Rite Aid (NYSE:RAD) soared more than 6% on Tuesday to reach multi-year highs.
McKesson essentially serves as the middle man between drug companies and pharmacies, as its services allow for a more efficient supply chain. Rite Aid has used McKesson for many years for drug distribution and sourcing, but their original contract was nearing an end. Therefore, this five-year agreement takes the partnership through March of 2019, and in an industry that will continue to change greatly during this period.
With that said, many are wandering why Rite Aid would trade to new highs - it's worth noting that McKesson also reached new highs on the news - on the announcement of just a distribution agreement.
The answer to this question can be tied to the vast changes that are occurring within this industry, which include more than $130 billion worth of brand drugs losing patent protection between 2011 and 2017, also called the patent cliff. Already, we have seen major effects of the patent cliff, as operating margins for pharmacies and drug distribution companies have risen drastically.
For McKesson, its operating margin has risen from 1.63% to 2.03% from 2011 till the last 12 months, respectively. And, Rite Aid has seen an unparalleled improvement from negative 2.16% to positive 3.76% in the same period. As a result, shares of both companies have soared: McKesson 290% in five years and Rite Aid 400% since January 2012.
As a result, one could argue that the large distribution partnership between these two companies have aided in the large returns that each stock has seen in recent years. Hence, an additional five-years has nothing but positive implications for both companies during this period of change.
The business of drug sales has changed greatly for all companies involved, as drugs are no longer bought in small quantities or require more difficult logistical networks. Instead, generic drugs are bought in bulk and with more pricing flexibility, which has drove margins higher.
Therefore, as more generics come on the market, theoretically, margins should continue to rise for both companies, which in turn should lead to larger gains. As a result, this partnership may seem small at the surface, but when you dig deeper it's likely a good indication that gains for either company are nowhere near ending.
Disclosure: I am long RAD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.