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]. 

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