Hmmm, wasn’t I just saying something about pharmacy industry consolidation?This morning, Walgreen (NYSE:WAG) announced its acquisition of Duane Reade, the largest regional pharmacy chain and a dominant player in the New York market. Read the official announcement.
The pharmacy industry is becoming a classic barbell market—many small players, a few big ones, and an ever-decreasing number stuck in the middle. The big get bigger while nimble independents survive in their shadow. The regional chains are trying to play the game of the nationals, but without the infrastructure or bargaining ability versus third-party payers.
The deal also portends another customer loss for AmerisourceBergen (NYSE:ABC), while Cardinal Health (NYSE:CAH) picks up incremental volume but at lower profits.
PHARMACY INDUSTRY IMPACT
The deal gives Walgreen’s significant presence in the highly competitive and hard-to-enter New York City market. Walgreen will also be able to leverage its infrastructure, although the Duane Reade name will remain post-acquisition.
I assume Walgreen will improve customer service because Duane Reade ranked dead last among chains in J.D. Power’s most customer satisfaction survey. Maybe New Yorkers are just a critical bunch.
Initial thoughts on the marketplace implications:
- Pharmacies must fight for market share. Remember when Walgreen used to open hundreds of new stores each year? Well, those days are gone because overall prescription growth is now in the low single digits. Scale matters in the slower growth retail pharmacy business.
- Walgreen will benefit from a cost-leadership position. As I discuss in Walgreen's Future Profit Potential, Walgreen’s strategy is in sync with two important industry trends: (1) low-cost prescription fulfillment, and (2) channel-neutral dispensing models.
- Buying share is cheaper than taking it. Consumers are pretty loyal to their primary pharmacy. Gaining market share with low prices is virtually impossible given third-party payment for most scripts and equal co-payments at any pharmacy. Plus, any price drop has to be big enough to make a consumer a customer to terminate a long-standing relationship. (Hello, Wal-Mart!)
- More regional acquisitions ahead. Smaller drugstore chains still retain market share in selected regions but are just too tempting for the big chains. A few other notable regional acquisitions in recent years include Longs (to CVS), Happy Harry’s (to WAG) and Snyder’s (split between CVS and WAG). Rite-Aid's days as a national player may be coming to end as well.
- Independent pharmacy will remain a viable channel. Don't panic. Surviving independent pharmacies are getting bigger (in both revenues and scripts per location) yet continue to receive the highest marks for customer satisfaction. The large wholesalers are also investing a lot to keep these profitable accounts alive. In my pharmacy industry economic report, I project that revenue growth at independent pharmacies will be flat despite overall market growth, but the total dollars will still be significant.
AmerisourceBergen’s (NYSE:ABC) drug corporation business currently services Duane Reade. Presumably, Duane Reade’s purchasing volume will eventually move to Cardinal Health (NYSE:CAH)—Walgreen’s primary drug wholesale supplier—when the current supply contract is over, reportedly at the end of 2010.
Duane Reade is about 2.2% of ABC’s retail pharmacy drug distribution revenues, although this translates into only about 0.7% of ABC’s overall corporate revenue. CAH won’t get the full benefit of the switch because Walgreen’s will probably move the more profitable generic sales to their own direct sourcing from generic manufacturers, although ABC apparently has very little of this generic volume, anyway.
Recall that ABC also has risk related to CVS Caremark’s (NYSE:CVS) 2008 acquisition of Longs Drug Stores. At the time of the acquisition, Longs bought more than 90% of its pharmaceuticals from AmerisourceBergen under a long-term contract, which includes a minimum purchase requirement over the contract term. At some point, CVS Caremark will consolidate purchasing volumes for brand drugs with its primary retail wholesaler (also Cardinal) while shifting generic purchases to direct relationships with manufacturers.
The timing of the switch is uncertain, especially in light of Walgreen’s statement:
“Duane Reade will continue to operate under its brand name after the transaction closes. With Walgreens currently operating 70 stores in the New York City metropolitan area, decisions will be made over time as to the best, most effective way to harmonize the Walgreens and Duane Reade brands. Walgreens expects to retain Duane Reade's store, pharmacy and distribution center employees and many members of Duane Reade's senior management team following the acquisition. Over time, consolidation of core functions at the corporate offices will occur.”Gosh, the fun never stops, does it?