By Josh Nathan-Kazis
In eight years, national pharmacy chains have gone from an invasive species to an endangered one.
They arrived in the 1980s like a beetle to a hardwood forest, burrowing into virtually every suburban strip mall, rural township, and urban business district in the U.S. By 1990, there were 18,600 chain pharmacies across the country; by 2010, there were more than 22,500.
The chains had some great years. They squeezed out independent pharmacies, a third of which closed between 1990 and 2010. The share prices of the two biggest chains, now known as Walgreens Boots Alliance and CVS Health, multiplied around 14 times between the start of 1995 and the middle of 2015, while the S&P 500 index only quadrupled. Walgreens'
total revenue climbed from $42.2 billion in 2005 to $103.4 billion in 2015, while CVS' revenue grew from $37 billion to $153.3 billion over the same period.
Today, their entire business model is under pressure. You can see it in the October bankruptcy filing of Rite Aid, the third-largest of the U.S. chains; in the share price of CVS, which is down more than 30% over the past two years; in the unrest among chain pharmacists, who have held sporadic walkouts in some cities.
Turning the chains around won't be easy. Their biggest problem has been the declining reimbursement rates that pharmacy-benefit managers pay them for the prescription drugs they sell, says John Ransom, an analyst who covers Walgreens for Raymond James. Those cost pressures are unlikely to disappear.
Adjusted operating income for Walgreens' U.S. retail pharmacy division, which encompasses the retail stores and the pharmacy counters they contain, fell from $5.4 billion in the company's 2016 fiscal year to $3.7 billion in the company's 2023 fiscal year, which ended in August, a 31.1% drop. At CVS, the company's retail pharmacy division, which also includes its long-term care pharmacies, had operating profits of $7.3 billion in 2016. It has since changed how it reports results; its new retail pharmacy division had adjusted operating income of $6 billion in 2023. As profits have dropped, the chains have begun closing hundreds of stores.
Among the 20 analysts tracked by FactSet who cover Walgreens, only three rate it a Buy or Overweight, even though the stock trades at less than seven times earnings expected over the next 12 months. Most rate the stock a Hold, an indication of the work the company needs to do to rebuild investor confidence.
As for CVS, the company's prospects are less dependent on its retail outlets, and its share price, at a recent $75.08. is more closely tied to the performance of Aetna, its insurer. Three-quarters of analysts tracked by FactSet rate it Buy or Overweight; their average target price is $89.47.
The chain retail pharmacies remain an important part of the U.S. healthcare system, supplying everything from antibiotics to blood pressure monitors and vaccines to hundreds of millions of Americans. Fixing them will take reconsideration of the purpose of a chain drugstore. Both CVS and Walgreens are expanding the healthcare services they provide, as they seek new justifications for their immense nationwide footprint. That shift will take years, and the prospects for these new strategies are uncertain: Walgreens is closing dozens of clinics in its primary-care chain amid profitability troubles.
Over the past few months, something has shifted at the big pharmacy chains. Both CVS and Walgreens have signaled an openness to big, structural changes in how they operate their businesses. The new approaches at the pharmacy counter, and store closings, could stanch the bleeding at the big retail pharmacy chains.
But these changes, particularly the store closings, could create real challenges for people who rely on those stores for their prescriptions.
"The reality is that we need all kinds of pharmacies in order to be able to provide the level of access to care and pharmacy services that our society needs in the U.S., but we've got to have a model that supports that," says Michael Hogue, CEO of the American Pharmacists Association, which backed some of this fall's walkouts, where pharmacists refused to show up to work at retail chains to draw attention to their concerns about understaffing. "We just have not had a model that's been supportive."
The companies are already shuttering some stores, generally citing population shifts and changes in buying patterns. CVS said in late 2021 it plans to close 900 locations through the end of this year, and Walgreens is in the process of closing up to 500 U.S. stores. Rite Aid's future plans are obscured by the bankruptcy proceedings, but The Wall Street Journal reported last year that the company has proposed closing as many as 500 of its stores, and has announced definitive plans to close almost 200 in the months since it filed for bankruptcy protection.
In a statement to Barron's, Rite Aid said it had closed certain stores to reduce its spending on rent and strengthen its financial position. "At this time, we have not made or confirmed any decisions on additional specific store closures as part of our financial restructuring process," the company said.
Charles Rhyee, who covers Walgreens and CVS for TD Cowen, says that the chain pharmacies should consider closing far more stores than they have proposed , while keeping open those that fit in with their efforts to expand into healthcare services. "I think they're slowly getting there, but maybe from an investor standpoint you would want something a little faster," he says. He acknowledged that store closings are made difficult by long leases.
Walgreens CEO Tim Wentworth, who took over leadership of the company late in 2023, says that dramatic waves of store closings aren't in the works, and that having a big national footprint is important as the company increases the healthcare services it offers. "I don't believe we have too few stores," he says. "I believe there is room to move our footprint probably modestly downward. But that by itself is not as big a leverage as making sure that we've got really good points of distribution for patients."
CVS, for its part, says that it will "continue to take a thoughtful approach in evaluating the size of our retail footprint," but that it plans to maintain "a national presence that provides convenient access to pharmacy services, including in underserved communities."
A big chunk of the problem facing the chain pharmacies is that people don't shop like they did in the 1990s. During their period of rapid expansion, online shopping was in its infancy, and if you wanted batteries and a toothbrush, a quick 10 p.m. trip to CVS was the ultimate in convenience. The companies put their stores at the "corner of Main and Main," as Walgreens' CEO at the time liked to say, and would boast about the proportion of the U.S. population that lived within five miles of one of their locations. Today, that number is around 85% for CVS and 78% for Walgreens.
Shopping habits since then have changed, and multiple national retail chains have declared bankruptcy.
While concerns about shoplifting have led chain pharmacies to lock up items at certain locations, the impact of shoplifting on the profitability of the individual companies is hard to measure. Neither CVS nor Walgreens break out their shoplifting losses in financial reports, though Walgreens cited "higher shrink levels" as one reason behind a drop in its gross margins in its quarter ended in November 2023. At an investor conference in January, Wentworth said that the impact of shoplifting is different from store to store, and that the company assumes that shoplifting levels won't drop in the near-term.
For the retail pharmacy chains, shoplifting and shifts in retail consumer habits aren't their biggest problem. That's because Americans still prefer to pick up their medicines in person. So-called front-of-store offerings, like candy and batteries, account for just a quarter of sales at Walgreens and CVS.
Most of the revenue comes from the pharmacy counter, where consumer habits haven't changed all that much. In 2022, mail-order pharmacies filled just 9% of U.S. prescriptions, compared with 47% filled by chain pharmacies, according to the Drug Channels Institute. That's roughly the same as the breakdown in 2010, when mail-order pharmacies filled 7% of prescriptions and chain pharmacies filled 48%, according to a 2012 report from the National Association of Chain Drug Stores.
That means that the troubles facing the retail pharmacies lie not so much in the broader shift to online shopping but in what goes on behind the pharmacy counter itself.
Pharmacies buy their prescription drugs from a distributor like Cardinal Health, then get reimbursed by pharmacy-benefit managers, which contract with the patients' insurer. The terms of those reimbursements are complex, and retail pharmacy executives have complained for years that they allow less and less room for profit.
The problem is that the chain pharmacies have little leverage in their negotiations with the pharmacy-benefit managers, which have accrued enormous power in the drug chain. Three large PBMs, including CVS-owned Caremark, process 80% of U.S. prescriptions, according to the Drug Channels Institute. (CVS says that its pharmacy negotiates with Caremark just as it negotiates with other PBMs, and that there are "strict firewalls" between CVS Pharmacy and Caremark.) The pharmacies need to cut deals with those PBMs in order to access patients. Meanwhile, the chain pharmacies face enormous competition on the pharmacy side, much of it from retailers whose business models rely much less on profits made at the pharmacy counter. Of the roughly 58,900 pharmacy counters in the U.S. in 2022, 16,800 were located inside of supermarkets or mass-market merchants like Walmart, according to the Drug Channels Institute.
That dynamic has pushed the reimbursement rates lower and lower. "The question is, why do they keep taking these lower and lower reimbursement rates?" says Ransom, the Raymond James analyst. "And the answer is that while the contracts are still profitable, the PBMs are going to push this right to the line every time."
A spokesperson for the Pharmaceutical Care Management Association, a trade organization representing PBMs, said that the PBMs are simply responding to high drug prices. "Blaming PBMs misses the fundamental reason for high-cost drugs, which is the prices set by drug companies," said PCMA spokesman Greg Lopes. "The job of the PBM is to keep the cost of prescription drugs as low as possible for employers and their employees, and we do that."
Ransom says that chain pharmacies could ease some of their financial pressures by shrinking. "We think drugstore counters need to significantly contract," he wrote in an October note to investors. Thanks to long leases, the number of chain drugstores locations has barely budged. Despite all the changes in consumer habits and in the pharmacy business, the number of chain drugstores in 2022 was 20,900, down only slightly from the 22,600 in 2010.
Fewer pharmacies would give each one more power to negotiate with the PBMs.
"What would make this work is [if] they get pricing power," Ransom says. "What would give them pricing power? Scarcity."
On top of the lower reimbursement rates, the growing role of cheap generics has taken another bite out of pharmacy counter profits. Since the reimbursements the pharmacies receive from the PBMs are tied to the cost of the drugs they process, more cheap drugs means lower revenue. In 2018, 90% of prescriptions in the U.S. were for generics, up from 75% in 2009, according to the Congressional Budget Office. The prices of generic drugs, meanwhile, have been falling since 2010.
Walgreens' Wentworth, who previously ran Cigna's pharmacy benefit manager, says that the relationship between the PBMs and the pharmacies isn't working. "It's becoming distorted to where the retailers need to, frankly, reset the conversations with PBMs," he says.
CVS in early December proposed its own solution, announcing a new proposed model for how its pharmacies will get paid by the PBMs. The new model will be simpler and more transparent, the company said, and will tie the pharmacy's level of reimbursement directly to the cost of the drug plus a set markup and a per-patient fee. Executives said in an investor presentation that the new model would "reset the financial outlook" for the retail business.
"It ensures the sustainability of retail economics," CVS Chief Pharmacy Officer Prem Shah said on a Dec. 5 investor day presentation.
The company still needs to convince PBMs to play ball. In response to a question from Barron's, a CVS spokesperson said that the company plans to implement the new model starting in 2025, and that feedback had been "positive." There are indications that the PBMs are thinking along the same lines, which could bode well for adoption. Earlier in 2023, Optum Rx, the UnitedHealth Group-owned PBM, introduced its own set of new payment models, constructed along similar lines as the CVS proposal.
On an investor call in February, CVS CEO Karen Lynch said that the company was "actively engaged in constructive discussions" with several PBMs about the new model.
The CVS plan is an ambitious one, and reflects pressure on companies up and down the drug supply chain from efforts like the Mark Cuban Cost Plus Drugs Company, which sells generic drugs using a similar pricing model.
Wentworth said that Walgreens, too, would like to shift to similar cost-plus contracting models. "If they want them, we are more than willing to do it," he said of the PBMs.
The CEO is clear-eyed about the challenges facing Walgreens. But for the first time in years, there is a clear path to resetting the retail pharmacy chain business. The companies must proceed carefully as they consider closing more stores, but fewer chain pharmacies seems inevitable over the next few years. For investors, a trend toward a smaller number of chain pharmacies, and a resetting of the relationships with the PBMs, could slowly ease the pressures on the model, as the companies work toward reinvention.
Wentworth said there could be an industrywide shift toward simplified contracts, amid pressure from payers and regulators. "There feels like there's some pull here," he says. "It may come to pass. It's not going to be overnight."
Write to Josh Nathan-Kazis at josh.nathan-kazis@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
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