Can Rite Aid and Walgreen Overcome This Threat?

Walgreen and Rite Aid have both shown some weakness in margins that could hurt these high-flying stocks, but are these problems long-lasting?

Jul 2, 2014 at 5:00PM

Walgreen Company (NASDAQ:WBA) shares have been volatile since the company reported earnings on Tuesday, as margin pressure was unexpected and created some concern among investors. Moreover, Rite Aid Corporation (NYSE:RAD) saw a similar problem with partner McKesson Corporation (NYSE:MCK), therefore investors can assume it's an industrywide problem. However, is margin pressure long term, or will Rite Aid and Walgreen return to prior form?

Are margins becoming an issue?
Despite 6% revenue growth, Walgreen missed expectations on both the top and bottom lines during its last quarter. While revenue was a slight miss, investors were more concerned about its $0.03 EPS miss, and that its gross margin declined 40 basis points to 28.1%. In recent years, we've watched margins rise consistently, but fears have since sparked that margins are possibly reaching a max for pharmacies.

Rite Aid's fiscal first-quarter earnings report continued its six-quarter streak of profitability, although its net income of $41.4 million was cut more than half from last year. While higher taxes played a large role in Rite Aid's drop in profit, reimbursement rates were also noted as a primary cause for margin pressure.

Walgreen noted on its conference call that lower third-party reimbursement rates were a key reason for pharmacy margin pressure. So, with two of the top three pharmacies both seeing the same problem, it seems reasonable to ask whether this is a long-term macro problem, or if it's simply a speed bump along the way to higher stock prices?

What's weighing on margins?
On June 5, Rite Aid shares fell 10% after the company lowered its full-year profit guidance by $10 million because of issues derived from reimbursement rates. With 954.3 million shares outstanding, Walgreen's $0.03 per share quarterly profit miss translates to nearly $30 million, thus implying the same problem weighed on its business.

With that said, why would reimbursement rates be lower? Rite Aid's struggles have to do with its supplier, McKesson, while Walgreen's are in connection with its supplier/distributor. McKesson is a $43 billion company whose job is to stock, supply, and then ship drugs to pharmacies, along with processing orders and handling various responsibilities on the regulatory side of the drug supply chain.

Patent Cliff

Source: MarketMinder.

Rite Aid and McKesson agreed on new terms of their partnership earlier this year to increase the scale of generic drugs and to improve the delivery process. Generic drugs are quickly growing as a percentage of total prescriptions because of the patent cliff, a period of five years where $133 billion in brand drug sales lose patent protection. However, this shift from brand drugs to generics has also caused problems with reimbursement rates for both Walgreen and Rite Aid.

Should investors worry?
There is some lag time for pricing new generic drugs between the pharmacy who purchases drugs and the supplier that gets its product from the manufacturer. For example, Rite Aid or Walgreen may pay brand drug prices and then have to wait on reimbursements, which have taken longer because of the increased volume of generic drugs.

However, it is a solvable problem, one that should improve as the kinks are worked out in gauging supply and demand for brand versus generic drugs following a patent expiration. Ironically, generic drug introductions is one of the key reasons that margins for pharmacies have increased, and that Rite Aid has gone from the brink of bankruptcy to one of the best-performing stocks of the last two years.

These generic drugs are often purchased in bulk, and because of their lower cost, pharmacies are given much better pricing flexibility versus brand drugs. This is the macro advantage of the patent cliff for pharmacies, which still exists today despite the problem with reimbursement rates. Looking ahead, there are two years left with significant incoming patent expiration, which means margins could still have a lot to gain as high-priced branded drugs lose patent protection.

Foolish thoughts
As a result, McKesson, Rite Aid, and Walgreen are all still operating in a macro environment that has allowed each stock to outperform the broader market during the last three years. While it's impossible to know when reimbursement rates and generic drug supply will become stable, investors have to like the overall direction of the industry, and the realization that reimbursement-related problems are nothing more than growing pains.

Leaked: A huge opportunity for those who move quickly
The best investors consistently reap gigantic profits by recognizing true potential earlier and more accurately than anyone else. Let me cut right to the chase. There is a product in development that will revolutionize not how we treat a common chronic illness, but potentially the entire health industry. Analysts are already licking their chops at the sales potential. In order to outsmart Wall Street and realize multi-bagger returns you will need The Motley Fool's new free report on the dream-team responsible for this game-changing blockbuster. CLICK HERE NOW.

Brian Nichols owns shares of Rite Aid. The Motley Fool recommends McKesson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at www.fool.com/podcasts.

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to www.fool.com/podcasts, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.

 


Compare Brokers