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Morningstar | Despite Its Position as the Largest Retail Pharmacy in the U.S., Walgreens Faces Margin Pressure

Walgreens has been one of the most successful retail operators since its founding in 1901 and has remained a major player within the pharmaceutical supply chain for many decades. The firm processed approximately 20% of total U.S. prescriptions during fiscal 2017, which makes it one of the largest retail pharmacies. With the acquisition of Europe-based Alliance Boots, the firm is now a premier global retail powerhouse. Nevertheless, we believe Walgreens faces a pressured operating environment, given the rapidly growing pricing power of the large pharmacy benefit managers. These PBMs are able to aggregate an enormous amount of claim volume and leverage this into powerful pricing negotiating power. Walgreens will try to offset this headwind by driving sales volume through consolidation and selling more nonnpharmaceutical products. In our opinion, this demonstrates the weaker position along the pharmaceutical supply chain for Walgreens, as it tries to counter a more pressured retail pharmacy operating environment with cosmetic, grocery, household, and convenience goods. This strategy will also put the firm in even more direct competition with a vast array of retailers and into sectors where profits and outsize returns on invested capital are hard to come by.On a positive note, the firm recently acquired half of Rite Aid's store fleet, which solidifies Walgreens as the largest retail pharmacy chain in the U.S. This acquisition will not only increase its volume and geographic reach, but also materially augment its global generic purchasing volume. Walgreens will also be better-positioned to build on its preferred pharmacy strategy. This strategy entails the retail pharmacy discounting its generic drug inventory to become a preferred pharmacy in PBM retail networks and to drive store foot traffic. While this strategy has promise, Walgreens has yet to report an improvement in same-store comparable results for front-end products. Additionally, the firm has struggled with compressing gross margins over the last handful of years. We believe these trends directly reflect the steep headwinds facing the pharmacy retailer.