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Monday, May 17, 1999

An Investment Opinion
by Alex Schay

Of the Body, Of the Market

In late April, when asked by a Bloomberg reporter about his company's prospects for remaining independent in the foreseeable future, Tom Pigott, Chief Executive Officer of the online pharmacy replied cryptically, " is building for the future, and we'll see what the future holds."

CVS Corp. (NYSE: CVS), the nation's largest drugstore chain in terms of total bricks laid, clearly realizes that its business future will require an online presence. With "convenience" the raison d'etre in pharmacy circles, offering online distribution in order to round out the overall convenience package is a no brainer. While CVS has been developing its existing site to support its bricks and mortar operations, the firm announced today that it will acquire in a $30 million all stock pooling transaction (which will not be dilutive this year). will operate as a subsidiary of CVS.

So, why might you buy prescription drugs online? The short answer is, usually you wouldn't. If you have some malady, and it's already been diagnosed, chances are you want to go as quickly as possible to the nearest store and pick up your cure. The online medium right now is targeting customers with "chronic" conditions, as well as others who need refills on a regular basis (often these are overlapping circumstances). Still, the market has been estimated to be an $8-$12 billion opportunity. Coupled with over the counter drugs, personal care products and other drugstore staples, the market balloons to $70-$80 billion. opened its online doors in January -- the first online pharmacy to do so -- and since that time has reported a 25% compound weekly growth in sales for its first quarter of operation (with roughly 50% of its orders due to the online element of its business, the balance comes from phone and fax orders). In terms of "lives covered" has built an impressive network of relationships reaching 100 million people -- or roughly 200 insurance plans through PBMs and HMOs. This of course allows customers to deliver insurance information and make the familiar co-payments, rather than pay the full retail price for drugs. Situated in the middle of the country, claims that with a $9.95 fee, it can overnight its drugs anywhere in the country, making the value proposition a little more compelling.

CVS's alliance with reflects its desire to be first to market (among the traditional chains) with an "integrated retail Internet offering" this summer, taking advantage of's advanced backend (automated prescription order fulfillment). Plus, doing some back of the envelope calculations, with only 1% penetration of the refill market for in its first year, CVS might be looking at a 9% return on investment after twelve months. The $30 million stock deal looks like a very attractive price. In the meantime, CVS will expand's over the counter and ancillary products from its present total of 3000, to about 9,000 offerings. With CVS pouring $200 million into advertising every year, it will be quite easy for the company to direct eyeballs online if the proposition is appealing to consumers.

Do you think that convenience doesn't matter? During 1997, CVS implemented "Rapid Rx Refill," which enables customers to order prescription refills 24 hours a day using a touch-tone telephone. In just over 18 months after its debut, Rapid Rx Refill accounted for approximately 50% of refills. Ordering drugs online can be just as painless and, coupled with the opportunity to pick up some consumer staples, the lure for the online firms is obvious.

Drug retailers derive a significant amount of their pharmacy business from third-party payer programs. That is, many chain drug stores own PBMs as subsidiaries (like PCS, Inc., which is owned by Rite Aid, and PharmaCare which is owned by CVS). In fact, in 1998 about 85.4% of Rite Aid's pharmacy sales were third-party prescription revenues. The two major vehicles for prescription growth have been these plans, as well as the purchase of "prescription files" from independent pharmacies (essentially customer lists).

Although managed care providers have made the cost of prescription drugs more affordable for a greater number of people and have supported prescription drug therapy as an alternative to more expensive treatment (such as surgery), they have a tendency to demand lower and lower plan costs from PBMs -- which hurts their margins. CVS has a "minimum margin policy" with regard to this aspect of its business, and it has noted on numerous occasions that it has had to turn away third-party payers that do not meet its profitability requirements. Investors should monitor these trends -- for any acceleration in low-margin pickups can have some serious effects on operating performance.

Thus far, has been extroverted in asserting that it can bring retail drug costs down, thanks to the online cost filter. Investors need to be aware of these relationships and the possible clashes as the merger proceeds. Overall though, the deal is a good one for CVS, making sure that the firm is not just protecting market share erosion, but actually attempting to expand its reach as well as provide a complete offering for its existing customers.

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