Amazon isn't the only threat keeping Walgreens up at night

Add geopolitical tensions to the list of worries weighing on Walgreens.

Mounting fears of a "hard" Brexit and an escalating tariff battle between the U.S. and China are compounding anxieties at the Deerfield, Ill.-based drugstore chain, which was already contending with a potential threat from Amazon and uncertainty about its future in a rapidly changing healthcare industry.

The combination of short- and long-term worries, along with disappointing financial results, has pushed Walgreens Boots Alliance shares down 23% this year.

"It's got to be an extremely difficult time to operate. The rules are shifting very rapidly," says Philip Levy, a professor at Northwestern University's Kellogg School of Management. "A hard Brexit has been the default ever since (Prime Minister) Theresa May launched Article 50. And if they don't get their act together, that's exactly where they are going."

The failure of Parliament to approve an exit agreement increases chances the U.K. will leave the European Union without a deal, potentially snarling cross-border trade and triggering a recession in the country. Both would hurt Walgreens, which does business across Europe and operates 2,485 Boots drugstores in the U.K.

Boots is already dealing with tight reimbursement rates under austerity measures enacted during the financial crisis of 2008, which led the U.K.'s National Health Service to reduce payments to pharmacies. Those cutbacks "continue to exert pressure on the pricing of and reimbursement timelines," Walgreens said in its recent annual report.

That could get much worse if a hard Brexit tanks the British economy and forces the NHS to squeeze harder. According to the Bank of England, a no-deal exit could cause the U.K. gross domestic product to plummet 8%, worse than the depths of the Great Recession.

"It's already a big problem; there isn't much money for the NHS. If that continues, it will make it much worse (for reimbursement rates)," says Lorand Bartels, an international trade expert at the University of Cambridge. "When it comes to buying medicine, the (NHS) basically have monopoly power. They say how much it will cost."

A Walgreens spokesman says "there are currently supply chain agreements in place for WBA (Walgreens Boots Alliance) which would not change upon Brexit. However, as the terms and conditions of Brexit are still being negotiated by the U.K. government and the European Union, it is not possible to predict the impact at this time."

On the other side of the globe, U.S.-China trade tensions pose another threat. President Donald Trump on June 10 repeated his vow to raise tariffs to 25% or higher on $300 billion worth of Chinese goods if China refuses to meet his demands in trade talks at the G-20 summit later this month.

Tariffs would raise costs for retailers like Walgreens that import low-cost merchandise from China. If tariffs take effect, Walgreens would have to choose between passing along the added cost by raising prices—which could hurt sales—or absorbing the expense—which would pinch already-slim profit margins.

These short-term risks complicate Walgreens' efforts to adapt as sweeping changes transform healthcare delivery in the U.S. Under Walgreens' traditional business model, customers come to its stores to pick up prescriptions and purchase higher-margin merchandise like sunscreen or toothpaste on the way out.

That model is displaying cracks, as Walgreens' store traffic and "front-end sales" sputter. On April 2, Walgreens reported that net income dropped 14% to $1.16 billion in its most recent fiscal quarter, as revenue of $34.53 billion fell short of analysts' expectations. Pharmacy reimbursement pressures in the U.S. and U.K. pinched profit margins, and front-end sales at U.S. stores open at least a year sagged 3.8%. Walgreens blamed the declining front-end sales on weak demand for cold and flu medications and management's decision to de-emphasize low-margin merchandise.

CEO Stefano Pessina called it "the most difficult quarter we have had since the formation of Walgreens Boots Alliance" in the 2014 merger of Walgreen with Alliance Boots, the European company Pessina previously led. Walgreens' shares tumbled double digits on the earnings report and kept falling to a six-year low of $49.34 on May 31. The stock closed at $52.89 on June 13.

Walgreens' role in an evolving industry remains unclear. Pressure from government and private insurers to reduce medical costs has triggered consolidation, including the merger of arch rival CVS Health with insurer Aetna. Walgreens hasn't forged a similar deal, relying instead on its network of 9,500 U.S. stores and exclusive pharmacy agreements with large health insurers. The company also is offering more healthcare services at its retail locations.

"CVS is becoming more integrated," says Bloomberg Intelligence analyst Jonathan Palmer. "Walgreens has doubled down on retail."

Looming in the background is Amazon. The online giant sent a shudder through the market in June 2018 when it announced an agreement to acquire PillPack, an online pharmacy that offers home delivery.

Since the acquisition, Amazon received pharmacy licenses to operate in 19 states and can deliver drugs in all 50 states. Amazon has been quiet on the pharmacy front lately, but it could move on Walgreens' business at any time.

"Everybody should be scared of Amazon," says Morningstar analyst Soo Romanoff. "Obviously, it's a threat to everyone's business."

"Amazon isn't the only threat keeping Walgreens up at night" originally appeared in Crain's Chicago Business.