Can Rite Aid and Walgreen Overcome This Threat?

Walgreen Company (NYSE: WAG  ) 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.

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.

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