UPDATE 5-Medco shares tumble after losing contract to CVS

* FEP mail, specialty drug contract moving

* Contract generates nearly $3 bln in revenue

* CVS had been managing retail drug benefits for FEP

* Medco shares drop as much as 12.5 pct

* CVS shares rise nearly 2 pct (Adds analyst comments, rewrites first paragraph)

By Lewis Krauskopf

NEW YORK, May 27 (Reuters) - Medco Health Solutions Inc MHS.N will lose a major pharmacy benefit contract to CVS Caremark Corp (CVS.N) starting next year, a setback that sent its shares down by as much as 12.5 percent on Friday and sparked further concerns about its ability to retain business.

The surprise decision on the Federal Employee Program account, for which Medco has been providing mail-order and specialty pharmacy benefits, follows closely on Medco losing a contract with Calpers, the biggest U.S. public pension fund.

The FEP move stands to hit Medco's profits next year by an estimated 8 percent while also reigniting concerns over whether the large U.S. pharmacy benefit manager will be able to hang onto another big contract that could be decided later this year. Chief Executive Officer David Snow only a couple weeks ago expressed confidence to Reuters that Medco was well-positioned to retain the FEP contract.

"It's a big loss because it's a high profitability contract with a lot of mail," Jefferies & Co analyst Arthur Henderson said. "The gold standard supposedly in the PBM business for mail is Medco."

For CVS, the win helped validate its controversial acquisition of the Caremark drug-benefit business at a time when the company is warding off calls to split up the business, although some analysts said they suspected CVS offered a discount to win the account. Its shares rose nearly 2 percent.

The contract concerns dim some of the glow for Medco, which like other PBMs is expected to benefit greatly from a wave of new generic drugs expected in the next few years. PBMs profit more from low-priced generics than brand-name medicines, using their size to leverage discounts from manufacturers.

Gabelli & Co analyst Jeff Jonas called it "just a rough patch for the company" and cited Medco's strength in developing clinical programs for specialty medicines and genetic testing.

"The generic wave is going to help everyone in terms of improving margins and profits," Jonas said. "Overall Medco is still going to be a net business winner, but obviously not in 2012."

$3 BILLION CONTRACT

Medco was notified on Thursday that the Blue Cross Blue Shield Association intends to move its mail order and specialty pharmacy benefit coverage for the Federal Employee Program, the company said in a securities filing.

CVS, which has been administering FEP's retail pharmacy benefit management program since 1993, will add the mail-order and specialty pharmacy services, it said in a press release.

The FEP contract generates nearly $3 billion in annual revenue, including about 9.8 million mail order prescriptions, Medco said.

"We're disappointed that they have chosen to go in a different direction," Medco spokeswoman Jennifer Luddy said.

Medco shares have risen about fivefold since the company went public in 2003, but lately have been more sluggish. They are down 5 percent this year while main rival Express Scripts Inc (ESRX.O) is up 8 percent.

Pharmacy benefit managers, or PBMs, administer drug benefits for employers and health plans and also run extensive mail-order pharmacies. Generic drugs delivered by mail are particularly profitable for Medco.

Medco said the FEP contract represents less than 10 percent of its estimated 2011 earnings, but that the contract loss would not hurt earnings this year because it runs through the end of 2011.

Henderson estimated the contract was worth about 40 cents per share for Medco, or about 8 percent of his total 2012 earnings estimate of $4.92.

The loss was also a blow because Medco has had a very high retention rate, Henderson said.

Wall Street is concerned that Medco may further lose a contract with insurer UnitedHealth Group Inc (UNH.N), which represents 17 percent of revenue and high single-digit percentages in earnings. That contract is set to lapse at the start of 2013, and some analysts expect UnitedHealth to move more of its drug benefit services in-house.

Investors also have been worried that Medco's ability to retain business might suffer because of a controversy involving Calpers, the California Public Employees' Retirement System.

Earlier this year, Medco received a subpoena from U.S. securities regulators involving a probe into a former Calpers board member whom Medco paid as a consultant to help secure a lucrative contract with the pension fund. Medco has said the Calpers issue has not been a significant business distraction.

"From a reputation standpoint, did Calpers damage them more than we have come to believe lately?" Henderson said.

CVS, meanwhile, has had a rocky history with its PBM business after buying Caremark for $27 billion in 2007. Late in 2009, the PBM lost $4.8 billion in contracts heading into the new year, and the president of the unit left.

At the same time, CVS disclosed that the Federal Trade Commission was investigating some of the combined company's business practices, leaving questions about whether the merger made sense.

CVS said earlier this month that it had no plans to split up its operations, even though the Caremark part of the business has been a drag on overall profitability.

"That's a big win for CVS at a critical juncture of them trying to prove that their PBM is working," Henderson said.

Shares of CVS were up 71 cents, or 1.9 percent, at $38.86 in afternoon trading on the New York Stock Exchange. Medco shares were off $6.01, or 9.3 percent, at $58.43, after falling as low as $56.38. (Additional reporting by Jessica Wohl in Chicago; editing by Gerald E. McCormick, Lisa Von Ahn, Phil Berlowitz)