Thursday, October 29, 2015

The Walgreens-Rite Aid Deal: Ten Things You Should Know

Wow. Walgreens Boots Alliance is acquiring Rite Aid. As I told The New York Times: “The pharmacy consolidation endgame has begun.

Read on for my analysis of the deal and what it means.

Feel free to add your own thoughts in the comments below. (Yes, you can comment anonymously.)

THE NEWS

Given the consumer angle, the deal has been widely covered. Here are two significant news reports that outline the transaction’s high points:
And here are the surprisingly skimpy official company documents:
The deal was not a total surprise. In April, I asked Will Walgreens Boots Alliance Buy Rite Aid?

ADAM'S OBSERVATIONS

1) WBA is doubling down on retail pharmacy.

Rather than buying a big PBM (Express Scripts?), Walgreens is doubling down on its pharmacy dispensing business. This strategy is consistent with the retail-centric themes that WBA described during its April analyst day. See my comments on pharmacy hypercompetition and payer relationships in Walgreens Boots Alliance: Analysis of its New U.S. Pharmacy Strategy.

On yesterday’s earnings call, Walgreens president Alex Gourlay even reiterated that the company’s retail stores would continue to sell tobacco. I guess Walgreens likes being at the Corner of Happy and Hacking®.

2) Surprisingly, WBA is claiming that mega-scale with payers did not drive the deal.

The new WBA will have more than 12,000 locations, accounting for about one in five retail pharmacies. Its network now exceeds the CVS retail network, which had jumped ahead after the CVS-Target deal.

Meanwhile, about three-quarters of all store-based retail prescription claims are now processed by three pharmacy benefit managers (PBMs): Express Scripts, the Caremark PBM business of CVS Health, and the OptumRx business of UnitedHealthcare.

In theory, WBA’s new scale could provide some countervailing power in its negotiations over network access and reimbursement rates. For instance, the company may have to offer smaller discounts to participate in preferred networks. On yesterday’s call, however, CEO Stefano Pessina emphasized that the Rite Aid acquisition was motivated by internal and financial synergies of about $1 billion, rather than by a desire to increase negotiating power. Is this strategic spin or a frank acknowledgement that PBMs are the power players in the drug channel? Hmmm.

3) Envision Rx is a learning opportunity, not a strategic driver.

In February, Rite Aid announced its acquisition of EnvisionRx, a small, privately held PBM. See Rite Aid-EnvisionRx: Initial Thoughts on the Deal. Rite Aid had seemed to be building a mini-CVS Health. In the 10 months since, however, Rite Aid hasn’t executed on any new preferred network offerings or specialty pharmacy strategies.

Therefore, the EnvisionRx potential still exists. However, WBA executives pooh-poohed any desire to expand into the PBM business. Gourlay referred to EnvisionRx as an “important but very small PBM business” that would “help us understand access in America better.” Pessina called EnvisionRx an “opportunity to learn.”

Put less charitably, those comments mean that WBA’s management team has a clear retail mindset but lacks experience with payer businesses.

I expect that chatter about an imminent Express Scripts acquisition should end, too. Over time, perhaps WBA will learn enough to make a run at a bigger PBM target.

4) The FTC will approve the deal.

The Federal Trade Commission (FTC) will review the deal and could try to block it as anti-competitive. According to antitrust experts cited in the media, the FTC will study specific geographical areas where Walgreens and Rite Aid compete.

I don’t perceive that this review will pose significant barriers. Even in regional markets where the combined company would have a high share, retail pharmacy competition should remain robust and barriers to entry should remain relatively low.

Wholesalers are also providing a broad range of business management services intended to increase the profitability and productivity of independent drugstores and other smaller customers. These services also include ownership transfer and pharmacy start-up. (See section 2.2. of our new 2015-16 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors.) Note that the number of independent pharmacies has remained remarkably stable, despite pharmacy closures, acquisitions, and file buys.

At worst, WBA may have to divest (not just close) stores in certain markets. Oddly, Pessina dodged the FTC question with some vague answers about internal analysis. So we don’t know how many store divestitures would trigger deal renegotiation or termination. I suspect his evasiveness was one key reason that WBA’s stock price dropped by 11% after the earnings call.

5) The deal adds even more complexity and opacity to WBA.

The Rite Aid deal adds even more complexity and opacity to an already complex and opaque global business. Walgreens Boots Alliance operates one of the largest U.S. drugstore chains, the largest European drugstore chain, and one of the largest European drug wholesalers. WBA’s reporting of aggregated “synergies” also makes it very hard for investors and outsiders to evaluate the underlying performance of different business segments.

On yesterday’s call, the CFO spent the first 45 minutes discussing global financial results. (Actually, he slowly and methodically read the prepared powerpoint slides. Painful.) That left less than 30 minutes for questions about the Rite Aid deal. I felt that the WBA management team provided only vague answers to many good questions.

And don’t forget that Rite Aid is still a turnaround story. The majority of its stores have not been renovated. Many lack attractive retail locations. The WBA management team will definitely have its hands full.

6) It’s good for AmerisourceBergen, but horrible for McKesson.

Pity poor McKesson. It has been on the losing end of multiple consolidations. After 2015, McKesson will face the possibility of losing three large customers: Omnicare, Target, and OptumRx. The Rite Aid deal is a bigger blow. For full analysis of the McKesson-Rite Aid relationship, see Section 9.3.3. (page 133) of our new 2015-16 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors. UPDATE: This morning, McKesson reported that it will be retaining Omnicare brand distribution business, but generic sourcing will shift to Red Oak.

As Walgreens’ current wholesaler, AmerisourceBergen will presumably benefit from additional low-profit, brand-name drug distribution revenue. Any generic sourcing benefits, however, will be captured by WBA, which will likely pay ABC a fee for generic distribution to its stores.

The timing of any volume shift is uncertain. McKesson’s deal with Rite Aid extends through March 2019. We don’t yet know about termination or change-of-control provisions in their agreement. On yesterday’s call, Pessina was non-committal about McKesson’s future role. Meanwhile, ABC's stock was up 4.7% yesterday, while McKesson's stock dropped by 2.8%.

7) Wholesaler outsourcing will make integration easier.

In recent years, both Walgreens and Rite Aid have transitioned to direct-store deliveries from their primary wholesaler and eliminated self-distribution capabilities for pharmaceuticals. Thanks to these outsourcing deals, both companies have become more operationally nimble, which will make it easier to combine pharmacy operations. Plus, the new WBA management team, almost all of whom hail from Alliance Boots, are experienced at effectively integrating horizontal acquisitions.

8) WBA will (probably) proceed with its ABC warrants.

In 2016 and 2017, WBA has the right (but not the obligation) to purchase 45.4 million shares of AmerisourceBergen’s common stock for $2.4 billion. Those ABC shares are currently worth more than $4.4 billion. See Why Walgreens Boots Alliance is Triggering a Huge AmerisourceBergen Stock Buyback.

The Rite Aid deal is an all-cash transaction. WBA is therefore suspending its share repurchase program and applying the funds to the Rite Aid acquisition. Will WBA still want to spend the cash for the ABC shares? I think it will, but the $2 billion paper gain could create other creative financial opportunities. Keep an eye on this issue.

9) All hail our global channels overlord.

Billionaire Stefano Pessina has been methodically building a global drug channels powerhouse. He essentially persuaded Walgreens’ previous management to pay him and his team to acquire Walgreens and fire them. Rite Aid was one of the last remaining significant pharmacy assets available to purchase and clearly fit into his master plan.

Forbes estimates Pessina’s net worth to be $13.2 billion, up an astonishing $7 billion since March 2013. Let’s face it: He’s not doing it for the money.

10) Big deals beget more deals.

Expect follow-on deals throughout the drug channel, as the unaffiliated players try to figure out survival strategies for our increasingly consolidated healthcare markets.

P.S. No word yet on what will happen to Rite Aid’s Peepness+ rewards program.

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