The market is moving in a direction away from Walgreen’s core strengths. 

— Jefferies & Co. analyst

Harvard Business School professor Michael Porter’s 1980 book “Competitive Strategy: Techniques for Analyzing Industries and Competitors” is probably the most important book on industry analysis and business strategy ever written. In it, Porter introduces his “five forces” of competition that help analyze how profitable a company can expect to be in its industry:

• Bargaining Power of Suppliers
• Bargaining Power of Buyers
• Threat of New Entrants
• Threat of Product Substitutes
• Competitive Rivalry Within the Industry

I want to focus on the first two forces listed, because they illustrate an important battle going on right now between pharmacy benefit manager (PBM) Express Scripts (NYSE: ESRX) and drugstore chain Walgreen (NYSE: WAG). PBMs like Express Scripts are “buyers” of drugs while drugstores like Walgreen are “sellers” of drugs consumed by the members of the health insurance plans partnered with the PBMs. Express Scripts and Walgreen cannot agree on a new contract to replace the one set to expire on December 31^st 2011. The main point of dispute is how much Express Scripts reimburses Walgreen for the drugs it dispenses to health plan members (who typically are responsible only for a co-pay of between $10 and $50, depending on the drug). 

PBMs vs. Drugstores

Which side has more market power – the buyers or the sellers? One way to tell is to look at the relative price performance of the companies’ stocks. I’ll add CVS Caremark (NYSE: CVS) to the mix since it is a hybrid of the two, owning both retail drugstores and a PBM. For a start date, let’s use March 9^th 2011, which is when Walgreen announced that it was divesting its own PBM – Walgreens Health Initiatives – to Catalyst Health Solutions (NasdaqGS: CHSI). The winner by a landslide is CVS Caremark:

Source: Bloomberg

Express Scripts has performed slightly better than Walgreen but it’s pretty much a wash. Walgreen’s competitive advantage is that it is the largest drugstore chain in the U.S. with 7,800 locations (including 250 Duane Reade stores in the New York City area) and the best computer technology in the business. Express Script’s competitive advantage is that it is the third-largest PBM in the country with an 11.8% market share, behind only Medco Health Solutions’ (NYSE: MHS) 18.2% share and CVS Caremark’s 17.8% share. Its client list includes both Wellpoint (NYSE: WLP), the largest U.S. health insurer by membership, and TriCare, which is the largest health insurer for the U.S. military. If Express Scripts’ merger with Medco ends up being approved by antitrust regulators (doubtful at this point), the combined entity would become the largest PBM by a wide margin.

Walgreen Earnings are Poor

Based on Walgreen’s first-quarter financial report, it looks like Walgreen’s is the loser. Earnings fell 4.5% year-over-year because of a slow flu season (600,000 fewer shots administered compared to last year) and costs associated with its split from Express Scripts, which currently makes up $5.3  billion (7%) of Walgreen’s total annual revenue.

Express Scripts controls the purse strings and has locked its insurer clients into long-term contracts (although it may be sued by Wellpoint), so prescription drug customers are likely to stay with Express Scripts and dump Walgreen rather than switch PBMs. As a Morningstar analyst recently pointed out:

About half of Express Scripts’ revenue is derived from two long-term contracts that extend more than five years. The remainder of the company’s client book is on three-year contract cycles, leaving only a midteens percentage of revenue up for renewal in any given year.

Walgreen is the Loser

Advantage: Express Scripts. It’s a fact of life that most people get their healthcare through their employers, so employers and their PBM partners have the power. And those PBMs that can offer employers the lowest costs will win. A combined Express Scripts/Medco will be able to offer the lowest costs to employers, but until then CVS Caremark is probably the low-cost leader.

Bottom line: Based on Porter’s Five Forces, CVS Caremark looks best positioned for the future with vertical integration between PBM and drugstore. Vertical integration means synergies and lower prices, which is all I really care about as a consumer.

Walgreen needs to ask itself why a drug customer would go anywhere else but CVS Caremark. Beats me.