Remember when Back to the Future predicted flying Deloreans and real hoverboards – like the ones that actually float off the ground? When I woke up on Thursday, March 8th, I looked out my window to see if the future was here – spoiler alert – it’s not, but there was huge news in the healthcare space that day that made me think I was watching a movie in the 1980’s.
The healthcare industry was shook up when Cigna announced that it was acquiring Express Scripts for $67B. This followed on the heels of last December’s announcement that CVS was acquiring Aetna for $69B. These domino chain of events lead to speculation and then confirmation that Walmart was in talks to acquire Humana.
There are so many facets to both of these deals that I am finding to be nostalgically fascinating. At their core, these are protection plays that will create more closed networks under the guise of consumer savings — trickle-down health economics, if you will. Before I give my commentary, let me quickly bring you up to speed on the business rationale for these two deals:
Horizontal integration of patients
Payers have been trying to curb costs for decades by negotiating in-network care for all aspects of healthcare. This became an even greater focus in an active 340B and post-ASP market where hospitals have been acquiring clinics to capitalize on the site of service arbitrage on drug payments. Simply put, payers save money by controlling where patients go for their healthcare through acquiring physician groups and negotiating in-network (aka “closed”) affiliations. Patients choose in-network versus out-of-network care based on significant out of pocket savings – enforcing these closed networks.
Vertical integration of drugs
This is the most significant source of upside for investors. When CVS announced their intent to acquire Aetna, they claimed, optimistically in my opinion, that they would be able to generate $750m in synergies. The vast majority will come from drug contract negotiation leverage, by squeezing margin out of channel middlemen (primarily wholesalers). What a lot of people don’t realize is that all of these companies that are consolidating primarily purchase their drugs from one of three companies: AmerisourceBergen (ABC), Cardinal or McKesson. These wholesalers do not like this consolidation because they know that it will lead to profit compression. Here are a couple of interesting facts that undoubtedly are impacting boardroom conversations at the wholesalers:
- CVS’s largest customer is Aetna. In the two companies combining, CVS will guarantee the demand volume of Aetna in perpetuity and get additional value out of Aetna’s mail order consolidation with Caremark (who was acquired by CVS for $21B in 2006). CVS purchases their drugs from Cardinal while Caremark mail order procures their drugs from McKesson. There is obviously some room for synergies here.
- Cigna combined with Express Scripts creates some very interesting channel dynamics. Let’s start with Express Scripts – as the country’s largest pharmacy benefit manager (PBM), they have historically been ABC’s largest customer. This got extremely interesting when Walgreens / Boots Alliance entered into a 10-year partnership with ABC and purchased ~26 percent of the company in 2014 (accounting for 30 percent of ABC’s revenue back then). So from ABC’s perspective, Express Scripts and Walgreens became their two most important customers by revenue. Enter Cigna. Cigna has historically been aligned with OptumHealth (a UnitedHealthcare company) for its oral pharmacy volume. This business is fulfilled by Cardinal (who won this business from McKesson when Optum acquired Catamaran in 2015). In my opinion, Cigna would not want to continue to support a UnitedHealthcare company so a potential shift of their drug volume from Cardinal to ABC would yield significant synergies as well (even potentially through Walgreens).
Confused yet? Me too.
The amount of consolidation in the industry right now is sounding eerily familiar to the health maintenance organization (HMO) model that Kaiser founded and made popular in the 1980’s. Now, can you remember why they claimed this integrated delivery model would succeed? Reduced costs to patients would drive the savings of this integrated model, leading to a reduction in insurance premiums, and lower out of pocket expenses.
It can be debated whether HMOs actually delivered on this or not. Although HMOs might argue that their premiums went up less than comparable PPO plan premiums, it’s hard to prove definitively because 1) plan premiums vary considerably by market and 2) the increase in cost of care has largely been driven by drug price increases.
The claim used by HMOs in the 1980s is the same argument that the payers and PBMs are making on why these mergers will be good for everyone. I have no doubt that these mergers will lead to significant savings for the payer and PBM mega entities, but the jury is still out as to whether these savings will be passed down to the patients. That said, I would love to be pleasantly surprised, though I will say that I am still waiting for my hoverboard and flying cars.