New Era Begins for Walgreens

A new era has begun at Walgreens, with the firm reporting results for the first time as the new

Year over year, total revenue increased 22%, driven largely by a two-month operating contribution from the Alliance Boots assets and good performance by Walgreens' U.S. operations. While total company like-for-like sales figures are skewed given the major acquisition, the domestic operations did show some solid signs of top-line improvement. Retail (front-end) sales increased a decent 2.5%, but the firm was able to drive pharmacy (back-end) revenue up an impressive 10%. Walgreens saw a major improvement in the number of prescriptions processed, which management attributed to a "strong cough, cold, and flu season." Walgreens also said it was able to increase its prescription claims market share for the quarter, which we find highly positive. We are encouraged by these results and believe the firm has an opportunity to benefit greatly from increased U.S. pharmaceutical usage.

However, our main concern about the profitability of the firm's core pharmacy operations remains. Management reported that the U.S. division produced $1.3 billion in operating profit, implying a 6.19% operating margin. This is about flat with year-ago results, and with management reporting improved retail sales margins, we believe the firm still faces significant prescription reimbursement pressure from major pharmacy benefit managers. From our perspective, this will be the main headwind for Walgreens' new management team over the next several years. We believe the growing pricing power of major PBMs may limit Walgreens' ability to negotiate favorable reimbursement rates.

With this dynamic in mind, management said during the earnings call that it is open to many options in order to offset the pricing leverage of its major payer customers, including the possibility of vertical M&A or integrated strategic partnerships. From our perspective, this is a signal that Walgreens may be open to greater PBM integration. This is a key development and a major shift in tone from the previous management team. While an all-out acquisition could be too difficult to execute, we believe a true merger of equals or strategic partnership seems more likely. In our opinion, a more integrated relationship with a major PBM would be highly beneficial to Walgreens and would offset much of its reimbursement headwinds.

Pharmacy Customers' Growing Power Adds Pressure Walgreens has been one of the most successful retail operators since its founding in 1901 and has remained a major player in the pharmaceutical supply chain for many decades. The firm processed a little more than 16% of total U.S. prescriptions during its fiscal 2014, which makes it one of the largest retail pharmacies. With the recent acquisition of Alliance Boots, the firm is now a premier global retail powerhouse.

However, we believe Walgreens faces a pressured operating environment, given the rapidly growing power of pharmacy customers. The firm contends with a pharmaceutical customer base that has enormous pricing power. Walgreens derives a significant majority of prescription revenue from third-party payers (employers, insurers, managed-care organizations, government programs), and large pharmacy benefit managers represent most of these customers. Large PBMs are able to aggregate an enormous amount of claim volume and leverage this into powerful pricing negotiating power. This dynamic puts enormous pressure on retail pharmacies, and the ability of these players to push back on pricing demands from customers is a challenge. In the United States, consumers of prescription drugs typically use only five major intermediaries to adjudicate more than 70% of the total adjusted prescriptions filled annually. This effectively makes two thirds of Walgreens' revenue heavily reliant upon only five major customers, which can lead to enormous pricing pressure.

While approximately two thirds of Walgreens' revenue is derived from the sale of prescription drugs, we believe the firm is analogous to a mix of convenience and mass retail store. Management has said it will look to push front-store (nonpharmaceutical) products in order to drive revenue and profits. In our opinion, this demonstrates the weaker position along the pharmaceutical supply chain for Walgreens as it tries to offset a more pressured retail pharmacy operating environment with grocery and convenience goods. This strategy will also put the firm in even more direct competition with the mass grocers and retailers and into sectors where profits and outsize returns on invested capital are hard to come by.

No Significant ROIC Recovery in Sight Obtaining a moat in the retail grocery and convenience goods industry can be an arduous task. Given this dynamic, we don't believe Walgreens has an economic moat. We believe the confluence of pricing pressure from major pharmacy customers (drug benefit plan payers, PBMs, government entities), greater competition from mass grocers and retailers, and heavy dependence on nonpharmaceutical (front-store goods) products for profitability has steadily pushed the firm's returns on invested capital downward. In fact, ROICs adjusted for operating leases have steadily fallen toward the firm's adjusted weighted average cost of capital of 8.7% over the past five years. We do not foresee a significant recovery for this metric and believe these returns will remain on the same trajectory over our explicit forecast.

The 2012 contract/pricing dispute with Express Scripts served to highlight the precarious situation in which Walgreens finds itself. The firm is beholden to a few major customers that can apply enormous pressure at any given time; this is a major concern that will most likely curb economic profits over the long term. We do admit that drug plan payers find the convenient distribution channel of Walgreens advantageous, but the growing prevalence of other distribution channels (other mass retailer and mail-order pharmacies) has created more options for drug plan payers.

To offset some of the previously mentioned headwinds, Walgreens has sought to enhance its own supplier purchasing power by acquiring Alliance Boots (a major European pharmaceutical retailer and distributor) and partnering with AmerisourceBergen (a major U.S. pharmaceutical distributor). The opportunity to gain distribution efficiency and enhanced manufacturer pricing leverage with these relationships will be a positive for Walgreens. However, the ultimate synergy outcome of these partnerships is still uncertain. In addition, these partnerships were in direct response to the Express Scripts contract dispute. In our opinion, Walgreens needed to offset the pricing pressure of lower reimbursement rates from payers by building its own supplier negotiating power and potentially gaining better manufacturer pricing. With that said, we are not totally convinced these strategic moves will be able to significantly change the long-term trajectory of the firm's ability to produce consistent economic profits. While ROICs will be positively influenced by these tactics, we believe the efficiencies gained will not offset the pricing power of drug plan payers and the variability of consumer discretionary spending.

Even though the firm may not possess the competitive advantages to consistently produce economic profits, we believe its competitive positioning is not deteriorating, either. While some of the other players along the pharmaceutical supply chain do have significant leverage over Walgreens, we believe there is enough value and demand to ensure a stable moat trend. The firm's extensive retail footprint in convenient locations throughout the U.S., its recognized brand, and prime distribution channel are solid variables that should keep its economic moat stable.