Why are Walgreen and Rite Aid’s Revenues Dropping?

There is an interesting mystery at Walgreens Boots Alliance (NASDAQ: WBA) and its acquisition target; Rite Aid (NYSE: RAD). The mystery is why are revenues at the two drugstore chains suddenly dropping?

Rite Aid reported revenues of $32.64 billion in August 2016 that fell slightly to $32.57 billion in November 2016, Ycharts data indicated. During the same period in 2015, Rite Aid’s revenues grew by $1.46 billion; rising from $27.85 billion in August 2015 to $29.31 billion in November 2015.

Ycharts data for Walgreens for that quarter was not available when I looked on January 14, but news reports indicate the drugstore giant missed its earnings projections. The Street reported that Walgreens’ third-quarter revenues were projected at $8.2 billion, but it came in at $8.1 billion. If that’s correct, Walgreen like Rite Aid saw its revenues and presumably its sales fall in third quarter 2016.

Is the Amazon Effect hitting Walgreens?

What is going on here? Is this Wall Street darling suddenly stumbling or is some sort of economic slowdown beginning. My explanation for the revenue stumbles is neither, instead the Amazon effect has finally arrived at the drug store.

Amazon (NASDAQ: AMZN) does not compete directly with Walgreen in its biggest revenue stream: prescription drugs. Yet the Everything Store does many items that drugstores stock; including cosmetics, toiletries, over the counter drugs, cleaning supplies and toys to name a few.

Since many of these items are small and lightweight they are easy to ship. That means they’re perfect for Amazon to send out to Prime customers. Nor is it just Amazon, Walmart (NYSE: WMT) is ramping up its online game with a membership shipping program and the acquisition of Jet.com.

Since both Amazon and Walmart are deep discounters that offer free shipping they are in a perfect position to compete with Walgreen. Amazon Prime in particular is a major threat to retailers like Rite Aid because it gives customers a strong incentive to buy online to justify the pass’s existence.

Are Price Controls Hurting Walgreens?

A major problem for Walgreen is that many of the items it sells; such as make up, are small and high mark-up. Those items are both easy to ship, and easy to deep discount.

This can seriously hurt Walgreen because it depends heavily on the sales of such smaller high mark-up goods to generate additional revenue. The mark up on goods like perfume can make up for revenue that Walgreen might lose from price controls on prescriptions.

One problem WBA faces is that the prices it can charge for many prescriptions are severely limited. The company operates 2,510 Boots stores in the United Kingdom, where the National Health Service sets prescription prices and keeps them low. Here in the United States, there are no price restrictions on prescriptions financed by Medicare, but other government insurance programs such as Medicaid limit prices.

Will High Operating Costs Doom Walgreens?

Price controls can be a serious problem for Walgreens, because like many retailers it has high fixed costs. These include real estate and related costs including utilities, taxes, maintenance etc.

One problem a chain like Walgreen faces is the rising real estate prices in US cities which means rising property taxes. Property taxes in most American cities are based on real estate values. A related problem can be increased rent or leases for stores.

Beyond that Walgreens faces high labor costs, the average pharmacist in the United States took home $121,500 a year. Since all 8,173 Walgreens and Duane Reade stores in the United States need a pharmacist that adds up to salary costs of around $993 million (nearly one $1 billion) for just one position.

If that was not bad enough there are pharmacy technicians, their average salary was $30,410 a year. Since every Walgreens or Rite Aid location needs several of them that’s another high labor cost.

These costs might explain why Rite Aid reported a net income of just $90.81 million, $493.32 million in cash from operations and a free cash flow of only $24.58 million on revenues of $32.57 billion for the third quarter of 2016. Operating costs are high and profit margins are low just .19% for the third quarter.

Rite Aid has No Float

Drugstores like grocers seem to have very little float because of high operating costs. This puts them at a major disadvantage when dealing with a company like Amazon that carries a lot of float.

Amazon reported $14.6 billion in cash from operations and $18.35 billion in cash and short-term investments for third quarter 2016. Rite Aid reported cash and short term investments of $9.807 million for third quarter.

Although Walgreens managed to buck the trend with $9.807 billion in cash and short-term investments for second quarter 2016. It also reported $7.847 billion in cash and short term investments and a net income of $4.173 billion for the same period.

Can Anybody Make Money in Drugstores?

My guess is WBA gets all of that float from the prescriptions; and the steady source of revenue that is government-financed national health insurance programs. That source is less available to Rite-Aid because the US, unlike the European and Latin American countries where Walgreens also operates lacks a national-health insurance program for all citizens.

This means that the only way to succeed in drugstores is to have another stream of revenue available. Walgreen’s major direct American competitor CVS Health (NYSE: CVS) manages prescription plans. Other rivals like Kroger (NYSE: KR) and Walmart (NYSE: WMT) operate diversified businesses that include drugstores, filling stations, supermarkets, discount stores and in Walmart’s case a large online retail operation.

How can Walgreens Increase Revenues

All this means Walgreen is either going to have to locate some big new streams of revenue or greatly reduce expenses. Unlike Walmart, it is not in a position to reduce costs through layoffs because it needs pharmacists and pharmacy technicians to operate. That means it will have to close stores or change its business plan.

One possibly is cut back on or eliminate the non-pharmacy retail operations. Another is to add more additional services such as FedEx Shipping which Walgreens is doing. A future solution might be to convert the retail operations into some sort of high-profit business such as a coffee shop, a deli or a fast-food outlet.

The addition of FedEx suggests another solution, converting drugstores into pickup locations for merchandise ordered online. Walmart is already experimenting with such locations in the United States and the UK.

Will Robots Save Walgreens?

Two final strategies Walgreens can adopt to cut expenses and increase profits are automation and centralization. One solution might be to adapt the pill sorting and other pharmacy robots now used in hospitals for retail stores.

Another potential solution would be to set up centralized pharmacies that supply several stores. Such a centralized location utilizing pharmacy robots might greatly reduce costs.

One way to make this work and reduce costs would be to use a service like Uber for delivery. Walmart is already experimenting with retail delivery by Uber and Lyft.

All this makes one thing clear; Walgreens is going to need to drastically change its business model if it wants to survive. If it does not, this drugstore giant might face a death spiral of dramatically falling revenues.