- Amazon continues to startle markets with its market performance to date, leaping almost 52% through Friday's market close.
- Amazon's partnership with JP Morgan Chase and Berkshire Hathaway has markets speculating on the path the company will take in applying its resources to the US healthcare leviathan;
- Amazon's most recent foray into the retail pharmaceutical space with the purchase of closely held PillPack now gives the giant the necessary regulatory licensing to compete in 49-states;
- Retail pharma's biggest players continue the consolidation process with vertical and horizontal integration schemes to slow the pace of the Amazon competitive threat;
- Investors remain wary as Amazon's pace gathers momentum.
Amazon’s (NASDAQ:AMZN) interest in the $450 billion US pharmaceutical market is long-standing. The company already sells over-the-counter medicines like aspirin and antihistamines, to go along with its copious offerings of supplements and vitamins on its worldwide platform. It already has licensing to sell pharmaceuticals in 12 states (Nevada, Arizona, North Dakota, Louisiana, Alabama, New Jersey, Michigan, Connecticut, Idaho, New Hampshire, Oregon, Tennessee, with an application pending in Maine). And now with the purchase of the closely held, online, Manchester New Hampshire-based PillPack that will clear in the latter part of the year, Amazon with the stroke of a pen has the necessary licensing to sell pharmaceuticals in 49-states. Investors were certainly quick to notice and the reaction hit markets with tsunami force. With the 28th of June announcement, brick and mortar stalwarts of the pharmaceutical retail world like Walgreens Boots Alliance (WBA), CVS Health (CVS) and Rite Aid (RAD) collectively shed about $11 billion in market value.
Amazon’s renown logistical efficiencies and willingness to sacrifice short-term margins for long-term market share were at the fore of the market move. Most prescriptions in the US are still filled in person and the delivery of scripts remains highly fragmented. If Amazon did nothing else but centralize the distribution of pharmaceuticals, this alone could likely apply enough downward price pressure on the cost of drugs to deliver real savings to US consumers. Centralizing and organizing existing data is the most likely front of significant cost savings and returns for both the end user and company alike. It could provide augmented negotiating clout to force better pricing deals on drug manufacturers. Even if mere convenience becomes the watchword of the makeover, laying the groundwork for cost reductions in the delivery of pharmaceuticals to those in medical need is a worthy endeavor for a country that spends almost 18% of its total annual output on healthcare. While the ordering, dispensing and delivery of pharmaceuticals to consumers is heavily regulated by myriad agencies at almost every level of government, the logistics of the operation plays to Amazon’s well-honed strengths. And after all the applications are committed to computer code and the process, literally, hits the road after the necessary regulatory blessing is in place, the delivery of scripts should not be much different than the delivery of books—and the thousands upon thousands of goods and services Amazon already plies to consumers online across the country and around the world. Getting there, however, will mean overcoming an entrenched modus operandi in the delivery of pharmaceuticals that hasn’t changed much in the last century.
Figure 1: Amazon against the S&P 500 Benchmark
Amazon (green area, upper frame) is already up a staggering 52% through Friday’s market close (13 July), driven in part by online consumer spending that is up 9.1% through the end of May YOY. The stock is trading well above its 20-day exponential trading average since April (blue line, upper frame). The feat is all the more startling given that consumer spending fell 0.9% through the end of the 1st quarter, its lowest post since the 2nd quarter of 2013. Amazon claimed about 44% of all online sales through the end of 2017, according to One Click Retail data. The pace of Amazon’s market performance is equally startling given the muted performance of the S&P benchmark (green area, top frame) whose YTD performance struggles with returns just short of 4% over the same period (see Figure 1, above).
The benchmark will continue to struggle as mounting uncertainty over US trade policy dampens both new orders and capital investment plans across the economy. New orders dropped 0.6% overall in May over April with transportation new orders falling 0.3% while non-defense new orders falling 0.6% for the period. Capital investment overall fell 4.8% with nondefense capital spending falling 6.5% for the period. Commercial and industrial loan books expanded at a pauper rate of 0.3% in May after a 2.1% surge in April, which just happened to be the biggest monthly demand surge for C&I books since February 2014. May’s anemic rise was the worst post since back-to-back negative growth months in October and November of last year. While the country’s job creation capabilities remained robust with 213,000 jobs being created and enticing 601,000 back into the labor force during the month of June, capital investment is now being held hostage by US trade policy—a grip that becomes all the tighter as the dollar value of tariffed goods climbs. And despite ballooning deficits due to TCJA and added government spending, the dollar’s 2nd quarter performance racked up 5.5% gains against the euro and double-digit percentage gains against the rand and the real and about 4% against the renminbi. At present, better US growth prospects appear to blind more traditional fears conjured by ballooning deficits as global investors continue to pile into US assets.
Amazon’s YTD drive was lifted decisively by the very public joining of forces with the funding muscle of Warren Buffet’s Berkshire Hathaway (BRKB) and JPMorgan Chase (JPM) in January. The yet-to-be-named company is charged with the mandate of targeting the excessive costs of delivering healthcare in the country. While the first phase of the enterprise is setting up the template to reduce the cost of healthcare delivery to the collective sum of the group’s employees, component parts of the company will almost certainly contain a new, centralized take on the pharmacy benefit manager (NYSEMKT:PBM) format—complete with a top-to-bottom technological makeover of how scripts are ordered, packaged, dispensed and delivered to end users. The same such makeover is in store for each facet of the healthcare delivery system as app-based online medical screening becomes more widely available and barriers to entry by technology startups enshrined in state and local law break down myriad professional practices that serve more of a purpose of protecting traditional practitioners than protecting consumers. In states were routine online eye exams are legal, for example, the process of ordering glasses or even contact lenses could be had from a smartphone—dramatically reducing the out-of-pocket costs to consumers. Harvard professor of medicine, surgeon and writer Atul Gawande was recently named to head the project’s first phase.
Figure 2: Walgreens Boots Alliance and Rite Aid against the S&P 500 Benchmark
A rather different paradigm of forward growth emerges from the bricks-and-mortar retail pharmaceutical space where market scale continues to dominate strategic thinking. In October 2015, Walgreens proposed a deal worth $9.4 billion for the purchase of Rite Aid’s 4,600 stores, which was eventually rejected by the Federal Trade Commission on anti-trust grounds. The deal was finally terminated in June 2017 with Walgreen paying out a $325 million termination fee.
Undeterred, Walgreens agreed to less robust purchase of Rite Aid assets two months later which included 1,932 Rite Aid stores and three distribution centers in Connecticut, Pennsylvania and South Carolina for a sum of $4.4 billion, about 42% of Rite Aid’s total marketable assets. The FTC agreed. As of the 27th of March, the store transfer was completed. The transfer of three Rite Aid distribution centers and related inventory will begin by the 1st of September.
Walgreens Alliance Boots is a holding company that includes Walgreens and Boots Alliance, which dates from an initial purchase of 45% of the Swiss-based company in 2012, followed by the complete purchase in December of 2014. Walgreen Alliance Boots, now based in Deerfield, Illinois, is in 25 countries. In March and August 2016, Walgreens Alliance Boots exercised warrants on almost 56 million common shares of AmerisourceBergen (ABC), taking about 25% of the company with the two separate purchases. ABC is one of the largest distributors of brand-name and generic pharmaceuticals, healthcare products and supplies in the country.
The combined company operates 8,100 retail stores separated in two segments, those in the US and its territories and those in the international space. The continental US has 7,979 of the total of the domestic segment which includes the US, Puerto Rico and the Virgin Islands. The international segment comprises 4,722 stores with 2,486 or 53% being in the UK and 1,193 or 25% being in Mexico. Other international store locations include Chile, Thailand, Norway, the Republic of Ireland, the Netherlands and Lithuania, all with less than 1% of the total. The total store count comes to 12,822 with 63% being in the US and its territories and 37% being located abroad.
Following the same pattern, 74% of the company’s fiscal 2017 sales, or $87.302 billion of the company’s total sales of $118.2 billion came from the US with 11% or $12.60 billion in sales coming from the UK. About 14% of total sales came from Europe excluding the UK with about 0.02% being scattered widely across the rest of the company’s geographic reach. Long-lived assets followed a similar trendline with the US playing host to 76% or $10.34 billion of the total $13.6 billion. About 18% or $2.5 billion of long-term assets are located in the UK while the remaining company assets are dispersed widely about the world.
Company earnings have been mixed since the incorporation of Alliance Boots in December 2014. Net earnings were up 110% YOY to $4.2 billion by the end of fiscal year 2015 in August. Diluted earnings per share trended similarly. Dividends increased by 7% to $1.373/share while long-term debt soared from $3.72 billion to $13.2 billion. By the end of fiscal year 2016, net earnings had fallen just over 2% to $4.2 billion while EPS fell 4.50% to $3.82/share. Dividends increased 6% while long-term debt increased 40% to $18.71 billion with the ABC stock purchase in March and August of that year.
With another year passing, Walgreens launched a second, this time scaled down attempt at buying Rite Aid assets. By the end of the fiscal year 2017, net earnings had dropped 2.15% to $4.1 billion. Diluted EPS also trended downward by 1% to $3.78/share while declared dividends increased to $1.525/share, up 5% YOY. Reported debt for the period dropped to $12.7 billion. Internationally, total sales fell to $11.8 billion, down almost 11% for the period as a weak dollar fared poorly against the stronger pound and euro. Operating income fell 28% despite an increase of 50 stores to the period mix.
In the company’s third fiscal quarter through the end of May, consolidated sales hit $34.3 billion, up 14% YOY. Operating income rose 5.5% for the period to $1.6 billion while diluted EPS rose 26.2%, the latter being aided by a lower number of outstanding shares YOY. It was a good quarter. TCJA helped the company’s bottom line by reducing the effective tax rate to 7.6% for the period, down from 12.4% YOY. By segment, gross US sales at $25.92 billion for the period was up 15% for the period from 9,964 stores, an increase of over 22% YOY. Pharmacy sales were up 19% for the period due mainly from the acquisition of Rite Aid stores. Retail sales were up 5.3% YOY, also due to the inclusion of Rite Aid sales in the quarterly report.
Investors remain wary. Walgreens (green line, upper frame) is down just over 13% through Friday’s market close (13 July). The stock has traded well below its 20-day exponential trading average (blue line, upper frame) since May, underperforming the S&P 500 (green area, upper frame) over the same period. Market momentum fell negative in the latter days of June (lower frame). The company’s long-term credit rating stands at BBB, the last call for investment grade. Meanwhile, RAD (black dotted line, upper frame) has seriously underperformed the S&P benchmark since March save for one last leap of faith in the latter part of June before diving into market oblivion with few signs life (see Figure 2, above).
Figure 3: CVS Health and Aetna against the S&P 500 Benchmark
CVS Health, the country’s largest PBM, is trying to stay competitive by building vertical market scale with the proposed purchase of Aetna (AET), the third largest health insurer, in one of the year’s biggest M&A deals. The cash and stock deal prices out at a whopping $69 billion ($77 with debt) as two, noncompeting companies occupying different sectors of the healthcare equation attempt to join forces. An obvious efficiency includes cost reductions in clinical care through an increased customer base for CVS walk-in facilities to deal with nonemergency patient treatment. The increase use of walk-in medical treatment has been shown to reduce high cost visits to emergency room facilities that have become a default mechanism for non-critical care, especially as the availability of regular doctors on short notice becomes all the more problematic. CVS is also rolling out same day delivery of its scripts in several major urban markets while increasing the delivery of medical services in many of its 8,100 retail stores and almost 1,700 leased pharmacy outlets in Target facilities across the country. The deal still awaits a verdict from the Department of Justice.
Beyond this initial sketch, the cost efficiencies of this vertical merger become much more nuanced. With the May announcement of the merger between Cigna (NYSE:CI) and Express Scripts (NASDAQ:ESRX) and Optum Rx United Healthcare, the three payer PBMs could dominate their captured client bases without setting up a clear path to achieve cost efficiencies that would trickle down to the end user—the consumer. Weak market competition, historically, has been a recipe for increasing, rather than decreasing, costs to the consumer. The merger lends few credible projections to counter such a view.
Investors to date have largely agreed. CVS announced the purchase in the first week of December last year, valuing Aetna’s assets at roughly $207/share, a premium of just over 16% to its then $178/share market price. It took until the end of January before Aetna peaked at an all-time high of $193.74 before falling back to $168.11 by the last week in March—less than a week after shareholders approved the deal. Since the vote, however, the stock has gained just over 14% to $191.89 through Friday’s market close (13 July). The trend will likely continue until the market catches up with the market premium CVS is paying to acquire Aetna’s assets. Seven months after the December announcement, investors remain wary.
Revenues increased to $184.77 billion through the end of 2017, up just over 4% YOY. Operating profit fell to $9.52 billion, down just over 8% YOY as operating expenses rose almost 3% YOY. Net income, however, increased to $6.6 billion for an 25% increase for the period. Earnings per share rose just over 31% to $6.45/share while cash dividends increased to $2.00/share, up just short of 18% for the period. Debt ended the year at $22.2 billion with $4.8 billion of debt being retired ($3.5 billion in long-term debt) during the year. The annual totals were based on 9,846 stores, up almost 1% YOY.
More recently, revenues through the end of the 1st quarter ending in March came to $45.7 billion, up almost 3% YOY as both pharmacy services (up 3%) and front-end retail (up 6%) were positive for the period. The effective income tax rate at 32% dropped from 37.3% in March 2017 due to the impact of TCJA. Income from continuing operations rose just under 6% to $998 million.
Market performance year-to-date puts CVS (green line, upper frame) close to correction territory at just over 7%, trading well below its 20-day exponential trading average (blue line, upper frame) since the beginning of April. It was only in the first week in May when Aetna (black dotted line, upper frame) began to break away to its $207/share offer price as party to the deal, well after the deal had been approved by shareholders. CVS itself has experienced a measured comeback, up almost 6% since the beginning of July. Market momentum has also improved as the market catches up with the $207/share offer price that underlies the deal (see Figure 3, above). Investor sentiment remains far from a ringing endorsement.
Figure 4: Rite Aid against the S&P 500
On the 28th of February, Rite Aid entered into a cash and stock merger with closely held grocery chain Albertsons, which will take over the remaining assets of the company which includes 2,569 pharmacy outlets in 19 states not included in the Walgreen purchase. The yet-to-be announced merged company, which is expected to be floated on the New York Stock Exchange in the latter part of the year or early 2019, will combine roughly 4,900 locations and 4,350 pharmacy counters along with 320 walk-in clinics across 38 states and the District of Columbia. The deal will close in the second half of the year.
In a letter to shareholders in February, Rite Aid's CEO John Standley pressed hard for a yes vote on the company’s $24 billion merger which will create the fifth largest food and drug retailer in the country. The company would fall behind the ranks of WalMart (NYSE:WMT), CVS, Kroger (NYSE:KR) and Walgreens, with estimated revenues topping out at $83 billion from their current $22 billion through the end of 2017. The merger would create 4,310 pharmacy and grocery centers in 38 states and the District of Columbia. Still, the combined grocery and pharmacy centers would be less than half the size of both CVS at 9,760 stores and Walgreens at 9,430. The merger would also include Envision RX Options, Rite Aid’s PBM. The shareholder vote on the merger runs through 9 August.
Interestingly, the letter came out three days prior to Amazon's announced purchase of PillPack which is expected to imbue the vote with a good deal of reflection.
Rite Aid (green line, upper frame) has struggled financially for a number of years. The company’s stock has traded well below its 20-day exponential trading average (blue line, upper frame) since April. Market momentum (lower frame) turned negative in early June (see Figure 4, above). Revenue growth over the company’s fiscal year ending 3 March declined 5.6% YOY to $15.8 billion over 2,604 stores. They declined 0.3% through 2017 fiscal year ending 4 March YOY, posting $16.77 billion with 2,632 stores in the report. They grew in fiscal year 2016 ending 27 February by 1.6% YOY to $16.8 billion with 2,645 stores in the mix. Total revenues grew by 3.9% through fiscal 2015 ending 28 February to $26.53 billion over 4,587 stores. Pharmacy sales as a percentage of total retail sales averages 68.3% since 2015, with an annual growth rate over the period of minus 0.78% as full-priced branded drugs lose their market exclusivity to less expensive generic knock-offs. Pharmacy sales continue to be pressured by the increase of generic drug sales Front-end sales averaged 32% for the period with a growth rate of 0.2% to the positive. Annualized same-store prescription count growth grew at a 1.35% rate for the period. The company’s stock performance to date is still searching for rock bottom through Friday’s market close (13 July). Little wonder the company was put up for sale. That CEO John Standley, who took home $7.6 million in total compensation last year while skillfully steering the company into its current market abyss, has been tapped to run the combined company, defies discernible logic.
Forward growth, then, poses two very different strategies for Amazon and its immediate competitors in the retail pharmaceutical space—one based largely on market nimbleness and technology and the other based on further vertical or horizontal integration of existing industry players using captured audiences in hopes of augmenting traditional paradigms of shareholder value. Amazon’s purchase of PillPack goes to the heart of one of the last vestiges of exclusive retail revenue streams where Amazon is not a major player—prescription drug sales. PillPack’s pending entry into the Amazon family of retail operations is the strongest signal yet that the company clearly has the healthcare sector in its sites—and with the purchase Amazon automatically leapfrogs the onerous regulatory task of being invited to the dance.
PillPack will also provide another important feature to the Amazon portfolio of companies—recurring sales. Pharmaceuticals are prescribed for specific durations of time with the potential for refills at each designated endpoint. The selection, packaging, refill, ordering and delivery services would fit rather nicely onto Amazon’s AWS platform, creating efficiencies that have a real potential to lower the cost of drugs by eliminating many of the myriad intermediaries in current supply chains. At some juncture in the process, end users would be able to order prescriptions with a few keystrokes on a smartphone, a computer—or even by voice commands—from the comfort of one’s living room, office desk or hospital bed. Such a technology-based platform would be warmly welcomed by an estimated 75 million millennials, the first US demographic grouping of size to span the computer, smartphone, smartwatch, smart headphone and, lest we forget Alexa, Siri and Hey Google—era.
By expanding on PillPack’s individual, date-stamped packaging concept, daily dosages are much more apt to be taken en total than depending on patient wherewithal to dispense the proper dosages from myriad pill bottles strewn about a bathroom sink. One in five patients in the US take more than three medications a day and roughly 50% of patients with chronic disorders fail to take the prescribed dosages of drugs they are prescribed, according to World Health Organization data. This simple failure not only compromise treatments but have led to tens of thousands of preventable deaths in the US annually.
These are some of the many avenues that Amazon has to ponder as it contemplates the dimensions of its online assault of the retail pharmaceutical space. Amazon has the technological, financial and innovative heft to bring clear efficiencies of scale to the $450 billion US pharmaceutical market—heft that PillPack clearly lacked as a standalone company. Amazon now has a workable format to affect change to an industry where change has all but ossified.
This article was written by
Analyst’s Disclosure: I am/we are long AMZN. 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.
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