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Prognosis For Drug Stores Is 'Active And Healthy'

Chains of all sizes are "guarded" to "stable," but the segment's bottom line emerges in good shape.

Acquisitions continue to have a profound impact on the drug store industry. The locally owned and operated pharmacy is becoming more of an endangered species, as large regional drug chains have gone on a buying binge, acquiring not only independent chains but other regional chains as well.

Large drug chains fill more of the nation's prescriptions at lower costs than their smaller brethren, thanks to deals made with managed health care companies. While third-party payments may be driving down pharmacy margins, they increase customer traffic and are therefore attractive to store owners.

According to the National Association of Chain Drug Stores, Alexandria, Va., the share of U.S. prescriptions paid for by third parties has increased from 26 percent to 55 percent in the last six years. "The third-party prescription trend has been one of the drivers of consolidation and has changed the profit picture for everyone involved," says Eric Bosshard, a financial analyst for Midwest Research-Maxus, Cleveland.

Geographic gorging Fueled by increased bargaining power with managed-care providers, major, multi-market pharmacy chains -- the Big Three being Rite Aid, CVS and Walgreens -- are replacing small chains and independent operators as the "neighborhood drug store."

Rite Aid Corp., Camp Hill, Pa., has been on a veritable feeding frenzy, gobbling up 23 retailers since 1989. In July, the company announced agreements to acquire two southern chains: Harco Drug Inc. based in Tuscaloosa, Ala., and New Orleans-based K&B Inc., which represent combined annual sales of $830 million.

The deals will bring Rite Aid more than 300 stores in Alabama, Florida, Tennessee, Louisiana, Mississippi and Texas; and they mark the company's entry into the latter three states. When the acquisitions are complete (Rite Aid expects closure this month), the chain will own more than 3,900 drug store units in more than 30 states, including units on both coasts.

Rite Aid's aggressive expansion (including last October's $1.4 billion purchase of Thrifty Payless) has prompted some concern regarding the company's debt load. However, stock performance has remained favorable.

In July, Rite Aid reported that total sales for the four weeks ending June 28 rose a phenomenal 88.1 percent to $823.4 million from $437.8 million for June 1996. Same store sales for the 17-week period ending June 28 rose 9.6 percent, the company reported.

The Thrifty/Payless deal, which garnered 1,000 stores and gave Rite Aid a major West Coast presence, helped the chain's share prices rise from $33 per share to $50 per share. At press time, Rite Aid's stock was trading at $52.56 per share.

Projected sales for 1997 total $12.6 billion, according to Rite Aid. Nevertheless, analysts are cautious about the company's investment outlook.

Moody's is reviewing the company's long-term credit rating, while Standard & Poor's has recently changed its assessment from "stable" to "negative." Bonni Zwickel, analyst for CS First Boston, New York, recently initiated coverage of Rite Aid with a "hold" rating.

In fiscal 1996, Rite Aid opened 145 new stores, relocated 121 units and expanded 102 units. At the same time, the company exited Massachusetts and Rhode Island, and it sold 109 Florida stores to Eckerd Corp.

For fiscal 1997, the company plans to add 125 new stores, relocate 200 stores and enlarge another 100, according to the company's annual report. (A company spokesperson reports that Rite Aid is in the process of eventually moving all its stores into freestanding locations.) Average store size is 10,500 sq. ft., and the chain typically seeks 1-acre corner parcels that can accommodate parking and a drive-through window.

The joining of giants Like Rite Aid, CVS Corp., Woonsocket, R.I., recently extended its market share, moving into new regions with the $2.8 billion purchase of Revco in May. A major presence in the Northeast and Mid-Atlantic regions, CVS garnered more than 1,400 stores in the deal, bringing its total store count to more than 4,000.

CVS reports that, including the Revco additions, same store sales for the company rose 9.9 percent. For the six months ending June 28, the company reports that its combined total sales were $6.32 billion, up 20.3 percent from $5.25 billion during the same period a year ago. It projects year-end sales to reach $13 billion.

The Revco acquisition gave CVS entry into the Midwest and strengthened its presence in the Southeast. (Last October, CVS purchased the 382-store Big B chain, based in Bessemer, Ala., for $380 million.)

Although the acquisition increases CVS's geographical reach and bargaining power, analysts expect a period of integration for the company. In a report from New York-based Smith Barney, analysts Gary Giblen and Lisa Cartwright note that CVS management has the challenge of upgrading and integrating the Revco stores to match CVS sales levels and front-end margin productivity.

Out of the fray Rounding out the Big Three, Deerfield, Ill.-based Walgreen Co. has not entered the merger game. According to the company, it has increased its profitability by upgrading technology, cutting costs, increasing volume and refusing unprofitable third-party prescription plans.

For the first nine months of fiscal 1997, Walgreen reported record sales and earnings; net sales for the period rose 13.5 percent to $10.1 billion, and net earnings for the periodadvanced 17.2 percent to $331 million or $1.33 per share. Total sales in comparable stores rose 8.2 percent for the period.

This year, Walgreen has added 151 new stores, 43 of which were relocations. The company plans to add approximately 80 more stores by year end.

Plans are even loftier for 1999, according to Walgreen. The chain has announced it will open about 355 stores on its way to a total of 3,000 Walgreens stores nationwide by 2000.

Scrutiny, but no slowdown The rampant consolidation within the drug chain segment has focused anti-trust concerns on the major players. For example, Rite Aid ran into opposition from the Federal Trade Commission last year when it announced plans to acquire Revco.

The FTC squelched the deal over concerns of Rite Aid saturating the East Coast and thereby gaining an unfair competitive advantage. The CVS-Revco deal did not present the same complications except in Virginia and in Binghamton, N.Y., where CVS will divest 120 Revco stores, CVS reports.

Analysts speculate that acquisitions and battles among the major drug store chains are coming to an end. However, smaller players are still at risk from regional chains, says Bosshard.

According to Bosshard, 30 percent of the nation's drug stores are independent, and he expects them to continue to fall victim to larger, growth-hungry retailers. Even regional chains are wary of falling prey to each other. Dow Jones reports that shares in Melville, N.Y.-based Genovese Drug Stores have risen from close to $12 per share in April to more than $21 per share in late July due to takeover speculation.

Fundamentals are favorable Until consolidation tapers down (and no one is predicting when that will occur), it remains to be seen whether drug store chains can sustain growth without relying on acquisitions. However, the fundamentals appear to be sturdy.

According to the National Association of Chain Drug Stores, a survey of 44,000 chain and independent stores revealed that, in the United States, average sales per square foot total $454. Six years ago, the total was $285 per square foot.

Jonathan Ziegler, a vice president in the San Francisco office of New York-based Salomon Brothers, says drug stores represent one of the most rapid growth areas of retailing. An aging population is often given credit for the sector's health; however, he adds, an increasing birth rate should not be ignored.

With favorable demographics and young management, the drug chains are establishing growth tracks and creating shareholder value, Ziegler says. "The Big Three are all well-managed companies with programs in place to drive sales," he explains.

"They do not wait for traffic to come to them," he adds. "They are out selling their services, working with employee groups, pharmaceutical companies and health care groups."

"They are also trying to develop their front-end business and a convenience format," he notes.

Moving away from traditional in-line locations continues to be the segment's most visible trend. "Convenience through the use of freestanding stores is clearly the focus," Bosshard says.

Since being purchased by Plano, Texas-based J. C. Penney Co. last Nov-ember, Eckerd Corp. has continued to roll out new stores in its freestanding format. Rite Aid, which recently rolled out a new store prototype, also is opening freestanding units. The prototypes feature a convenience food center, one-hour photo service and a business service counter.

Ziegler observes increasing store sizes, but he suggests there is "room for a smaller format." He notes that Rite Aid may reduce the size of its Thrifty Payless stores, and other chains may follow in an effort to differentiate themselves from supermarkets and discounters.

James B. Frantz is a New York-based freelance writer specializing in commercial real estate.

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