICARE, the Department of Defense’s military healthcare system that provides health benefits to 9.5 million active duty service members, National Guard and Reserve members, retirees, their families and survivors, is requiring all of its members to utilize mail order pharmacies to order branded versions of chronically needed drugs through Express Scripts (ESRX), a pharmacy benefit management (PBM) company. Otherwise their members will have to pay more to continue to use the local pharmacy for drugs they use every day like heart medications, blood pressure pills, and diabetes therapies. TRICARE stands to save substantially over the next several years as it continues to convert its beneficiaries to the newer systems. Just to give you an idea of how massive a move this is, CVS has publicly stated that only 5 million people utilize its mail order service every year through its Caremark subsidiary.
Investors should pay attention here. In this day and age in which you can have a roll of toilet paper delivered from Amazon to your front door in less than two days with military precision, why can’t we do the same with prescription drugs? And if the U.S. government has realized this and is converting millions of its beneficiaries to a single mail order pharmacy, how long will it be before private insurance plans also jump on the bandwagon?
A Retail Store That Happens to Dispense Drugs
Historically the local pharmacy has always been a diversified retailer. In 1886, Coca-Cola was introduced as a soda fountain drink at Jacobs Pharmacy in Atlanta, Georgia. Today the business of doling out the nation’s prescription drugs is a lucrative one. CVS and Walgreens stand out among the crowd with approximately $139 billion and $76 billion in net revenues for 2014, respectively. These are large corporations with consistent performance and market caps approaching or exceeding $100 billion each. While their own businesses have branched out into several subsectors of pharmaceutical delivery (including mail order and specialty pharmaceutical services), the primary storefront model has remained unchanged for a half century.
The specialized nature of this industry has prevented many would-be disruptors from, well, disrupting the market, but that could change overnight. The primary barriers to entry which larger players retain include being able to meet stringent regulatory requirements and enjoying entrenched relationships between distributors. However, TRICARE’s intervention represents a disruption to the storefront system. The mail order business is going viral, and this is a moment the pharmacy companies are ill prepared for. The National Association of Chain Drug Stores has already expressed concern about TRICARE’s new mail order push and focus on a single PBM.
Up till now consumers drive to their local pharmacy where they either wait for the prescription to be filled, or receive an email or text whenever the prescription is filled. In either event, customers usually park their cars outside to go inside the pharmacy. They walk to the back of the store, passing aisles packed with over-the-counter drugs and retail merchandise on their way to the prescription drug counter. The pharmacies rely heavily on the foot traffic to the store for the incidental sales that happen on the way to the drug counter – chips, soda, toothbrushes, beauty products. Some people may opt to go through the drive through window, but many more actually enter the doors – that’s what CVS and Walgreens have always counted on.
In 2014, revenues from CVS’ pharmacy services was $88.4 billion, with a profit from those sales at $4.7 billion. That gives CVS a gross margin of 5.39% on prescription drug sales. On the retail side, CVS brought in $67 billion in revenues selling general merchandise, with a profit of $21.2 billion. The gross margin for CVS on retail sales was an astounding 31.38%. Walgreens does not provide a breakdown of revenues and profit by segment, but we know from analyzing their numbers that they rely on retail sales just as much if not more heavily than CVS. Already traditional pharmacies have seen their brick and mortar business assailed by Wal-Mart (WMT) as large retailers try to steal their foot traffic. In a new world dominated by mail order pharmacies, that retail revenue evaporates even further.
Blockbuster vs. Netflix
At its peak Blockbuster had a network of 9,000 stores and 60,000 employees. Blockbuster clung to a dying business model and failed to embrace the streaming revolution fast enough to compete with Netflix (NFLX). Could CVS and Walgreens be next?
CVS and Walgreens have 7,812 and 8,229 retail pharmacies, respectively, that rely heavily on pharmaceutical sales services to drive its more profitable retail sales. If there is a disruption of in-store prescription sales, it’s more likely that they will have to reduce their national footprint drastically. However, there will almost always be a need for a walk in pharmacy for immediate access to the initial regimen of a drug.
Both CVS and Walgreens have also taken steps to offer mail order pharmacy services while trying to place their own brand of products (cough syrups, cotton swabs, etc.) and other services in their brick and mortar operations to continue to drive foot traffic and retain some purpose for their shopping stores. CVS has built Minute Clinics into its network of pharmacies where patients can receive routine medical treatment and annual vaccines. Walgreens announced a deal with Theranos, a startup deploying a new diagnostic system that rapidly tests drops of blood for disease. Both companies are probably betting that these new services will draw consumers through their doors for more than just picking up prescriptions. But these newer services may not have the time they need to sustain the brick and mortar pharmacy model if a disruptor emerges.
For instance, as more insurance plans convert to mail order pharmacy services, a disruptor with the ability to change people’s habits (something like an Uber) may align itself with another large competitor (enter Wal-Mart) that has the infrastructure and network to hold large volumes of product and the resources to overcome any regulatory hurdles. Such an alliance could rapidly accelerate the decline of foot traffic to CVS and Walgreens stores. Other advents, like the surge in paperless e-prescribing directly by physicians, witnessed over the past several years, could further catalyze the decline of the traditional pharmacy model.
A similar confluence of products, services and infrastructure was put into place that allowed the rise of Netflix. Broadband became commonplace, and consumers began buying streaming appliances to sit on top of DVD players. The market surged as consumers became more comfortable with on demand video services through cable providers. Today we have the power of mobile computing on virtually every cell phone in the nation. Mobile computing has changed human behavior in stunning and unprecedented ways and can rapidly alter the way consumers interact with our economy, even in how we prescribe and purchase prescription drugs.
Companies like CVS and Walgreens will need to employ a delicate balancing act to survive a changing landscape. While they have their own PBM and mail order pharmacy businesses, these businesses cannibalize their much more lucrative retail store sales in which they are heavily invested. When one takes into account the pressures these companies are facing from almost every quarter on the pharmaceutical sales side, it’s no wonder Walgreens attempted an inversion in 2014 in order to lower their tax rates. The company decided against moving its headquarters to Europe after public outcry condemned Walgreens for “abandoning” America. Ironically, the inversion would have bought them a bit more time to reshuffle their business model to ensure they are able to survive cataclysmic change in their industry.
For now the traditional pharmacy model may seem secure, but Blockbuster didn’t fall in a day and Netflix didn’t rise overnight. They required developments in technology, investment in infrastructure and shifts in consumer attitudes around how content is consumed. With the meteoric rise of smartphones since then and all the technology surrounding them, the speed at which business models rise and fall today is even more breathtaking. It shouldn’t be surprising if one day companies like CVS and Walgreens are also challenged by more innovative business models.