Image Source: Mike Mozart
Target (TGT) and CVS Health (CVS) announced an agreement June 15 in which CVS would acquire, rebrand, and operate Target’s pharmacies and clinics for the price of approximately $1.9 billion. After the deal closes, CVS will operate 1,660 of Target’s pharmacies in its stores under the CVS/pharmacy brand name. The nearly 80 Target clinics involved in the deal will be rebranded as MinuteClinic, and CVS plans to open up to 20 new clinics in Target stores, part of the CVS/minuteclinic goal to operate 1,500 clinics by 2017. Target and CVS also plan to open five to ten small, flexible store formats that will be branded TargetExpress and include a CVS/pharmacy.
After Target’s recent Canada debacle, we were left scratching our heads as to where the company would look next for geographic growth opportunities, and we think this question remains unanswered. For those that may have missed the event, Target closed the last of its 133 retail stores in Canada April 12, laying off 17,000 employees and taking a $5.1 billion quarterly charge. The justification for leaving Canada boiled down to the following rather unusual short-term oriented statement: “Unfortunately, we were unable to find a realistic scenario that would get Target Canada to profitability until at least 2021.” We didn’t think the problems in Canada were unfixable. Inventory, pricing, and branding should be core competencies for any successful retailer.
But that brings us to today, and the deal with CVS makes sense.
In the minds of consumers, Target is more of a retailer, as opposed to a pharmacy, and management has finally admitted that reality with the CVS accord announced this week. If abandoning Canada was the first indication, the executive suite at Target seems to be one focused on simplicity, and changing healthcare regulations have certainly become a headache in an operation that’s losing money, as Target’s pharmacy business had been. Not only will Target offload this profit headwind, but the company will retain pharmacy-related traffic by keeping the stores within, well, its very own stores. It will also capture CVS customers that visit Target to fill subscriptions, helping it compete more effectively with Walmart (WMT) and Costco (COST), for example.
The acquisition of Target’s pharmacy and clinic business is a natural extension of what CVS does best, and taking out a “smaller” competitor in this area only makes sense. The deal will also improve CVS’ swagger at the negotiations table. As a pharmacy benefit manager (PBM), CVS participates in bidding wars against other PBMs for large contracts with drug producers. Following the purchase, big pharma should find the growth potential of being associated with CVS’ larger post-deal network incrementally more attractive, likely helping CVS win more contracts, which have been trending toward all-or-none exclusivity arrangements. The firm will also be able to use its larger scale to demand higher reimbursement rates from insurance networks.
PBM peers, Express Scripts (ESRX)–which together with CVS, controls more than half of the market–Rite Aid (RAD) and United Health (UNH) are likely watching in worried fascination as the deal with Target is not the only major move CVS has made recently. In late May, CVS acquired Omnicare (OCR), the largest institutional pharmacy operator in the US, for ~$12.7 billion. The acquisition will enable CVS to significantly expand its prescription dispensing abilities in assisted living and long-term care facilities, a market expected to continue to grow at a strong rate due to the aging of baby boomers (seniors’ use of pharmaceuticals is more than three times that of the general population). CVS will capture the cost advantages associated with the size and scope of Omnicare, and institutional exposure is a new segment for CVS, pushing its operations outside the traditional retail drugstore arena.
But another winner of the agreement between Target and CVS may not be completely obvious.
Last winter, Express Scripts thought it had changed the game after coming to an agreement with AbbVie (ABBV) in which the PBM would exclusively offer AbbVie’s HCV treatments in the pharmacies it represents. In exchange for such exclusivity, the agreement was priced attractively and sparked concerns that high-priced drugs across the pharma chain would face tremendous pricing pressure, to the detriment of Big Pharma profits. In perhaps an equally savvy move, CVS countered the agreement by announcing it would offer exclusive coverage of Best Idea Newsletter portfolio holding Gilead Sciences’ (GILD) HCV treatments, which studies suggest are more convenient for patients and have better cure rates (see here).
This deal may be a win-win for Target and CVS, but as the latter gains share in the PBM arena, Gilead becomes a key derivative beneficiary as well; in fact, we attribute some of the recent strength in 9-rated Gilead’s equity to CVS’ deal-making. We’re reiterating our view that price-to-fair value convergence continues at Gilead, and we value shares at $162 each, offering huge upside at the moment. Though their respective business models are certainly attractive, Target and CVS aren’t nearly as cheap, and while we like the agreement, we’re not rushing to add either of them to the respective newsletter portfolios.