This is a logical, tuck-in acquisition that builds regional scale à la Duane Reade. The deal won’t be enough to stop the narrow network trend or force Express Scripts back to bargaining table, but it does add heft to an already big player and fit with broader pharmacy industry trends. Investors were comforted to know that management still has some sensible ideas about capital allocation. See below for details.
BTW, the deal implies a small customer loss for McKesson (NYSE:MCK), while Cardinal Health (NYSE:CAH) picks up a bit more incremental volume at lower profits.
And here's a drug channel puzzler: Will Walgreen—now the biggest non-US wholesaler—continue to operate USA Drug's SAJ Distributors subsidiary, a $100 million+ drug wholesaler serving about 1,000 independent pharmacies?
TOO BIG TO IGNORE?
Walgreen has built a large, multi-channel footprint that crosses retail, mail, specialty, and home-health care dispensing formats. Here’s a look at their store count as of May 2012:
- Slow-growth encourages consolidation. In 2011, total prescriptions dispensed grew by a meager 0.3%. (See How the Pharmacy Industry Changed in 2011.) Organic growth is hard to come by. This is especially true for Walgreens, for which same-store sales are dropping by 10% or more. See Walgreens is Losing Its Battle with Express Scripts.
- Buying share is cheaper than taking it. Consumers are generally loyal to their primary pharmacy. Most people still have third-party coverage with equal co-payments, so pharmacies don’t have to compete on price and can only provide minimal financial incentives for switching. Walgreen even got into trouble with the U.S. Department of Justice when it provided $25 gift cards for prescription transfers, as detailed in Walgreens Pharmacy Chain Pays $7.9 Million to Resolve False Prescription Billing Case.
- Preferred networks are still uncommon. Commercial payers are still slow to adopt limited network models, with the exception of the Maintenance Choice model. In contrast, preferred network plans are growing the most quickly in Medicare Part D program, in which individual beneficiaries must make a deliberate trade-off between costs and pharmacy availability. See Humana-Walmart Preferred Network Plan Wins Big in Part D.
- Scale matters. Bigger is better, especially when it comes to generic purchasing and payer negotiations. Smaller pharmacies can simulate some of these benefits with Pharmacy Services Administration Organizations (PSAOs) and buying groups. U.S. antitrust law (rightly) prevents outright collusion among these pharmacy competitors. For better or worse, a single, consolidated organization can act unilaterally in contract negotiations with buyers and suppliers.
- Local scale matters even more. Local market share growth provides incremental bargaining power against pharmacy benefit managers and payers. Walgreen’s market share is already above 40% in such major cities as Chicago, Houston, Miami, San Francisco, Phoenix, Minneapolis, and St. Louis. The Southeast, where USA Drugs is strongest, fills an important map gap. Express Scripts was able to drop Walgreens from it network while still meeting access requirements, but it gets harder as the chain spreads.
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