Payer Pushback Is Weighing Down Retail Pharmacy Stocks

Prescription volume is climbing at Walgreens Boots Alliance (NASDAQ: WBA) and CVS Health (NYSE: CVS), yet growth rates at these pharmacy retailers are slowing. Why aren't retail pharmacies benefiting more from aging baby boomers?

In this clip from The Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes and contributor Todd Campbell explain how falling drug prices for generic drugs are putting a lid on growth rates and crimping stock prices industrywide.

A full transcript follows the video.

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This video was recorded on Sept. 20, 2017.

Kristine Harjes: Todd, how did these hold up legally? Is one method of extending the patent more useful than another? What do you think?

Todd Campbell: Well, manufacturing patents are pretty easily negotiated around by generics. So, I would rank that as being the bottom tier. I would say method of use, probably a little better than that. And then, of course the actual composition would be the strongest. So, the reformulations are probably the strongest way to go for these. You're also seeing combinations, you can also do combination drugs where you take your drug and combine it with another new drug, and that'll extend out your patent protection as well. So, there's a lot of different routes that they can go, and you can argue what that means or doesn't mean for society, if it's a good thing or a bad thing. But, I think from an investment standpoint, you have to know that, especially if you're considering some of these drugs, or buying shares of some of these companies that are making these blockbuster drugs.

Harjes: And as an aside, the composition of matter patent, that's the original, that's the hardest to challenge, that's what people mean when they say the main patent on a drug. Sometimes you'll do a quick search and say, "When does the patent on whatever expire?" And there'll be 50 different patents in there. The one that matters the most is the composition of matter patent. That's the one that Todd was mentioning is the hardest to challenge.

Moving on to our last listener question of the day, a listener named Rich wrote in via the Google form accessible on our Twitter account, @MFIndustryFocus, and said, "Lots of aging Americans and prescriptions, but drugstore stocks seem to be struggling even before Amazon hinted at trying to enter the Rx business. Why can't these drugstores and retail pharmacies grow or at least reward shareholders anymore?"

Campbell: That's a great question. You look at it and, 76 million baby boomers undeniably living longer, and therefore requiring more healthcare. How is that not a good thing for companies that are filling their prescription medicines?

Harjes: Absolutely, and there are a ton of different factors going into this situation for these. We're going to leave aside questions about the mergers -- well, I don't want to completely ignore the mergers altogether, but for this very specific example that I'm not going to delve into too much on the show would be Rite Aid. We will put that aside because I feel like we've talked about that a lot on the show recently. But even aside from that specific example, this is a space that's seen a lot of consolidation over the past decade or so.

Campbell: Yeah, CVS and Walgreens are at the Goliaths without a doubt. If you add the two of their market shares together, you would probably end up with 40% or 50% of all filling of drugs at retail pharmacies in the country. So, they're a great proxy to look at in trying to answer this question. I think one of the things that you look at it and say, OK, you have this great demographic tailwind, but you also have to say, wait a minute, there's a disconnect there between that tailwind and what we're actually seeing in the financial results of these companies. If you look at the trailing 12 months and year over year growth for these companies, you'll notice that year over year growth has been kind of range-bound at CVS since 2010, and it's been more than cut in half since 2015. And if you look at the trailing 12-month operating margins for CVS and Walgreens, you'll see that they peaked in 2014, and they've been sliding steadily ever since, and that's because the cost of goods has increased for these companies. So, you've got a tug of war going on. You have all of this demand, because they are indeed feeling more prescriptions, but you have to also recognize that they're facing headwinds tied to how much payers want to pay for these drugs, for example. And that's offsetting a lot of that growth.

Harjes: Exactly. If you're an insurer and you see this trend that more people are feeling their prescriptions for more and more drugs, more expensive drugs, and you're still taking in the same amount in premiums, you're going to push back and try to pay as little as you can for these. And when you look at the entire drug supply chain, there are a lot of players in it, and each one of them wants to take a cut, which really puts a lot of pressure on margins for everyone involved. But since we're specifically talking about the retail pharmacies, that is something that you can see in the financial results.

Campbell: Yeah. If look at Walgreens' most recent quarter, they had an 8.5% increase in prescriptions filled. They filled 255 million prescriptions. But comparable sales at their pharmacies only increased 5.8%. So, again, that disconnect, and that disconnect is due to reimbursement pressure. If you look at generic prices, Kristine, since 2008, they have been steadily declining. Brand name prices have grown. Brand name prices are up 200% since 2008, according to Express Scripts. But generic prices are down 74%. And more and more drugs are being filled with generics. So, as the generic fill rate climbs, and prices are falling, it's creating all these bottom line headwinds.

Harjes: Yeah. What is kind of surprising about the generics versus brand name drug, as far as margins go, when you look at what the pharmacy actually collects in margin, it's much, much higher for generic drugs. And that doesn't seem like it would be the case at first, but it is. The numbers support this. You see margins of about 43% on generic drugs, and yet only 4% on brand name drugs.

Campbell: Right. But if you're selling a generic drug for $10 and a branded drug for $1,000, which would you rather? You're getting rid of your margins, but it's on a smaller --

Harjes: Yeah, but then you also have the volume consideration, where most drugs that are dispensed are generic drugs.

Campbell: 85% of them now, up from less than half of all drugs in 2003.

Harjes: Yeah.

Campbell: I think, Kristine, what you and I are both saying is that the generic drug business is not necessarily a bad thing for pharmacies, because it's still providing growth. And, as you said, it's higher margin. But, because of the price compression that's going on, it is putting a little bit of a cap or a lid on the growth that it might enjoy otherwise. And since we don't know where prices are heading from here, and stocks are forward-looking instruments, that creates some uncertainty for investors. It's probably behind most of the reason that stocks have been a little lackluster.

Harjes: Yeah. So, that's the back of the store pharmacy segment of these companies. There are a couple of other business segments that I feel like we should also touch on. For example, Rich writes in his question that the stocks seemed to be struggling even before Amazon hinted at trying to enter the prescription business. Yes, that is true, but Amazon was a threat to these companies well before that, and that's because these companies also sell things in their physical store. Something that I'm sure listeners of the Tuesday Consumer Goods show know very well, brick-and-mortar retail is struggling quite a bit due to pressures from Amazon and other online retailers.

Campbell: Yeah. They get about 20% of their revenue from other parts of the store. So, any kind of a hit to that, even if it's a couple percent, over a course of billions and billions in revenue, it's going to create one more headwind that they have to overcome. And I think rewards programs help to provide some insulation longer-term. This is still a good business. I think that's an important takeaway. It's a good business. But maybe it's not going to grow as fast as some people thought three or five years ago.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Kristine Harjes has no position in any of the stocks mentioned. Todd Campbell owns shares of AMZN. The Motley Fool owns shares of and recommends GOOG, GOOGL, TWTR, and AMZN. The Motley Fool owns shares of ESRX. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.