The largest drugstore chain in the U.S., Walgreen (NYSE:WAG) turned around a year long decline in sales in January, reporting monthly sales of about $6 billion, a 6% y-o-y increase. The turnaround is a result of prescription sales amounting for about 65% of its total sales. Partly owing to the higher incidence of flu in January, the prescriptions filled at comparable stores increased by about 14% in January, compared to a year ago. Walgreen’s same store pharmacy sales had been suffering in 2012, as a result of the loss of Express Scripts prescriptions to competitors such as CVS Caremark (NYSE:CVS) and Rite Aid (NYSE:RAD) among others and the introduction of generics. In this article we take a look at the factors which support our forecast for the revenues Walgreen earns per prescription it fills at its pharmacies.
Growth In Generics Penetration
An estimated $260 billion of prescription drugs sales are scheduled to go off patent between now and 2018.  In all, blockbusters with a combined $170 billion in annual sales will lose patent between 2012 and 2015. ((Cliffhanger, The Economist, December 2011)) Hence, the rate at which branded drugs get replaced by generic alternatives is expected to continue at near 2012 levels in the near term. In 2012, an estimated $35 billion of prescription drug sales were exposed to generic competition.
In general, generic versions of drugs generate lower total sales per prescription. As a retailer, Walgreen gets a part of the final retail value of a drug sold as its revenue. Hence, the end of patent protection for a branded drug negatively impacts the company’s revenue. Walgreen estimates that the generic drugs lowered prescription sales by about 9% in the quarter ending November 2012, versus about 2% in the prior year’s quarter. The patent cliff as the trend is being referred to supports our near term forecast for the revenues Walgreen earns per retail prescription filled.
The pharma industry has been investing heavily into research and development to replace the revenues that are under threat from patent expiry. We believe these investments will result in an improvement in the branded drugs penetration in the long term, and hence, expect the ‘revenue per retail prescription’ filled to improve beyond 2015.
The Return Of Express Scripts Customers
Express Scripts is a pharmacy benefit manager and works as a middleman between drug makers and employers. Pharmacy benefit managers pay pharmacies to dispense drugs. The dispute between Walgreen and Express Scripts began in mid-2011 over pricing terms. Express Scripts claims the company was demanding a 20% hike in its reimbursements while Walgreen says that the pharmacy benefits manager was offering “below-average” reimbursements.
Walgreen filled about 90 million Express Scripts prescriptions in 2011.  The disagreement on the pricing terms resulted in the two companies ending their arrangement at the beginning of 2012, and is estimated to have cost Walgreen a loss of $5.3 billion in annual sales. Customers were forced to switch to another pharmacy or pay more for drugs if they continued to use Walgreen. The dispute took a turn for the worse when Express Scripts acquired another pharmacy benefit manager Medco in April, further costing Walgreen millions of prescriptions.
In July, the two companies reached an agreement which allowed Express Scripts customers to return to Walgreen starting September 15, 2012. Walgreen followed up the new agreement with the launch of its loyalty program, Balance Rewards, which too came into effect on September 15, 2012. The new agreement resulted in a substantial improvement in the prescriptions filled by the company each month. The y-o-y drop in prescriptions filled improved from 10% in June to a 14% increase in January. The company said the percentage of Express Scripts customers filling prescriptions in its pharmacies continued to increase in January. We expect the continuing return of Express Scripts customers to keep the ‘revenue per retail prescription’ filled under pressure in the near term.
Greater Medical Expenditure From The Aging Population
The portion of U.S. population over the age of 60 is set to increase substantially over the next decade.  Older people are more likely to use medicines to attend to their aging bodies and carry more ailments per person. Hence, we expect the number of drugs prescribed per prescription to be higher for older people than those young. A greater portion of population in the greater than 65 years age bracket will thus positively impact the revenues pharmacies earn per prescription filled.
We believe that the combined impact of the patent cliff and return of Express Scripts prescriptions is going to be prominent in the near term. However, the aging population, positive results from the heavy investment by drug manufacturers into R&D and an expected slowdown in the return of Express Scripts prescriptions filled by Walgreen will result in the metric returning to historical levels in the long term.
We have a $38 Trefis price estimate for Walgreen, which is 10% below the market price.
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