Walgreen and Express Scripts remain at an impasse. Walgreen's (WAG) fourth-quarter results slightly exceeded our expectations. However, the relatively strong performance was overshadowed by management commentary that seemed to indicate Walgreen and Express Scripts (ESRX) remain far apart in their negotiations, with little hope of reaching an agreement before their current contract expires. We are maintaining our fair value estimates for now, but will be inclined to lower Walgreen's valuation if the contract is not renewed.
We have consistently stated that it is in both Walgreen's and Express Scripts' best interest to come to an agreement. While investors are rightly concerned that Walgreen's management claims "no substantive progress" has been made in the negotiations--sending Walgreen's shares down 6% on Tuesday--the companies still have three months to find a compromise.
On the other hand, the fact that Walgreen appears to be digging in its heels is not promising. We believe Express Scripts has the upper hand in this negotiation, thanks to its relatively stable membership base and the nation's current obsession with controlling health-care costs. Express Scripts' CFO commented at a recent conference that most of Express Scripts' clients support the company in the dispute and are unwilling to pay a premium price to keep Walgreen in the pharmacy network. The CFO also characterized the portion of its business that could be at risk as "not meaningful" to overall earnings.
In the meantime, Walgreen has been trying to convince Express Scripts' customers to bypass the pharmacy benefit manager and contract directly with Walgreen. In response to a question on the conference call about whether any employer groups had actually signed a separate agreement with Walgreen, management refused to answer. Between contract provisions that may prevent such agreements and the added complexity for employers, we are skeptical that Walgreen can retain a significant portion of business this way.
Also on the conference call, management offered an initial estimate of the potential earnings impact in 2012 of the loss of Express Scripts. It estimates the lost earnings between $0.21 and $0.07 per share. The former number assumes Walgreen retains 25% of sales to Express Scripts' members, while the latter assumes it retains 75%. Both numbers assume that Walgreen can achieve cost savings to offset half of the gross profit loss. In our opinion, even the $0.21 estimate (which would represent about 7% of projected 2012 earnings) is optimistic. Given the high-fixed-cost nature of the retail pharmacy business and our opinion that the vast majority of sales to Express Scripts' members will be lost without the contract, we would expect the actual earnings impact to be greater than this.
The full edition of this week's Morningstar Healthcare Insights is available here on Select.