Why Is Walgreens Keen On Doing More Acquisitions?

Walgreens (NASDAQ:WBA) recently completed its acquisition of Alliance Boots, a British retailer of health and beauty products, expanding its reach to more than 25 countries with over 12,800 stores. Before the company even reported its first earnings after the acquisition, there was speculation  about the possibilities of Walgreens acquiring Rite Aid, the third largest drugstore chain in the U.S. Such an acquisition would further increase the company’s scale and provide access to new revenue sources such as pharmacy benefit management. Furthermore, the company’s Acting CEO, Stefano Pessina, said that significant synergies could be realized from M&A activities because of the complex structure of delivering medicines today. However, it’s not the synergies that are driving Walgreens’ interest in more acquisitions, but the government’s focus on reducing healthcare costs.

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Increasing Healthcare Expenditure And ObamaCare

Health care expenditures in the United States are currently about 18 percent of GDP, and this share is projected to rise sharply. Almost half of current health care spending is covered by Federal, state, and local governments. If health care costs continue to grow at historical rates, the government’s spending on health care will rise to nearly 34 percent of GDP in 2040. Roughly a fourth of this increase is estimated to be due to the aging population and other demographic effects, and the rest is due to rising health care costs. ^[1]

The Affordable Health Care Act, commonly known as Obamacare, is aimed at addressing this issue. The government will now be more involved in pricing of pharmaceutical products and motivates drug stores to evaluate costs and steer patients to generic medications. The cost squeeze is already starting to affect pharmacy retailers’ margins due to the steps taken by the government, such as the step down in Medicare Part D rates earlier this year.

Cost Reductions A Must To Avoid Margin Pressure

To avoid a hit to their margins due to the factors discussed above, drug retailers will need to find ways to cut costs, which is the main reason why Walgreens is keen on doing more acquisitions. Currently, Walgreens is looking inwards to cut costs. During the recent earnings release, the company announced that it would close approximately 200 stores (about 2% of the total count) across the country to reorganize corporate and field operations, and drive operating efficiencies. It also expects to generate some savings by streamlining information technology and other functions. The company, during the recent earnings release, said that it has identified additional opportunities for cost savings, primarily in their Retail Pharmacy USA division. These additional cost opportunities are expected to generate cost-savings of $500 million, which will be realized by 2017.

However, more significant savings could be realized from mergers and acquisitions. While horizontal consolidation (i.e. integration of companies operating in the same market) can help companies in getting leverage with suppliers in  negotiating drug prices, vertical consolidation across one’s network could help eliminate multiple layers in the delivery process, contributing more to margins. The latter is the primary reason why we think Walgreens might consider acquiring Rite Aid. Considering the company’s history of growing through acquisitions, such as those of Duane Reade and Drugstore.com, it is likely that Walgreen will continue to move in the same direction.

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1. The Economic Case for Health Care Reform, The White House [↩]