Wal-Mart is not trying to get rich selling generic drugs for $4. Analysts expect the retailer is seeking to increase customer interest in the pharmacy and hopes that once in the stores, those customers will buy other merchandise. It's a smaller-scale version of the company's grocery strategy.
It looks like a loss-leader, but Wal-Mart disputes that characterization, as does Bear Sterns analyst Christine Augustine, who, in a Sept. 21 report, maintained that "the generic medicines that appear on Wal-Mart's $4 list are older drugs that are less profitable for pharmacies." It's possible purchases in the higher-margin sections of the store will offset the seemingly modest margin squeeze in generic drugs.
The worry some investors appear to have is that CVS and Walgreen, whose range of non-pharmacy offerings, although solid, is no match for Wal-Mart. The reality is much less threatening.
Analyst William A. Dreher Jr. of Deutsche Bank last week pointed out that for the largely insured clientele of the major drugstore chains, "[g]eneric co-pays are already 'nominal' and are typically around $5 and may be less than $4 under many health plans." There doesn't seem to be much incentive for CVS and Walgreen customers to sacrifice the convenience of buying medications locally in order to travel to a Wal-Mart. Even so, assuming rivals have to match the Wal-Mart price moves, Dreher believes it would cut only 0.35 percent from CVS's sales, and 0.48 percent from Walgreen's top line.
Of course, there is a risk that once Wal-Mart starts cutting prices in pharmacy, it won't stop and plans to extend the cuts to other drugs. This would be especially disconcerting to drugstore shareholders, given that it would come on top of the margin pressure already likely to come from an increasing portion of pharmacy sales stemming from Medicare Part D. That issue that impacted Walgreen's fourth quarter.
The Title D margin squeeze is a legitimate concern, although it needs to be balanced against the gains likely to flow from increased pharmacy utilization. Narrower margins are acceptable if offset by higher turnover.
However Title D plays out, it does not seem likely that Wal-Mart has the wherewithal to wage a broad, aggressive price war. Tables A and B show how Wal-Mart's fundamental position sacks up relative to CVS and Walgreen.
Casual observers tend to see Wal-Mart as being almost omnipotent. The retailer is clearly superior in some areas, yet below par in others. In short, it doesn't tower over rivals like CVS and Walgreen to such a degree that it can cavalierly do what it wants.
Perhaps that's why the scope of the price cuts, just 132 drugs by one analyst's reckoning, was so restrained.
The generic drug strategy seems to be a small thing that, combined with other such gestures, could ultimately help preserve forward progress at a company that's become too large to jolt the world with bold moves.
At the time of publication, Marc H. Gerstein did not own shares of any of the aforementioned companies. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.
Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.
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