CVS CEO Says Government Contract Win Will Hurt Retail PBM Margins

CVS Caremark Corp. (CVS) recently won a lucrative government contract now held by Medco Health Solutions Inc. (MHS), helping fuel what CVS hopes is a turnaround for its pharmacy-benefits management business, but its chief executive acknowledged the win comes at a cost.

Larry Merlo, who took the helm of CVS earlier this year, on Wednesday told a Sanford C. Bernstein conference that the "transparent" pricing of the new pact to serve over 5 million federal employees, retirees and dependents will lower the margins at the retail pharmacy side of the PBM business. Merlo declined to be more specific, citing company policy to not discuss the profitability or financial details of any one contract.

CVS has held, since 1993, the contract to provide just the PBM service at its retail CVS drugstores to the Federal Employee Program, or FEP, administered by Blue Cross Blue Shield. With this new deal, it will begin next year to integrate mail-order and specialty pharmacy benefits management. Medco had previously managed the FEP's mail-order pharmacy benefits, and its financial chief earlier told the same conference that Medco had made a "very competitive" offer for the combined future FEP business, adding the government told Medco it chose CVS based on the financials of the contract CVS proposed.

Medco CFO Richard Rubino noted that the company has lost FEP as a customer before and won it back. "It's never over with FEP."

Merlo continued to press the case that the combination of the retail pharmacy and PBM business, created with the 2007 merger of CVS and Caremark, will finally begin to show tangible benefits next year, following years of struggles to integrate the two businesses. Caremark has struggled with internal missteps and against opponents who accuse the combined company of unfair and anticompetitive practices, and it lost a total of $4.8 billion in contracts last year.

When CVS reported first-quarter results last month, Merlo put forth his most ardent defense of the merger, rebuffing those who have called for the two businesses to be separated and outlining a multi-step plan to make Caremark a success. Under the leadership of Per Lofberg, a respected PBM industry veteran CVS hired in late 2009 who was once Medco's chairman when it was part of Merck & Co. (MRK), CVS has aggressively gone after revenue-generating business. In addition to securing the FEP, Caremark also recently garnered the PBM contract to service Aetna Inc. (AET) members, but like with the FEP contract, the aggressive pricing will crimp margins in the short term.

Between the third quarter and fourth quarter of this year will show the "most dramatic" improvement of its PBM business, CVS CFO David Denton said during the company's post-results conference call.

At the conference, Merlo said the proof that Caremark has turned the corner will be a dramatic increase to the company's cash flow. He said it will generate upward of $30 billion in cash flow over the next five years. Where the projected returns on invested capital make sense, CVS will invest that cash flow in the business, and it intends to return the rest to shareholders in the form of dividends and share repurchases.

With the ratio of its dividend to its earnings that CVS is targeting, the implied annual growth of the dividend is 25% or so, Merlo said.

-By Maxwell Murphy, Dow Jones Newswires; 212-416-2171; [e-mail]