Here Are Three Factors That Can Have A Sizeable Impact On Walgreens’ Stock Price

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Trefis
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WAG
Walgreen

In the last year or two, the U.S. healthcare industry has seen a lot of changes. Government initiatives such as ObamaCare brought in more people under insurance coverage, expanding the addressable market for firms in this industry. At the same time, therapy costs are scaling new heights with the emergence of specialty therapies targeted at very rare conditions, driving healthcare expenditure up. Walgreens (NASDAQ:WBA) in itself, as a company, has made significant changes to the way it operates to increase efficiencies. As drug costs shot up, it changed the way it procures drugs by shifting from self-managed warehouses to an outsourced model. More importantly, it took the less traveled path of staying within its core business (pharmacy retail), unlike competitors such as CVS Health (NYSE: CVS), who expanded into the benefits management business. Walgreens expanded globally by acquiring its European counterpart, Alliance Boots, to form the first global pharmacy-led health and well-being enterprise.

Amid a multitude of events and factors transforming the industry, it is key for investors to understand how they could affect companies of their interest. In this article, we discuss three such factors influencing Walgreens and quantify their likely effect on its stock price. Note that the potential upside or downside is indicated in parentheses beside each factor.

Our current price estimate for Walgreens is $70, which is at a discount of about 20% to the market price.

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View our analysis for Walgreens

If Payers Design New Formulary Tiers (+10%)

For some time now, both consumers and drug retailers have been plagued by soaring generic drug prices. Adding to the misery of drugstores, payers have kept reimbursement rates flat, which has led to significant losses for most drug retailers. The primary motive behind Walgreens’ decision to outsource its distribution process to Amerisourcebergen was to hedge the risks arising from the above discussed trends. While this helped the company avoid losses to a certain extent, more help is on its way from payers.

The amount that retailers get reimbursed from payers varies with the type of drug. Branded drugs, specialty therapies and generics are usually separated into different tiers, each of them having different reimbursement rates (generics usually have a fixed dollar amount). However, with generic price inflation, the disparity between prices within the generics category has increased. According to a study conducted by the Drug Channels Institute [1], 50% of the drugs, in their survey sample, increased in cost and 50% declined (note that the magnitude of increases was significantly higher than that of decreases).

In such a situation, it is necessary to treat each generic drug differently when it comes to reimbursement rates, as one solution for all doesn’t work. Therefore, payers are working on creating a tiered pricing system for generic drugs that would require members to pick up more of the cost. While this pricing system is still in its formative stages, when put into effect, it could reduce drug acquisition costs for pharmacy retailers.

Per the current scenario, we expect Walgreens’ EBITDA margin to grow from the current 10% to 11% by the end of our forecast period. However, if the proposed new pricing system is brought into effect, it has the potential to push margins up. Considering a positive impact of 1.5 percentage point increase in the company’s EBITDA margin in the next three fiscal years (FY’16 to FY’18), it translates to a 10% upside to our current price estimate for the company.

Higher Pricing Pressure from PBMs Due To Consolidation (-10%)

On the other hand, the company’s margins could see some downside, given the consolidation in the PBM market.

Among the top three pharmacy retailers in the U.S., Walgreens is the only company which does not have a presence in the pharmacy benefits management business, which the other two competitors entered to battle rising drug costs. While scale has always been on Walgreens’ side, allowing it to negotiate better with PBMs, the balance is likely to now tilt in the latter’s favor, owing to the recent consolidation in the industry. Currently, the top three players in the market control more than 70% of the market. The creation of larger healthcare enterprises means that they have greater bargaining power, which in turn results in greater pricing pressures for drug retailers. This is likely to result in an increase in drug acquisition costs for pharmacies, impacting their profit margins.

Considering a negative impact of 1.5 percentage-point decrease in Walgreens’ EBITDA margin in the next two fiscal years (FY’16 and FY’17), it could result in a 10% downside to our current price estimate. This is more likely than the upside scenario discussed above, in our view, as consolidation has already taken place in the industry and newly-formed larger PBMs will waste no time in using their scale advantage for more favorable contracts with retailers.

Loss Of U.S. Prescriptions Share To Competitors With PBMs (-10%)

Naturally, drug retailers who have their own benefit management business are shielded from the above discussed risk (greater bargaining power of PBMs) and therefore could pass on higher benefits to consumers than Walgreens can. Promotional campaigns is one way that retailers achieve this to attract higher footfall to their stores, and PBM owning drugstores are better positioned to offer them. As consumers are expected to be increasingly sensitive to out-of-pocket costs (given the increasing drug prices), strategies such as promotional campaigns could turn out to be even more effective in drawing customers to stores. We believe that this will likely impact Walgreens’ share of the total prescriptions filled in the U.S.

Per our current estimates, Walgreens’ share of total prescriptions filled in the U.S. will increase from the current level of 22% to 24% by the end of the Trefis forecast period. Of the 2% gain in share predicted, 1.5% gain is expected to be achieved by the end of FY2017. However, with the above discussed trends in the industry, the chances of a gain in market share could be bleak. In fact, a loss in market share is quite a possibility. A 1 percentage-point loss in market share in the next two years (FY’16 and FY’17) translates to a 10% downside to our current price estimate.

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Notes:
  1. Retail Generic Drug Inflation Reaches New Heights []