Wal-Mart Thwarts Pharmacy Business

The outlook for the drug store industry is negative. Although the demographics of an aging U.S. population are favorable for the prescription drug industry, the outlook for pharmacies remains clouded due to several influences on the industry.

Competition will remain stiff in the pharmacy segment as other retail businesses continue to add pharmacy departments and as other low-cost pharmacy options come on-line. Discount retailers, in particular, have made substantial inroads in gaining market share during the last year. The trend toward generic drugs, while providing better margins for retail pharmacists, is expected to slow over the next year. In addition, various drug re-importation schemes have been proposed by large employers and state and local governments in an effort to manage escalating healthcare costs.

Clouding the outlook further is the legislation that provides drug benefits under Medicare. Real GDP declined 6.3% in the fourth quarter of 2008, and the unemployment rate rose to 8.5% in March 2009. Consumer confidence is low and retail sales fell 1.1% in March. Consumer confidence is a key to consumer willingness to make purchases, which accounts for nearly three-quarters of all U.S. economic activity. Falling home sales and declining financial markets have negatively impacted consumer spending over the last few months. Due to the housing crisis, consumers are uncertain about home refinancing and financing, a key source of consumer discretionary spending. Overall retail sales (and related front-end sales in drug stores) are expected to be under pressure until consumer confidence rebounds.

Companies like Rite Aid (RAD - Analyst Report), CVS Caremark (CVS - Analyst Report), and Walgreen (WAG - Analyst Report), are all facing severe margin contraction due to Wal-Mart’s (WMT - Snapshot Report) foray into the retail generic drug market.

Moreover, for Rite Aid, the acquisition of Brooks Eckerd increased both debt burden and interest expense. Further, the company has also shut down many stores as it reported a loss in the latest quarter. Moreover, it competes with Walgreen and CVS Caremark, both of which are expanding. In addition, both companies have higher margins than Rite Aid due to structural cost advantages, including purchasing power to obtain lower cost merchandise and significantly less interest expense.

Therefore, we currently hold a sell rating on Rite Aid, and a Hold rating on CVS Caremark and Walgreen.