Rite Aid's decision to expand distribution agreement with McKesson to include generic as well as branded prescription drugs is in line with prevailing trend in global drug channel toward partnerships, alignment, amassing scale to cut costs: Fitch Ratings

Cindy Allen

NEW YORK , February 21, 2014 (press release) – Rite Aid Corp.'s decision this week to expand its distribution agreement with McKesson Corp. to include generic pharmaceuticals in addition to branded drugs is in line with prevailing trends in the global drug channel and in healthcare more broadly, according to Fitch Ratings. The industry trend is toward partnerships, alignment and amassing scale to cut costs in an increasingly constrained reimbursement environment.

McKesson could become the biggest beneficiary of increased generic purchasing power among global drug channel participants, Fitch believes. The drug distributor's deal with Rite Aid strengthens its position in the increasingly important area of drug purchasing scale, particularly for generics.

After overcoming a few hurdles, McKesson closed its purchase of approximately 75% of Celesio AG earlier this month. Increased scale from that deal will allow McKesson to drive cost savings, particularly related to generic drug sourcing, and future growth. The Rite Aid agreement will further enhance McKesson's drug purchasing scale and will allow Rite Aid to tap into the resulting cost savings.

Notably, unlike other drug channel participants that have largely become parties to purchasing joint ventures (JVs), McKesson will not be forced to share these cost savings with partners. Fitch estimates that McKesson's generic drug purchasing power, including Celesio and Rite Aid, will rival that of the JV among Walgreen Co., Alliance Boots GmbH and AmerisourceBergen Corp. (ABC) in the next couple of years.

The forms and progress of business combinations and alignments in the global drug channel have been diverse. But the search for cost savings from increased purchasing scales is at the core of each relationship. Joint ventures to date have included CVS Caremark Corp. and Cardinal Health as well as Walgreen's and Alliance Boots, which teamed up in 2012 and added ABC last year. Walgreens and ABC also entered into a 10-year comprehensive distribution agreement and agreed on provisions which could allow for up to 30% equity ownership of ABC by Walgreens.

These developments raise questions for other drug channel participants. CVS Caremark may need to adjust its strategy now that its two largest competitors employ a distributor for virtually all drug volumes. (CVS stores are served by Cardinal; but its Caremark business is served by McKesson.) Also, with distributors increasingly able to garner better drug pricing, the purchasing JV among Express Scripts, Kroger and Supervalu (Econdisc) comes into focus.

These developments could lead to other large pharmacy operators (i.e. Walmart, Target, Safeway) deciding to join distributors' generic programs. Walmart and Target are currently served by MCK, and Safeway by CAH. It is still too early in the business combination cycle to draw a definitive conclusion.

In Fitch's view, comprehensive distribution agreements make the most sense for retail drugstores, then for grocers/mass merchants, then for mail-order pharmacies. Still, each sector could benefit from tapping into better generic pricing derived from greater scale.

At the other end of the channel, generic drugmakers will likely feel increasing pricing pressures from these growing drug purchasers. Smaller and mid-sized generic firms will likely be most affected, possibly leading to additional consolidation over the medium term. Though the largest global generic drugmakers will be less affected, drug channel consolidation is probably contributing to the firms' focus on bolstering their presence in specialty and other branded drug development, such Actavis plc's announcement this week to acquire specialty drugmaker Forest Laboratories, Inc.

For more information on this topic, please see our "Navigating the Drug Channel" report series, available at www.fitchratings.com

Additional information is available on www.fitchratings.com.

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