WAG/ABC – Quick Strategic Read-thru; Better for WAG than ABC

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Richard Evans / Scott Hinds / Ryan Baum

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March 20, 2013

WAG/ABC – Quick Strategic Read-thru; Better for WAG than ABC

Walgreens (WAG) and AmerisourceBergen (ABC) yesterday announced a 10-year agreement in which:

  • ABC handles US brand and generic wholesale distribution operations for WAG;
  • ABC participates in global purchasing using the aggregated buying power of ABC, WAG, and Alliance Boots; and,
  • ABC participates in an expanded portfolio of manufacturer services

WAG and Alliance Boots have been granted warrants for up to 16pct of ABC equity, thus at least to some degree ABC used its equity to buy its way into a distribution agreement. By extension, this implies that the economic returns to ABC for being in the agreement must be well above the typical returns one would expect from a ‘normal’ distribution arrangement between a large US-based wholesaler and a large US-based warehousing chain pharmacy. This looks like a very high hurdle. There are three opportunities for ABC to create value in excess of ‘normal’, corresponding to the three elements of the deal in the bullet points above. And, there is a downside risk to ABC, or at least a practical limit to how far the WAG alliance can go – ABC is highly dependent on sales to US independent pharmacies, who are naturally wary of WAG

First, the distribution arrangement includes generics in addition to brands; whereas the usual arrangement is for large US warehousing chain pharmacies to contract with wholesalers for brands only[1]. Capturing WAG’s generic volume gives ABC more turnover, and the added turnover comes at an absolute margin per unit which is generally higher than brand margins. A (perhaps the) crucial consideration is whether generic margins to US wholesalers are rising, stable or falling. We believe they’re falling[2]; if we’re correct, then WAG will have paid (in part) for ABC’s distribution services using a deflating currency (generic wholesale margins) – good for WAG, bad for ABC

Second, the agreement envisions aggregating the purchasing power of ABC, WAG and Alliance Boots into a single (or at least highly coordinated) global purchasing arrangement. There is almost no likelihood this results in ABC getting discounts on brands[3]; the question is whether ABC will get better prices on generics. For this to occur, two things have to happen: 1) the added purchasing power of the trio has to address a rate limit in ABC’s current prices from generic manufacturers – i.e. it has to be true that ABC would see substantially better US prices if it had substantially greater US purchasing volume; and 2) the trio’s global purchasing clout has to be exercised (at least somewhat) in ABC’s best interest

ABC has about 6 to 7 pct of US retail pharmacy outlets in its Good Neighbor Pharmacy program, meaning ABC can give (or deny) roughly 6 to 7 pct of the US retail market to any single generic manufacturer — powerful negotiating leverage to start with. WAG has a little more than twice as much share as ABC, so on a combined basis the two entities speak for roughly 20 pct of US generic volume sold at retail. If ABC could use this 20 pct purchase share in its own interests, we’d go along with the conclusion they’d get better US generic pricing. The problem here is that WAG owns all of itself, 45 pct of Alliance Boots, and at the moment only limited options on ABC. Thus it’s likely that WAG and Alliance Boots steer the application of the trio’s global purchasing power, especially if and when WAG completes the acquisition of Alliance Boots

Third, as part of the trio ABC has the opportunity to participate in an expanded portfolio of manufacturer services. In the EU, Alliance Boots has very tight manufacturer relationships – but these are for very EU-specific reasons[4] that generally are not present in the US. As a predominant EU wholesaler Alliance Boots has little if any reason to let ABC enter into its EU-market relationships with manufacturers; and, since the catalysts for these relationships are absent in the US, we doubt ABC is any more able to sell an expanded portfolio of manufacturer services as a result of Alliance Boots’ presence in the trio. ABC and WAG may intend to develop an expanded list of manufacturer services as a byproduct of their more closely integrated US operations – but having set US pricing and trade strategy for a large cap pharmaceutical company for many years, it’s not immediately clear to me what those marginal services might be, and why manufacturers would be more likely to buy them from ABC and WAG working cooperatively than from either company as a stand-alone

Finally, ABC must avoid having the WAG alliance negatively affect its sales to independent pharmacies, as these are a very large proportion of total profits. To the extent participation in the trio brings lower generic prices to WAG’s independent pharmacies, the ABC/WAG alliance would aid ABC in this regard. However ABC’s reliance on independents arguably sets a rate-limit on how far the relationship can go – where the WAG / Alliance Boots alliance can go to full acquisition without disrupting either company’s markets, the WAG/ABC alliance cannot – independent pharmacies are no more likely to order from a WAG owned wholesaler than your local bookstore is to order from AMZN

  1. Brand manufacturers do not want to be in invoice relationships with warehousing chains, and are happy for wholesalers to stand in the middle. If a wholesaler refuses to pay a brand manufacturer’s invoice on time, the manufacturer simply holds that wholesaler’s next order until it gets paid for the earlier invoice. There is little or no risk the manufacturer’s products go out of stock at retail, as virtually all retailers can order the manufacturer’s product from an alternate wholesaler. In contrast, if a brand manufacturer sells to and invoices a retail chain pharmacy, it cannot use the same leverage (refusing to ship) to collect late payments, since this would cause prescriptions for the manufacturer’s brand to go unfilled
  2. Please see “The Incredibly Slow (But Very Nearly Certain) Death of AWP” SSR LLC, January 15, 2013
  3. Because of the underlying dynamic in footnote 1 (most retail outlets can order from a back-up or secondary wholesaler), wholesalers (at least in the US) have almost no ability to impact brand share – positively or negatively
  4. Brand manufacturers (led by PFE) began moving toward direct to pharmacy (DTP) distribution arrangements in the EU in order to combat both parallel importing and counterfeiting. EU wholesalers were predictably outraged; however Alliance Boots’ subsidiary UniChem – to its great credit – saw the opportunity to be part of the solution, and negotiated an agreement to run PFE’s DTP program (and ultimately many others). The US lacks all of the essential elements of this story: 1) significant parallel importing; 2) counterfeiting as a direct result of lax wholesale operations; and 3) the EU’s relevant laws and regulatory standards which, unlike those in the US, do not compel a great deal of consistency in the terms offered to various players in the pharmacy supply chain
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