New chairman gives CVS Caremark chance to split

May 5, 2011

By Robert Cyran
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The merger that created CVS Caremark never made much sense. Combining the U.S. drugstore chain and pharmacy benefit manager resulted in lost contracts and Federal Trade Commission scrutiny. It has hurt investors too. The fall in first-quarter profit reported on Thursday emphasizes the point. The $50 billion company could be worth $13 billion more carved up. With David Dorman stepping in to be chairman, there’s a chance for the company to reconsider. He oversaw a similar split at Motorola.

The Caremark arm pools customers and uses this purchasing power to demand discounts from drug makers. CVS fills prescriptions and sells everything from diapers to candy. A merger meant Caremark customers could be pushed into CVS stores with preferential pricing. The union also meant new services — people with diabetes, for example, could get their medicine in the mail and attend clinics in CVS stores.

The deal lifted retail sales, but hurt the benefits business. Caremark lost nearly $5 billion of contracts last year. The company blamed its latest quarterly earnings decline on falling prices in the unit. Caremark customers don’t necessarily want to be pushed into CVS stores. Moreover, regulators are concerned CVS might be using Caremark customer data to compete unfairly against rivals. The company says it has ensured this can’t happen.

While CVS stores would lose sales if the company were to split, Caremark would add customers and improve its profit margin. Instead of encouraging clients to visit stores, it could mail more prescriptions directly to customers, which is more efficient. And it would mean fewer costly legal problems in Washington.

Investors attach a discount to the combined company. Rival drugstore chain Walgreen, as well as pharmacy benefits companies Express Scripts and Medco Health Solutions, trade at a premium based on estimated 2011 earnings. If the separated CVS and Caremark arms traded in line with rivals, investors would see a 25 percent share price lift. And a standalone Caremark might attract a takeover premium from a pure-play rival.

The merger’s major architects are gone. A new chief executive, Larry Merlo, took over in March. And Dorman is due to start leading the board next week. While the company says its new bosses have no plans to break up the company, undoing the deal would be an easy win for them.

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