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Walgreen's Narrow Economic Moat Is in Decline

Competition and pharmacy benefit managers are threatening.

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 Walgreen (WAG) faces intense competition, including from mail-order pharmacies and diversified retailers that have an incentive to price prescription drugs aggressively. Also, pharmacy benefit managers have gained bargaining leverage over retailers through consolidation. This situation may get significantly worse if  Express Scripts (ESRX) is successful in its acquisition of  Medco Health Solutions (MHS). There is also a risk of government reimbursement pressure in Medicare and Medicaid. For these reasons, we believe Walgreen's narrow economic moat is declining.

Walgreen's narrow economic moat is the result of scale, brand recognition, and mild customer switching costs. The company's large collection of retail pharmacies in prime locations offers unmatched convenience. Walgreen's brand is one of the best known in retail, and customers across the United States know what to expect when they enter a Walgreens store. Finally, it can be a hassle to transfer prescriptions between pharmacies, particularly for patients taking multiple drugs.

On the other hand, we see two huge threats to Walgreen's relatively slim economic profits: competition and reimbursement pressure. The retail pharmacy business has low barriers to entry, and Walgreen must deal with competition from not just independent pharmacies but also mail-order pharmacies, supermarkets, and retailing giants like  Wal-Mart Stores (WMT) and  Target (TGT). For this last group, prescription drugs account for a small percentage of sales but can drive traffic and increase customer loyalty, perhaps providing an incentive to price aggressively.

The threat of reimbursement cuts comes from both federal and state governments--many of which are struggling with massive budget deficits--and private pharmacy benefit managers. Industry consolidation has allowed the three leading pharmacy benefit managers to steadily gain market share over the past decade, increasing their bargaining power over suppliers such as Walgreen. This has been most evident in the ongoing contract dispute between Walgreen and Express Scripts. Without a resolution, Walgreen risks losing as much as 7% of its total sales. Even if a deal is reached, it is likely that Walgreen will have to make pricing concessions that will reduce margins. If Express Scripts' proposed merger with Medco  receives regulatory approval, the combined company will have unprecedented negotiating leverage.

Competition, reimbursement pressure, and the overall economic slowdown have combined to diminish Walgreen's same-store sales growth and operating margins over the past several years.

Source: Company reports and Morningstar research.

Returns on invested capital have been similarly unimpressive after capitalizing lease expense.

Source: Company reports and Morningstar research.

Still, Walgreen continues to benefit from the tailwinds of the generics wave, ongoing retail pharmacy industry consolidation, and a maturing of its store base. Despite our concerns about the company's long-run competitive position, we continue to believe its shares are about fairly valued.

Matthew Coffina has a position in the following securities mentioned above: WMT, ESRX. Find out about Morningstar’s editorial policies.