Walgreen shows rival chain CVS benefits of focus

March 9, 2011

By Lisa Lee
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Walgreen just gave its arch-rival in the drugstore business a badly needed prescription for what ails it. The $39 billion American pharmacy chain is selling its pharmacy benefits management arm to better focus on retailing. CVS has taken the opposite tack since it paid $26 billion for Caremark. That dog of a deal, which has dragged down performance and sparked an antitrust inquiry, looks increasingly like it should be unwound.

True, Walgreen’s pharmacy benefits management business was never a big part of the company. The unit, which is selling for $525 million in cash to Catalyst Health Solutions, contributes less than 2 percent to Walgreen’s bottom line. Still, with the middleman gone, Walgreen’s managers will be better concentrated on the firm’s core business.

Contrast that with CVS-Caremark. The company runs a retail operation similar in scale to Walgreen alongside a giant pharmacy benefits manager. Since the merger of the two, the Caremark business has lost some big enterprise contracts and downgraded earnings projections. It’s also spent precious management time explaining to enforcers at the Federal Trade Commission why the combination doesn’t hurt consumers.

Investors have noticed. The company’s shares have underperformed and trade at a discount not just to other drugstore chains, but to pure-play pharmacy benefits firms Medco Health and Express Scripts. To the market, the group is neither fish nor fowl. The solution, it seems increasingly obvious, is to let them swim their separate ways again.

The math supports this view. Walgreen sports an enterprise value of eight times 2011 EBITDA. On that basis, using Credit Suisse estimates for this year’s results, the CVS retail arm alone is worth $42 billion. At ten times Caremark’s estimated earnings — the multiple Medco and Express Scripts fetch — that business would be worth $23 billion. Add the two together, subtract $8.5 billion of net debt, and the equity should be worth $57 billion — or nearly 25 percent more than the current market cap.

True, the companies claimed $700 million of synergies from merging. But even if these vanished, their net present value would still amount to less than the potential upside from de-merging. Moreover, the looming presence of the FTC’s longstanding inquiry would vanish. Here’s a case where the market might nicely do regulators’ dirty work.

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