Thursday, August 24, 2006

Rite-Aid + Brooks-Eckerd: Will three wrongs make it Rite?

So much for taking the rest of August off!

As you all know by now, Rite-Aid plans to buy Brooks and Eckerd stores. Following this deal, Rite-Aid/Brooks-Eckerd will become the third-largest store-based pharmacy, jumping ahead of Wal-Mart.

My thoughts:
  • Good for Rite-Aid
  • Better for PBMs and payers
  • Bad for wholesalers
  • Potentially bad (over the next few years) for the chain pharmacy industry

Impact on Retail Pharmacy

Retail chains need scale so they can control access to patients and gain leverage against the payers, PDPs, and PBMs that want access to this network. As I point out in my June 8 dead canaries post, CVS and Walgreens are both trying to grab market share as quickly as possible. Chains with strong store loyalty and a high share of outlets in a given geographic market can negotiate better reimubrsement rates.

For reference, here is our breakdown of 2005 retail pharmacy sales by channel and company.

RetailPharmacy-2005.pdf

Ironically, this move may turn out to be negative for the chain pharmacy industry. The Rite-Aid/Brooks-Exckerd combination creates a credible third large chain pharmacy that PBMs and payors can play off against CVS and Walgreens. The presence of three big suppliers in a market creates much more competitive pressure, as wholesalers have discovered to their regret.

What about wholesalers?

As far as I know, both Rite-Aid and Brooks-Eckerd are McKesson customers, which means that there will be no meaningful volume movement between wholesalers. The deal will create even more customer concentration for McKesson, whose top two customers are CareMark and Wal-Mart.

Nevertheless, this deal creates risk because wholesalers have become dangerously dependent on these low margin power customers. Retail chains such as CVS, Walgreens, and Wal-mart have developed self-warehousing capabilities for distributing drugs to individual stores from their own warehouses. They act as their own wholesaler for generics and many OTC/CPG products.

In Q2, deliveries to customer’s warehouses were 49% of Cardinal’s Pharma Distribution & Provider Services revenue and 32% of McKesson’s Pharmaceutical Solutions revenue. Wholesalers rationalize these sales by arguing it incremental business that would otherwise go direct (true) and generates a reasonable return of capital (insufficient disclosure to verify this claim). Last year, I argued that changes in the drug channel could shift this business back to direct sales. (See my September 2005 white paper Preparing for the Future Retail Pharmacy Supply Chain.) Still a risk, in my opinion.

The Sink to the Bottom Line?

Let’s face it – Rite-Aid, Brooks, and Eckerd are notorious underperformers in retail pharmacy. Yes, things have improved, but none of the companies are as well run as CVS or Walgreens. As one industry executive quipped to me this morning: “If you tie two rocks together, they still won’t float.” Nonetheless, the deal makes sense given the marketplace dynamics.

That’s all for now. Back to my vacation from blogging!

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