Retail Pharmacy: Deep Dive, Headwinds, and Distress

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Welcome to the 109th Pari Passu Newsletter, 

Today, we are exploring the Retail Pharmacy industry. We will discuss the different business models, unit economics, capital structures, and turnaround strategies across the main retail pharmacies, CVS, Walgreens, and Rite Aid. Let’s look at some strategic decisions pursued by each player and broader market trends. With this context, we will get a better understanding of next week’s deep dive into Rite Aid’s Bankruptcy. 

Table of Contents

• Key Players in the Value Chain 

• The Unit Economics of a Pharmacy 

• Business Model Comparison

• Recent Interest from Private Equity 

• Last 20 Years Key Events

• Factors Behind Financial Distress

• Solutions to Address Liquidity Crunch

• Future Outlook and Other Industry Headwinds 

Key Players in the Value Chain 

Before diving into the business model of retail pharmacy, it is important to understand the broader value chain and the roles of key players. These players are mutually beneficial but also compete against each other to maximize their pie from drug sales, depending on their value proposition. 

• Wholesaler: purchases drugs from manufacturers and distributes them to pharmacies 

  • Key Players: McKesson, AmerisourceBergen, Cardinal Health

• Pharmacy: purchases drugs from wholesalers and distributes them to patients 

• Pharmaceutical Manufacturer: invests in R&D to produce and market the drug 

• Health Insurer: provides prescription drug coverage and negotiates with PBMs 

All these players also take on different types of risks: manufacturers bear the risk for actual sales and marketing, while wholesalers and insurers take on more risk on the inventory side, putting them in a passive position without direct control over supply and demand. However, to understand how these players interact with each other, we have to dig deeper into a relatively less-known business model called Pharmacy Benefit Managers (PBMs). 

Relationship with Pharmacy Benefit Managers (PBMs) 

PBMs are middlemen between drug manufacturers and patients, employers, and insurers to negotiate lower drug prices on prescription drugs. Having the ability to select which drugs insurers will cover, PBMs have direct control over which drugs will be more accessible to patients, influencing demand for each drug [2]. The top PBMs enjoy this negotiating leverage because they dominate 80% of the market share while no single manufacturer represents 10% of the market [3]. 

 To incentivize PBMs to prioritize their drugs over their competitors, manufacturers offer ‘rebates,’ which is a percentage of return from the drug’s listed price. For example, let’s assume Drug A’s listed price is $200 per unit, and the PBM is rebated 30%. For each unit sold, the rebates passed on to insurers and customers is 200*0.30 = $60. Their effect on the other stakeholders is the following: 

• Drug Manufacturers: Rebates decrease a manufacturer’s profits. Depending on how competitive the drug is, manufacturers would have to increase rebates to move from the non-preferred tier to the preferred tier on the drug list, also referred to as the formulary. Higher tiers are usually generic drugs and make patients pay the least from their pockets, increasing demand for the drug. 

• PBMs: Rebates generate profits for PBMs. PBMs can split a certain percentage of the rebates with insurers, usually ranging from 10-20%. Assuming 20% captured, the PBM profits $60*0.20 = $12. This rebate spread refers to the amount the network pharmacy receives less than the insurer pays the PBM for a drug. 

• Insurers: Rebates lower costs for insurers. The cost of insuring the drug per unit is $200, but considering they have received 80% as rebates, their actual cost is only $200*0.3*0.8=$48 (Total Cost PBM Rebate % of PBM Rebate passed to Insurers) per drug. The revenue from rebates can be passed onto patients by reducing the need for premiums and lowering the cost patients have to burden. 

However, when it comes to pharmacies, PBMs change their roles from receiving rebates to paying out reimbursement. Because patients paid for their prescriptions at a price lower than the retail price, PBMs have to compensate pharmacies for this difference. The capital to compensate pharmacies can come from insurance companies as service fees and the extra profits, referred to as ‘spread pricing,’ if the PBM can charge insurers more for a prescription than what they pay the pharmacy [2]. 

Over the past years, the three largest PBMs have gained 80% of the market share, enjoying the most negotiating power and ability to control costs. Each year, rebates are negotiated between PBMs, insurers, and manufacturers at the beginning of a new health insurance contract. However, in recent years, PBMs have been criticized for lacking price transparency and have been probed by the FTC to fairly represent the interests of patients and insurers. Certain insurers have been pulling out of contracts for these reasons, pressuring PBMs to experiment with new pricing models, among which CVS will implement in 2025 through the CostVantage program [4]. 

As the only retail pharmacy with a PBM, CVS  acquired CVS Caremark in 2007 and generated synergies across its three businesses, including its insurance provider, Aetna Health [5]. Here’s how CVS has been able to lock in a loyal customer base. First, you get your prescription from the doctor. Aetna Health, your insurance provider, determines how much the prescription is covered by the insurance plan, how much you will pay, and which pharmacies are in-network. The key point is that CVS Caremark has contracted with Aetna, so Caremark will make sure Aetna members get the best possible pricing. Then, you visit a CVS pharmacy, which is always in-network for Aetna members, to get your prescription. There would be no reason to switch out of CVS’ network as you can enjoy discounts on pre-negotiated drug prices. Through owning a large PBM player, CVS has been able to gain leverage through its network effects. 

On the other hand, Walgreens took the opposite approach to contract with third-party PBMs even if they had to concede cost control. Due to the regulatory risks and significant upfront investment required to build out PBMs, they decided to focus on growing their existing core operations, such as their healthcare services, international expansion, and digital transformation [6]. 

The Unit Economics of a Pharmacy 

Let’s break down the unit economics of a typical pharmacy to understand why management teams have been hyper-focused to achieve scale at the expense of taking on high leverage. Both CVS and Walgreens operate nationally, but CVS generates $840 of sales per square foot compared to an industry average of $640 per square foot. How were they able to achieve this? 

Pharmacies have multiple sources of revenue, including prescription drug sales, over-the-counter (OTC) products, front-end merchandise, and additional services such as counseling and wellness checks. On a volume basis, retail pharmacies file 138k prescriptions per year on average, significantly higher than the average of 48k for smaller independent pharmacies. As a pharmacy opens more stores and controls a larger volume of prescriptions in the total market, it can negotiate better terms to control costs. From buying in large quantities, they can receive discounts from manufacturers and wholesalers. Suppliers drive a significant portion of their venue from these pharmacies, giving the pharmacies more negotiating power for higher rebates and retail prices [7]. 

In a hypothetical scenario, a retail pharmacy increases from 100 to 200 stores. Each store generates $1mm in revenue from selling 1000 drugs with an average price of $1000. Its variable costs include wholesale costs for prescription and OTC drugs, which would cost around $700 per unit, resulting in a margin of 30%.  However, operating a pharmacy also involves some fixed costs, including wages, rent expenses, technology investments, and other maintenance costs, which would be around 20% of revenue. This leaves an operating margin of 10%. As the pharmacy scales to 200 stores, it will be able to negotiate better pricing to decrease the variable costs to $650 per unit and spread the fixed cost over a wider store footprint. From a total revenue of $200mm, their operating margins would increase to 15% from operating leverage. Other factors determining profits for a pharmacy include the area’s average household income, population density, quality of in-person services, and store footprint optimization.  

Comparison of CVS vs. Walgreen vs. Rite Aid Business Models

Now that we’ve established the general business model of a retail pharmacy, let’s compare how the three top players in the industry have pursued different strategies. Even though the products they offer are commoditized in nature, retail pharmacies have differentiated themselves through scale, capital allocation, and presence across various sub-verticals.  

CVS: A Vertically Integrated One-Stop Shop [8]

Founded in 1963, CVS owns 9,000 retail locations,1,000 walk-in medical clinics, and 204 primary care medical clinics and has generated $360bn in revenue for FY23. They have a diversified business model across the following three segments: 

• Health Care Benefits (30%): The insurance business Aetna generates revenue from premiums paid by members and managing medical claims. The segment also offers Medicare Advantage, Medicaid, and commercial insurance plans, generating revenue from managing members' healthcare costs and services. As the third largest player with an 11% market share, Aetna competes with other insurers based on the quality of their service, breadth of networks, and affordable premiums by reducing the costs patients have to pay. 

• Health Services Products and Services (40%): The PBM business, CVS Caremark, covers over 108mm clients and represents 50% of commercial prescriptions. It manages prescription drug plans, negotiates rebates from drug manufacturers, and processes prescriptions through retail and mail-order pharmacies. It also provides specialty pharmacy services for complex conditions.

• Pharmacy & Consumer Wellness (30%): This segment operates the CVS Pharmacy locations, selling prescription drugs and over-the-counter products, as well as health and beauty items. Revenue comes from filling prescriptions and retail sales. The Long-Term Care component serves assisted living and nursing facilities. In FY23, they filled $1.6bn prescriptions and dispensed around 26.7% of total retail pharmacy prescriptions in the U.S.

From a revenue perspective, the same-store sales for pharmacies have been strong as the price of specialty drugs has increased by 40%. Front store sales declined significantly due to a decrease in consumer spending and the lower sales of COVID-19 test kits. However, CVS is relatively hedged against macroeconomic and seasonal fluctuations as its products are mostly specialty prescriptions that online pharmacies cannot easily sell due to regulatory restrictions. The major pressure on revenue comes from the insurance segment where Medicare’s Star Ratings decreased its revenue by $1bn [9].

CVS's complex cost structure comes from exposure to very different business models. Their pharmacy and consumer wellness margins have been pressured most significantly due to a decrease in reimbursement rates from PBMs and government programs like Medicaid. While the health services segment margins have been stable at around 4%, the insurance segment’s margin has been the biggest contributor to the decline in overall operating margins. Aetna is especially exposed to older members who have decided to increase utilization of healthcare services after COVID, continuously pressuring margins from the heavy backlog. 

Even though CVS has been exposed to lower reimbursement rates across the industry, it is less affected because PBMs leverage their size to acquire medications at extremely low rates. A decline in the Aetna segment has been offset by a growing services segment and a stable pharmacy segment, buying more time for recovery. In October 2024, CVS’s management team explored a controversial break-up of their retail pharmacy and insurance units [10]. The market grew concerned about losing a large customer base and synergies from the three businesses. One example is how clients sign contracts with all three segments across CVS, making it operationally difficult to carve out one if a breakup happens. However, CVS’s new management team has abandoned the break-up plan and announced 271 additional store closures. This leads to our next topic – capital allocation pursued by management teams in an industry where companies compete on scale, regulations, and networks over product differentiation.  

Walgreens: Transformation into a Health Service Provider [11]

Walgreens, a key competitor of CVS, was founded in 1901 and operates a total of ~8600 stores in the US and ~3400 stores in the UK. In FY 2023, it generated $139.1bn of revenue across three business segments: 

• US Retail Pharmacy (80%): retail pharmacy segment that sells prescription drugs, health and wellness products, and general merchandise. Includes in-store and online sales of health services, beauty products, and grocery items.

• International Retail Pharmacy (10%): international pharmacy operations, primarily through Boots in the UK and other pharmacies. Offers prescription drugs, health and beauty products, and retail items with an emphasis on customer wellness.

• Pharmaceutical Wholesale (10%): wholesale operations that supply medicines, health products, and related services to pharmacies and other healthcare providers worldwide

Unlike CVS, which acquires companies in full cash, Walgreens acquired equity stakes in other companies and entered joint ventures to expand into different sub-verticals. In 2021, they acquired equity stakes in healthcare services companies Shields Health Solutions, VillageMD, and CareCentrix. From a strategic standpoint, these equity investments would reduce initial cash investment to lower the risk when entering new markets while enjoying the upside of the investment’s growth. 

However, similar to CVS, Walgreens also started to aggressively increase its leverage to push into the healthcare services segment. Since 2023, they have been increasing equity ownership in the primary care clinic VillageMD to 63%. Walgreens also offered a senior-secured term loan facility to fund VillageMD’s growth in exchange for preferred shares, but industry headwinds have recently made the management team reduce stakes. As a result, intangible assets such as the value of networks, trade names, and technology make up ~16% of the assets compared to ~1% of CVS’s assets. Monetizing intangible assets to raise new capital when liquidity is deteriorating has different implications from monetizing hard, tangible assets like real estate property and equipment, which we will touch on later. Given that rating agencies already downgraded credit ratings to BBB- (speculative grade), their primary goals are to deleverage from and improve cash flows through store closures [12].

Recent Interest from Private Equity 

On December 11th, 2024, the Wall Street Journal reported that Walgreens has been discussing a potential sale to private equity firm Sycamore Partners, which could close in early 2025 [13]. This is not the first time Walgreen has received PE interest. When Walgreens had a market value of $50bn in 2019, KKR made a $70bn offer, but the deal failed to close. At the peak of a low-interest rate environment, investors were cautious about buying risky leveraged loans, especially for a company like Walgreens with a debt load of $55bn. Ultimately, KKR and other lenders failed to agree on Walgreens’ valuation [14]. 

While a buyout this time would only value Walgreens at an EV slightly above its ~$8-10bn market value, going private may bring in some positive changes. With the help of a private equity firm, Walgreens can focus on turning around its business operations and paying down its $9.5bn debt, such as closing down more unprofitable stores and growing its presence in e-commerce. Given Sycamore’s specialty in consumer retail businesses, they could make Walgreens strategically focus on the retail business rather than investing in less profitable healthcare subsidiaries. Such changes would be much easier to implement as a private company. 

However, the deal may face a few challenges to close. Not only is the financing environment difficult due to high interest rates, but Walgreens is highly levered at $9.5bn with ~$4.5bn debt maturing in the next two years. Since additional debt financing would carry a very high interest rate, the deal would increase leverage from 2.5x and put extra pressure on improving cash flows. Furthermore, Sycamore has a track record of doing buyouts at a smaller scale. Regardless of whether the deal closes, the news shows how retail pharmacies have become a low-margin business needing operational movements. 

Rite Aid: A Less-Diversified, Regional Operator [15] 

Rite Aid Corp. is a Philadelphia-based retail drugstore and pharmacy chain operator. With more than 2,100 locations across 17 states and generating $24bn of revenue in FY 2023, the company operates in two main business segments:

• Retail Pharmacy (70%): sells prescription drugs and provides various other pharmacy services, such as administering immunizations against COVID-19, shingles, the flu, etc.

• Pharmacy Services (30%): provides an integrated suite of pharmacy benefit management (PBM) offerings through its mid-market PBM Elixir. These offerings include technology solutions, mail delivery services, specialty pharmacy, network and rebate administration, claims adjudication, and pharmacy discount programs 

During the pandemic, Rite Aid initially benefited from a sales boom as people stocked up on hand sanitizers, cleaning supplies, and beauty products. It sped up technological offerings, opened smaller format stores aimed at addressing pharmacy needs, and said it was focusing on winning over millennial and Gen X customers. But, as the pandemic wore on, customers started consolidating their trips to drugstores, cutting into Rite Aid’s opportunities to capture impulse purchases. Social distancing protocols led to a less severe cold and flu season during the first winter of the pandemic, resulting in a big drop in the company’s cough, cold, and flu business. Moreover, consumers were also turning to online alternatives like Amazon to buy these food, beauty products, and household goods [16].  

Competition from Walgreens and CVS in the pharma-retail space continued to diminish Rite Aid’s performance in the 2000s. Because these companies were much larger and thus had the advantage of economies of scale, they were able to produce goods at much higher margins than Rite Aid. Because of their size they also had greater resources to invest in technology and other innovations in the retail pharmacy space, making it difficult for Rite Aid to keep up with the rapidly changing industry landscape.

Theoretically, owning a PBM sounds amazing. As Rite Aid’s retail business was slowing in growth, the management team saw Elixir as a chance to diversify and capitalize on a niche segment not dominated by the major PBMs. However, Elixir was a regional PBM serving small to mid-market players that struggled to compete against the three largest PBMs with less negotiating power for lower drug prices and rebates. Initially, Rite Aid enjoyed a boost of $4.1bn in revenue after acquiring Elixir in 2015 for $2bn, but the number of covered lives plummeted quickly from more than three million to one million within a few years [17]. 

Last 20 Years Key Events

As legacy businesses, all three companies have undergone historical market cycles, such as the Global Financial Crisis (2008) and COVID-19 (2020). Sometimes, their equity performance has been subject to broader market trends, but idiosyncratic factors have revealed the level of financial health and strength of the business. Most notably, their stock performances have seen the greatest divergence post-COVID. 

Key Events for CVS [8]: 

• 2006: CVS's acquisition of MinuteClinic and thousands of drugstores led to an increase in stock price, bolstering investor confidence in its expanding healthcare capabilities

• 2011~: CEO Larry Merlo transforms CVS from a drug store chain into a one-stop shop through vertical integration, carrying out $68bn in acquisitions, and expanding store footprint to 9000 stores across the US

• 2017 - 2018: acquires Aetna Health for $70bn, one of the largest health insurance deals in history. The stock jumped as it marked CVS’s shift to an integrated healthcare model

• 2020: Earnings from strong sales of COVID test kits under the retail pharmacy segment were better than expected despite fewer visits to clinics during the pandemic. Insurance stocks rise as Biden Administration announces more investments into government-related insurance programs

• 2023: acquired Oak Street Health for $10.6bn in cash, adding a large network of doctor-staff clinics used by seniors 

• 2024: Poor performance of Aetna Health, the insurance business of CVS, and depressed stock prices, amplified by lower forecasts from other insurers. Under pressure from the activist investor Glenview Capital, CVS transitioned into a new management team with more cautious capital allocation strategies. A potential breakup of the insurance and retail pharmacy segment is no longer explored [19] 

Key Events for Walgreens [11]

• Mid to Late 2000s: continued to perform well, benefiting from increased demand for prescription drugs and health services as the U.S. population aged

• 2008: affected stock performance temporarily but regained momentum due to a strong core business 

• 2010: acquired the New York-based pharmacy chain Duane Reade for $1.1bn, expanding its presence in a market with high population density 

• 2014: the merger with Alliance Boots for $15.3bn allows Walgreens to become a global player in the pharmacy sector, boosting investor optimism about international growth

• 2018: attempts to acquire Rite Aid for $17.2bn, which was perceived positively by investors, but deal was struck down due to regulatory hurdles

• 2020~2021: as a critical provider of COVID-19 vaccinations and testing, played an essential role in the public health response during the pandemic but stock gains were offset by increased competition from CVS and Amazon Pharmacy  

• 2021~: commitment to increasing its healthcare services, including partnerships with healthcare providers, built up positive investor expectation to shift towards integrated healthcare solutions

• 2022: revenue for the retail segment peaked during the omicron wave (up 15%), boosted by strong vaccination and testing trends. Continued to expand into healthcare services from the acquisition of VillageMD and Shields Health Solutions. Stock dropped due to concerns about the long term profitability of the new investments

• 2023~: Faces industry headwinds, including shift in consumer spending, high leverage from acquisitions, integration difficulties with healthcare segments 

• December 2024: stock jumps by 18% (biggest one-day gain) after a report raises the possibility of a buyout from Sycamore Partners, leading to a market cap of ~$9bn

Key Events for Rite Aid [13]

• Mid-2000s: experienced recovery efforts and pursued growth through acquisitions, including the purchase of Brooks and Eckerd pharmacies in 2007. However, this expansion added to its debt and operational challenges.

• 2008: the combination of high leverage and competitive pressures from larger rivals like CVS and Walgreens exacerbated the stock's underperformance

• Early 2010s: modernizing stores and enhancing customer experience efforts provided temporary boosts to the stock

• 2015-2017: Rite Aid announces a proposed acquisition at $9 per share, increasing stock in anticipation of the merger

• 2017-2018: the merger faced regulatory challenges due to antitrust concerns and was scaled to only acquire half of Rite Aid's stores, leading to a drop in stock price 

• 2020~: initially benefits from the increase in prescription volumes during the pandemic but continues to face competition from larger pharmacy chains and online retailers. Investors become increasingly concerned about the ability to meet their debt obligations

• 2023 - 2024: After attempts to push back debt maturities, filed for Chapter 11 and re-emerges as a private company with $2bn debt load reduced

Over the past decade, retail pharmacies have benefited from investor excitement from acquisitions and entering new subverticals. The stock market rewarded them for taking on aggressive expansion projects even at the expense of benefitting the bondholders. However, these highly capital-intensive investments have not materialized in terms of profitability. With revenue growth slowing down and difficulty in controlling costs, investors have been demanding stable margins to preserve sufficient cash flows for meeting debt obligations. Even during the same industry downturns, such as the GFC, Rite Aid’s stock displayed the most volatility due to its 1) small market cap leading to lower liquidity (the level of trading activity), 2) pressure on margins due to its smaller scale, 3) less diversification in revenue streams that increased exposure to a decrease in consumer spending, and 4) failed mergers, lower cash, and operational challenges making it harder to access the capital markets for financing. Investors in Rite Aid would have been more concerned about credit metrics such as leverage in a downturn scenario, especially since there are not many monetizable assets. 2025 and beyond marks a significant inflection point when the expectations of equity and credit markets coverage, companies pursue cost-cutting measures, and launch new business models in the face of changing industry dynamics. 

Internal vs. External Factors Behind Financial Distress  

There are many reasons behind financial distress. The first bucket is idiosyncratic to the internal management decisions, capital structure, and business quality. The second bucket is more industry-level headwinds.

The key factors causing distress for retail pharmacies include:

1. Aggressive Push Into Healthcare Services 

After the Affordable Care Act (ACA) was passed in 2010 to democratize insurance across the lower and middle class, companies have pursued a value-based care approach that emphasizes quality over volume of service. By rewarding high-quality performance among healthcare providers, clinics can manage resources more effectively and retain repeat clients [20]. 

CVS decided to acquire MinuteClinic in 2006, which serves as a walk-in health clinic in CVS stores, offering basic healthcare services such as flu shots, wellness exams, and treatment of minor illnesses [8]. Through investments in health counseling and digital health services, they’ve been increasing customer interaction in various ways. 

Seeing more patients visiting doctors in person, CVS and Walgreens found primary care as a new vertical to diversify their revenue base. CVS pursued aggressive upfront investments to acquire primary care clinic Oak Street Health (2023) for $10bn in cash and home care provider Signify Health (2023) for $8bn. Oak Street Health mainly focused on seniors and was built next to CVS Pharmacies or on a standalone basis. Despite the previous CEO’s optimism about Oak Street’s long-term profitability, as Oak Street can absorb its four million insurance members, it still operates only 250 stores. Given it continuously operated with a negative net income (-$510mm in FY22) even before integrating into CVS, there is uncertainty about how long it will take to recoup the massive upfront investment. 

Running a primary care clinic is very capital-intensive. Primary care competes on the quality of healthcare providers who need expensive training. Quality can be sacrificed if there are longer wait times and high patient-to-doctor ratios. Clinics would also have to be located in a relatively higher-income neighborhood to keep patient volumes high. For these reasons, Walgreens has taken the opposite direction to reduce stakes in their primary care clinic, VillageMD, and possibly monetize them. While CVS’s push into primary care is still in the early innings, Walgreen’s pivot in strategy shows how debt-funded acquisitions are risky for business models that need continuous reinvestment to justify the costs and time to achieve scalability [21]. 

2. Leverage, Liquidity, and Credit Ratings 

All three businesses have grown aggressively to compete on scale and meet their capital-intensive business models. CVS most notably elevated leverage to above 4x to complete their $68bn of acquisition of Aetna Health in 2018, spending a total of $120bn in the last two decades. While this boosted short-term stock gains, it hurt the bondholders by straining cash flows from increasing annual interest payments to $2.89bn LTM Q3 2024 [8].  Similarly, Walgreens continued acquisitions using the proceeds from the sale of their non-core assets. 

As activist investor Glenview Partners pushed out previous CEO Lynch on October 18th, 2024, CVS is pivoting to a conservative capital allocation strategy. They’ve announced a halt in share buybacks, large-scale acquisitions, and debt issuance. While the management wants to commit to its high-grade ratings, Moody’s is reviewing a potential downgrade as Aetna Health’s creditworthiness has been declining [22]. Here’s where CVS’s diversified business model can be a double-edged sword as some subsidiaries with outstanding debt can deteriorate the parent company’s creditworthiness. In the event of a default, CVS or a guarantor, an entity responsible for meeting debt obligations if the original borrower defaults, would have to step in and cover its obligations. 

Before looking into Rite Aid next week, let’s compare the capital structures of CVS and Walgreens. As of LTM Q3 2024, CVS generated a net income of $5.01bn with $7.14bn in cash and $6.55bn of total debt.  From their total debt, the ‘current’ portion is only 7.5%. Their weighted average fixed coupon rate is 4.46%, while the weighted average maturity is 9/12/2036 [8]. Most importantly, their coupons are mostly fixed-rate, which locks in a lower, predictable interest expense compared to the higher interest expenses created from floating-rate debt during a high-rate environment. 

Compare this with Walgreens, which generated a negative net income of $1.54bn with $703mm in cash and $8.91bn of total debt as of LTM Q3 2024.  They also have a significantly higher leverage of 5.5x and a shorter weighted maturity of debt due on 6/16/2031, with $1.5bn of debt coming current. While its weighted average fixed coupon rate is slightly lower at 4.46%, the most recently issued $750mm 2029 senior unsecured notes were priced at a significantly higher coupon rate of 8.125% to compensate for increased credit risk. This is significantly higher than what blue-chip borrowers typically pay. Their high leverage and additional $61mm interest expense from the newly issued notes are pressuring free cash flow, so the prospect of refinancing the notes due from 2024 to 2026 may be lower. However, this does not mean Walgreens will default soon as its liquidity is still solid, supported by $5.75bn of undrawn RCF and $703mm of cash. Furthermore, the management team has been reducing cash returns to shareholders by pausing buybacks and halving dividends to $216mm while monetizing assets such as equity stakes in different businesses, which will be explored below. Nonetheless, given their greater exposure to the highly cyclical retail segment, increased reimbursement pressures, and fewer opportunities to raise new capital, Walgreen’s long-term runway looks very uncertain. [11].

3. Opioid Litigations and the Texas Two-Step Bankruptcy 

While management decisions and capital structure problems have pressured retail pharmacies, external factors have also created significant liabilities. Accused by state and local governments for failing to monitor highly addictive painkillers, CVS, Walgreens, and Walmart had to pay more than $13bn to resolve thousands of state and local government lawsuits. Each respectively agreed to pay $4.9bn, $5bn, and $3bn over the span of 10-15 years, but spreading the settlement costs out reduced the immediate burden on cash flows. Along with drug manufacturers, pharmacies have also been a target of the 4000 suits battling the US opioid pandemic, which has caused more than 500,000 deaths in the last two decades [24]. 

Similarly, Rite Aid was facing more than 1600 opioid settlement claims and allegations from the Department of Justice (DOJ)that its PBM business, Elixir, violated the False Claims Act (FCA) by inaccurately reporting rebates. But unlike its competitors with longer runways, Rite Aid could not pay out its opioid victims due to a lack of liquidity and the need to deal with their impending maturity walls [25]. 

However, over the past few years, other pharmaceutical companies have found themselves in similar situations and wanted to avoid the costly, complicated process of dealing with massive tort claims out-of-court. Instead, they have intentionally filed for Chapter 11 in Texas, giving rise to the ‘Texas Two Step” maneuver.  Texas law uniquely allows for a ‘divisive merger,’ where a single entity can be divided into multiple ones to distribute assets and liabilities as desired. Companies are able to split into a ‘badco’ and ‘goodco’ and transfer all the mass tort claims into the ‘badco,’ which is the entity that has filed for bankruptcy. While funding the bankruptcy, the ‘goodco’ still operates as an ongoing business that is free from these liabilities. As a result, companies can avoid paying out victims to whom they owe billions of settlement claims. These claims are usually tossed into the general unsecured claims and result in nearly zero recovery rates for the victims. Technically, any company is allowed to utilize this strategy, but the strategy is primarily meant to stand in court. This is why we’ve seen companies facing mass tort litigation like J&J, Georgia Pacific, and Trane Technologies repeatedly use this playbook [24].   

Historically, bankruptcy laws have provided relief to debtors such as Endo International and Purdue Pharma by pausing lawsuits, channeling everything into a single forum, and creating an orderly procedure for resolving these claims. However, healthy companies have also begun to intentionally use the Texas Two Step strategy even without being in financial distress. For example, J&J created a new subsidiary, LTL Management, that held all the legal liabilities before declaring this entity bankrupt. The Third Circuit rejected J&J’s use of the Texas Two Step as it wasn’t in clear financial distress. Comparing this to the paper giant Georgia-Pacific rejecting millions in asbestos liability claims under the Fourth Circuit, the U.S. Supreme Court would have to reconcile competing interpretations of the bankruptcy law [27].   

The rise of the Texas Two-Step strategy doesn’t simply imply increased opioid litigation. What it really shows is the bankruptcy court is a debtor-friendly forum that can be utilized in creative, unprecedented ways for companies to avoid opioid liabilities. For example, even though Rite Aid hasn’t pursued a creative strategy like the Texas Two-step, they’ve decided to take advantage of the legal tools offered by the bankruptcy courts, which will be further explored in Part 2. 

4. Headwinds in the Insurance Industry 

Given how retail pharmacies interact closely with insurers and CVS even owns an insurance business, it’s important to understand the impact of insurers on the profitability of retail pharmacies.  Since 2023, insurers CVS, UnitedHealth, and Elevance have all been pressured due to their high reliance on government insurance programs like Medicare and Medicaid. However, headwinds in the insurance industry have been a recurring challenge for retail pharmacies across various market cycles in the past decade:

• Expansion of Public Insurance Programs (2000s): First introduced in 2006, Medicare is a public insurance program primarily serving individuals above 65, with “Part D” being specifically designed to help lower the cost of medications. The program is funded through payroll taxes, premiums paid by individuals to keep their insurance plans alive, and government revenue.  However, Part D is specifically offered by private insurance companies. Medicaid is a government insurance program targeted toward lower-income families and individuals, jointly funded by the federal and individual state governments. Insurers earn profits from the difference between the medicare costs and the rate set by the government to help insurers cover the cost of providing health services [28]. With the expansion of these programs, insurers could cover more individuals enrolled in their programs and increase their negotiating power to demand lower drug prices from manufacturers. When insurers didn’t adjust the reimbursement rates to compensate for the lower drug prices, pharmacies lost more revenue. 

• Continuous PBM Consolidation and Affordable Care Act (ACA) Era (2010s):  The ACA widened health coverage, incentivizing PBMs and insurers to focus on cost-cutting. This encouraged PBMs to be selective with the drugs listed on the formularies and create a ‘narrow pharmacy network.’ Being part of this narrow network would lower a patient’s out-of-pocket costs and reduce their financial burden. To be considered to enjoy these benefits, pharmacies had to accept lower reimbursement rates to increase visits to their stores, directly hurting their margins [29]. 

• COVID-19 and the Post-Pandemic Era (2020s): During the pandemic, the government offered short-term funding to keep individuals enrolled in Medicaid. However, post-pandemic, hospitals have been seeking higher reimbursements and increased spending on specialty drugs driven by the Inflation Reduction Act. This lowered out-of-pocket costs for some members, which increased payouts to members and hurt insurers’ profit margins. To compensate for higher losses, insurers have been pressured to increase premiums to members that reduced enrollment, especially among healthy individuals willing to opt out of coverage. The remaining patient pool further drove up costs per member [30]. With the pandemic exacerbating mental health problems, demand for such services and medical cost treatment has surged and has heightened investor concerns around the possibility of a recovery in profits. CVS has been especially vulnerable to these trends, given that 30% of its members are enrolled in either Medicare or Medicaid [8]. 

Solutions to Address Liquidity Crunch

As public companies with strong real estate footprints and diversified asset bases, retail pharmacies have considered meeting liquidity requirements through various transactions. However, the management team must carefully assess the distinction between ‘core’ and ‘non-core’ assets so that raising cash does not hurt the company’s long-term runway. 

1) Early Asset Sales: Given that all three companies grew through acquisitions of different businesses, they have opportunities to raise cash through asset sales. Walgreens already monetized stakes in the public company Cencora from the 30% equity position they’ve previously built to work together on supply chain management, resulting in a total of $1.1bn extra cash, including share buybacks [29]. The management team is looking forward to monetizing some percentage of ownership in VillageMD and a few Chinese joint ventures. The various corporate partnerships pursued by Walgreens allow for them to leverage a wide portfolio of intangible assets, yet it is unclear whether they will receive fair market value given that VillageMD is unprofitable and the potential decline in  Cencora’s stock price. 

While CVS’s management team has not announced an official asset sale, they have many possible options. On top of their retail locations, they can fully or partially spin off Aetna, such as their commercial insurance division. A PE firm or larger PBM could buy out the PBM business, although this would be unlikely due to anti-trust and strategic reasons. 

Even though Rite Aid operated on a local scale, it still retained the Elixir business, which could have been monetized to raise more capital. Since 2018, there were expectations that, given heightened industry consolidation, Rite Aid could sell off Elixir and realize a maximum of $2.2bn in cash to pay down its $3bn debt [32]. However, the management team decided to continue operating Elixir. Here’s where a management team’s ability to assess market timing and capital allocation is crucial. While selling off its Elixir business wouldn’t have entirely turned around a deteriorating business, it could have been meaningfully used to reduce outstanding debt and stabilize the existing business. 

2) Sales Leaseback: As we’ve introduced in our sales-leaseback post, companies with a real estate footprint have been able to sell their assets to a third-party investor and lease them back to raise new capital. This has generated a steady stream of cash flows to reinvest back into the business, fund M&A, and pay down debt. Rite Aid took advantage of favorable real estate market conditions and entered long-term sales leaseback transactions, raising $308mm in extra capital from 2021 to 2023 [13]. Recently, however, Walgreens has started to scale down the sales-leaseback transactions that have raised an extra $4.6bn in cash from 2020 to 2023. However, this came at the cost of generating an annual ~$3.5bn in lease liabilities plus an annual cash interest of ~$175mm from the weighted average interest rate of 5.35% in 2023. At the same time, their FCF was decreasing by 40% YoY to $2.2bn in FY23 [11]. As Walgreens has announced aggressive store closures, they wouldn’t have found it necessary to enter lease contracts that last a minimum of 15-20 years. It also makes sense to wind down sales leaseback for a company with low FCF because it incurs additional operating costs that did not exist before. Instead, these cash flows can be more strategically allocated towards deleveraging or remodeling old stores in the long run, making sales leaseback a limited option for long-term liquidity.

3) Retail Footprint Optimization: Shutting down underperforming stores is one of the most straightforward solutions to reduce a retailer’s working capital needs and improve cash flows. All three companies have identified stores that are unprofitable or serve areas of lower population density. After identifying 25% of unprofitable stores in their portfolio, Walgreens announced plans to close roughly about 1,200 underperforming U.S. stores, which management expects to contribute around $100mm operating income. They also plan to re-model 800 stores, which aims to improve in-person customer experience by strategically placing products and updating outdated facilities. CVS also launched restructuring plans to save $2bn in costs, which includes cutting 2,900 employees and shutting down 900 stores [33]. 

But would simply shutting stores preserve liquidity for pharmacies? Having a significant real-estate footprint has created high barriers to entry for new players to achieve similar scale, but it turns into a major burden when companies are short in cash. Both CVS and Walgreens only own 5% and lease the remaining 95% of the stores. Even if closing down unprofitable stores would save labor costs, most pharmacies are obligated to continue paying the rent after the store closes, often referred to as ‘dark rent’ [34]. Most of the pharmacies that have closed in recent years were signed to 10-, 15- or even 20-year leases, at rents that often exceed today’s rates. For Walgreens, its average lease term on its $3.5bn liabilities is 9.2 years with an interest rate of 5.6% [11]. The triple net lease (NNN) contract requires them to pay for rent, property taxes, insurance, and maintenance until the lease expiration date. Closed stores depress profits on the financial statements because the value of the remaining lease term is ‘written down’ as an asset impairment. Not to mention, transitioning existing employees and exiting store leases would take another few years to stabilize operations. Here’s where the traditional dynamic of the real estate investor changes when a company files for bankruptcy. In Rite-Aid’s case, Chapter 11 offered the right to reject lease payments and continue closing its stores, which will be explored more next week. 

Future Outlook and Other Industry Headwinds 

As we assess the unique business models and broader industry trends in retail pharmacy, it becomes clear that financial distress is not simply a result of a singular event. A combination of macroeconomic headwinds, high leverage, and changing regulatory environments have been gradually building up. To understand the viability of a company’s future performance, it’s helpful to pay attention to any disconnections between both credit and equity performance across the capital structure. 

Going forward, one trend to monitor is the competitive threat of online pharmacies. The front-of-store sales of pharmacies, referring to anything not sold at the pharmacy counter, have been struggling for years with Amazon’s online pharmacy and retail giants such as Walmart offering more attractive options. Both companies have been pushing into same-day deliveries and offering discounts to existing customers, leveraging their cheaper distribution costs over a broad network. As both CVS and Walgreens push into healthcare services to diversify from products, they would have to better manage pressures from wage inflation and a shortage of pharmacists. Understaffing has also been a concern as pharmacists have been exiting the industry due to harsh working conditions, wage inflation, and burn out, directly impacting in-store customer experiences [14]. 

Today, we covered the business models of the retail pharmacy value chain including the roles of insurers, PBMs, and manufacturers. We compared the three biggest retail pharmacies and how they have responded to various industry headwinds based on differences in their business models, capital structures, and capital allocation strategies. Finally, we briefly touched on the topic of how opioid claims have been treated in-court. In our next post, we will dive deeper into how Rite Aid managed opioid claims in bankruptcy and the various levers they pulled to maximize value in a deteriorating business. Stay tuned! 

Sources: [1], [2], [3], [4], [5], [6], [7], [8], [9], [10], [11], [12], [13], [14], [15], [16], [17], [18], [19], [20], [21], [22], [23], [24], [25], [26], [27], [28], [29], [30], [31], [32], [33], [34]

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