Betting On Mutually Assured Destruction

Walgreens is the largest drug store in America with 20% market share of prescriptions. Express Scripts and Medco are two of the three largest pharmacy benefit managers in America. Express Scripts and Walgreens could not come to an agreement on an extension of their contract that ends at the end of this year. Express Scripts is also trying to merge with Medco.

It is not in Walgreens or Express Scripts best interest to lose each other. For Walgreens it would mean a large loss in business when the contract runs out. For Express Scripts it would mean difficulty in attaining new business and renewing contracts. The PBM business is extremely competitive and not having access to the drugstores that 20% of Americans prefer to shop at would give their competitors a giant leg up in winning new business. As an insurance company, why do business with Express Scripts when for the same price or very close to it  one can do business with Caremark and give customers access to all pharmacies. Why piss off 1/5 of your customers?

As in all negotiations both sides must behave as if they are willing to walk away. And obviously the analyst at Barclays believes the bluff. He assigned a 2/3 probability to the possibility that Walgreens and Express Scripts don't come to an agreement. Within that probability he assigned a 50% probability that Walgreens loses Medco as well once the takeover is completed.

Since it is in both companies best interest to come to an agreement I have to believe an agreement will eventually be reached. I think the worst case is that there is no agreement for a few months into next year. Assigning a 2/3 probability to no agreement with no room for reconciliation further out is absolutely ludicrous. It reminds me of the people who believed the debt ceiling would not be raised.

I believe Walgreens is a bargain at current prices. The business is recession resistant, will benefit from baby boomers filling more prescription, the multiple is attractive and management has  a good record of returning cash to shareholders. I believe we are simply witnessing a negotiation, which is creating an opportunity.

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