Why Walgreen could win the drug war

A lot can change in a year. Last March, Walgreen Co. was simply a domestic drugstore chain. Today, the Deerfield, Ill.-based company is part of an international juggernaut through a partnership with Europe's leading pharmacy chain Alliance Boots GmbH and, with a new 10-year deal with drug wholesaler AmerisourceBergen Corp., is about to change the way prescription meds are sold around the globe.

The tie-in with Amerisource, which gives Walgreen a one-stop shop for pharmaceuticals, should turn Walgreen into a more formidable competitor. Because of its scale, Amerisource often gets bargain prices from drugmakers. Now Walgreen can use its access to cheaper products to boost margins, reduce prices or both. That could pull in more customers—and not only in the U.S. Walgreen and Alliance Boots could become a low-price source of drugs for more of the world, its executives say.

“Walgreen will be able to buy generics cheaper than anyone else and, if they choose to do so, can also sell them for cheaper than anyone else,” says Adam Fein, president of Pembroke Consulting Inc., a Philadelphia-based pharmaceutical consultancy. That means Walgreen will be “well-positioned to win the pharmacy industry's race to the price bottom” that began in 2008 when Wal-Mart Stores began advertising $4 generic prescriptions.

The trick is making this happen. Walgreen has a short history of operating outside the U.S., through its 45 percent stake in Alliance Boots. It also recently bungled one of its biggest partnerships, with Express Scripts Holding Co., a pharmacy benefits manager that negotiates drug prices on behalf of corporate clients and then steers customers to preferred vendors. Losing Express Scripts customers cost Walgreen an estimated $4 billion in revenue.

“This is a direct tactical response to make sure something like that doesn't happen again,” says Vishnu Lekraj, an analyst at Chicago-based Morningstar Inc. “They're trying to build their negotiating power and scale.”

Wall Street seems confident the Amerisource deal will pay off. After the pact was announced on March 19, industry analyst Lisa Gill of JPMorgan Chase & Co. in New York raised her year-end target price for Walgreen stock to $55 from $41, noting that it should produce “incremental earnings” from lower costs. New York-based Goldman Sachs analyst Matthew Fassler, meanwhile, hiked his 12-month target to $50 from $46. Walgreen shares have risen more than 9 percent on the news, closing Friday at $46.49, which is a new 52-week high.

Under the new contract, Amerisource will supply $28 billion a year in brand-name drugs, generics and specialty drugs to Walgreen. Previously, it supplied only specialty drugs—complicated, often injectible treatments for chronic diseases like rheumatoid arthritis. Cardinal Health Inc. had provided Walgreen's brand-name drugs, and the retailer had sourced its own generics. The deal gives Walgreen the option to buy up to a 23 percent equity stake in Chesterbrook, Pa.-based Amerisource.

As the nation's No. 2 drug wholesaler, behind McKesson Corp., Amerisource typically can negotiate deep discounts from drug manufacturers; Walgreen will have access to that pricing, which means buying generic drugs for pennies per pill.

That's a huge advantage, because low-priced generics increasingly are driving traffic into pharmacies. In the late 1990s, fewer than four of every 10 prescriptions were generic, according to Mr. Fein. By 2017, nine of 10 will be. “Even for insured individuals, the cash price can be less than what you would pay with your insurance,” Mr. Fein says.

Raising the number of cash-paying customers would make Walgreen less dependent on pharmacy benefits managers and help bring back some of the business Walgreen lost in the rupture with Express Scripts.

The agreement also offers Walgreen the purchasing power necessary to expand into emerging markets in Asia and Africa. Alliance Boots—in which Walgreen took a 45 percent stake last year—offers a clear example of the growth possibilities that result from joining retail and wholesale operations. Formed in 2006 by the merger of British drugstore chain Boots and European wholesale pharmacist Alliance UniChem, Alliance Boots was able to move into China, Thailand, Turkey and Nigeria, among other markets.

The “collaboration will also generate opportunities to attract partners in new markets and prospects in existing markets around the globe,” Walgreen CEO Gregory Wasson says in the statement announcing the deal. (Through a spokesman, he declines requests for an interview.)