Tuesday, October 02, 2007

Wal-Mart's Gain is not Walgreen's Pain

I’ve been warning about the attack on generic pharmacy profits since I launched my blog 16 months ago. I even nominated Lobbying for Pharmacy Profits as a trend to watch in 2007.

Wal-Mart’s announcement of its expanded generic drug program and Walgreen’s weak profits are further evidence of this trend. But contrary to some press reports, I don't see a direct cause-and-effect relationship between these two events.

Walgreen’s Pain

Yesterday, Walgreen Co (WAG) announced a rare profit decline driven in part by lower reimbursements on generic drugs. (See Walgreen's Earnings Fall Spurs Concern in Sector.) The company’s stock dropped by 15 percent – a $7 billion loss in market cap.

But as I noted last week, chains such as CVS Corp (CVS) or Walgreens (WAG) are not really vulnerable to Wal-Mart’s program because customers with third-party insurance do not save much versus standard co-pays.

My take: payers and pharmacy benefit managers now recognize the generic profit potential, so they are squeezing pharmacies sooner and harder than ever before.

Wal-Mart's Math

In contrast, Wal-Mart’s program highlights the high generic margins embedded in the pharmacy business model, especially for cash-pay customers. Yet Wal-Mart’s $4 generics program is neither a loss leader nor a “classic bait-and-switch,” as the National Community Pharmacists Association claims.

Still not sure? Then let’s do some math!

OIG reported average pharmacy acquisition costs for a set of generic drugs in its June report Deficit Reduction Act of 2005: Impact on the Medicaid Federal Upper Limit Program. The cost data were collected from the three largest national drug wholesalers plus two regional wholesalers.

Six of the generic drugs in the OIG study also appear on Wal-Mart’s list. Here’s what I found:

Weighted average margin = 24%. These calculations dramatically underestimate Wal-Mart’s actual gross margin because Wal-Mart's product acquisition costs are much lower than the independents, supermarkets, and small chains that buy through wholesalers. (See my January post for background.)

Add in Wal-Mart’s minimal incremental costs of dispensing and it's clear that the $4 generics program could be very profitable.

BTW, these margins are below what retail pharmacies were earning when dispensing generics under Medicaid in 2002. But isn’t that what led to Average Manufacturer Price (AMP) in the first place?

For fun (?), I searched for a few drugs on the New York State Attorney General’s Office Prescription Drug Price Website. Example: the cash-pay, no-insurance price for Metformin 500 mg ranges from $4 at Target or Wal-Mart to more than $50 at many independents. CVS charges $24.89 and Walgreen (WAG) charges $29.99. I checked some online prices and found similar numbers – Drugstore.com charges $39.99.


Last week, NCPA accused Wal-Mart of "devaluing and destroying the practice of pharmacy." From my perspective, it looks like retail pharmacy is finally facing the consequences of their own business decisions. Wal-Mart is merely targeting an area of excess profits, to the ultimate detriment of less-efficient retail pharmacies. Stay tuned – this will get uglier!


  1. Yes, there is margin there but I would disagree with your comment that they have minimal dispensing cost. Depending on who you believe the cost s of dispensing range from $4-$ per RX, and that would wipe out the margin.

  2. Actually, my comments above do consider Wal-Mart's *incremental* costs of dispensing, which are not equivalent to the average costs you are citing.

    A simple numerical example will show what I mean.

    Assume a pharmacy has 1,000 scripts per week and fixed pharmacy costs (rent, salaries, etc) of $10,000. The average dispensing cost is $10 per script, excluding ingredient costs.

    Now let’s say that the pharmacy increases volume by 15%, which Wal-Mart has done. Marginal (incremental) overhead costs are probably $0.00, but average costs drop to $8.70 per script because fixed costs are utilized more efficiently.

    Most studies of dispensing costs compute average cost, which is meaningless for analyzing the profits of a growing pharmacy. I showed the fallacy of average cost thinking for Wal-Mart last December in Sloppy Reporting about Wal-Mart.


  3. Your point about incremental cost of dispensing is accurate unless the volume dictates that they add people. I wonder if the additional volume is causing misfills? Do you have any insight into how their rank and file RPh feel about the program? Medicaid official who are thinking about adjusting dispensing fees to offset the impact of AMP can use this to go no higher than $4 thus potentially harming the industry. Finally, the dollars that WM is quoting as saving the healthcare system ($600million and counting) is actually coming directly from their bottom line which should give shareholders another reason to be concerned. (as if they need another reason) Is is being offset somewhere else----hopefully.

  4. Are you really suggesting that pharmacy benefit managers are just now recognizing the generic profit potential? Since they own their own mail order pharmacies they have been aware of generic profitability for sometime, hence the maximum allowable cost (MAC). The real question is: Have the PBMs kept the profit or passed on the savings to the payers? You are predicting a large change in generic reimbursement; therefore, the answer must be (not really a surprise) that they did not pass on the savings.

  5. To the commenters above:

    Here's a good article from the Chicago Tribune that sheds some light into the pricing dynamics over time.

    Generic Zocor reduces profits

    As I wrote in my original post, insurers and PBMs are pushing sooner and harder than ever with MAC for retail.


  6. As independent pharmacy owners, we are dispensing more and more prescriptions that are adjudicated at the $8 or less level. Many are adjudicated below $4. Some do not even cover the cost of goods dispensed much less the average cost of $10 to dispense a prescription.

    Pharmacists have become insurance brokers 80% of the time. They are no longer allowed the time to spend with their patients. They are too busy dealing with the patient's insurance requirements and calculating whether they got paid enough to cover the net cost of goods.

    The pharmacy infrastructure in this country is being crippled on all levels. Pharmacy is a vital part of our heallth care system and deserves to be treated as such. It can not survive with the shrinking margins legislators are imposing on it.

    Many would challenge that the average retail script generates $60 in revenue at an independent pharmacy. The cash customer is gone and the PBM's adjudicates the payment.

  7. You keep commenting on the excessive profits in generics. I would place blame on this system on the retail pharmacies themselves. They have allowed the PBM's to reimburse brands at a margin of 10-11% and think they were being smart be taking the enormous profits in generics to make up he difference. What a stupid business plan. How did they think it would last. The whole payment structure needs to be tossed. I would think that it should be AMP plus a gross profit margin of 23-25% across the board.
    In effect no shell games being played by anyone!!!!

  8. Regarding the "incremental cost" per script: At some break-point in volume, it is true that additional headcount would be required and avg cost would thus increase in a significant leap. This is what my econ/acctg prof would have called "stepwise fixed" costs. While avg cost jumps, it also begins to immediately go back down again with each unit increase in production over the capacity range of the added unit of labor. WalMart are well-invested in workforce optimization techniques, and with their size have many tasks assignable to keep staff from lying idle during slack times, thus I am confident that their true step-cost is much smaller than the cost of a FTE associate.

    Further, I would assume that WM distribute these generics in a very efficient manner. I have no factual evidence but I would be shocked to find that they do not have a standard one month course of drugs such as erithromyacin pre-packaged and ready to be labeled with your Dr's orders.

    Classic story of commoditization- the locals must find a value they can uniquely add and a way to translate it into profits or else convert the floor space to (in my locale) swim suit sales...