(Reuters) - Walgreen Co and partner Alliance Boots said on Tuesday they signed a 10-year deal with AmerisourceBergen that will include daily drug distribution, enabling Walgreen to increase its sales of pricey specialty drugs.
Walgreen, the nation’s largest drugstore, distributes more than 80 percent of its own drugs, but over time most if not all of that distribution will be handled by AmerisourceBergen.
Much of what it sells now are bulk, low-profit prescriptions; by combining its distribution in the United States and Europe with AmerisourceBergen, Walgreen will be able to negotiate better prices for those bulk drugs. In addition, it said it will have new access to more specialized drugs, like those for cancer treatment.
AmerisourceBergen, which said the contract is worth $28 billion in fiscal 2014, will replace Cardinal Health Inc, whose distribution contract with Walgreen’s ends in August. Cardinal shares fell 7 percent to $42.76.
There is pressure on the healthcare industry, from pharmaceutical makers to sellers, to cut medical costs, especially as millions of Americans will soon receive more healthcare coverage. Consumers have also reduced their own spending on prescriptions, making it even tougher to increase profitability in the business.
The move will give AmerisourceBergen and Walgreen a boost in size that can help them negotiate better prices.
“If you run more product through your network, the more you can scale the assets, the more you can scale costs, and the more bargaining power you have,” said Vishnu Lekraj, an analyst at Morningstar.
Walgreen, the largest U.S. drugstore chain, will use AmerisourceBergen’s network to start daily distribution of drugs. Previously Walgreen used its own employees, transportation and warehouses to ship products on a daily basis and used an outside company like AmerisourceBergen weekly.
Walgreen and Alliance Boots have the right to buy up to 23 percent of AmerisourceBergen, starting with a 7 percent stake on the open market, now valued at about $800 million. Walgreen and Alliance Boots also received warrants exercisable for 16 percent equity in Amerisource. The first tranche, an 8 percent stake, can be exercised at a strike price of $51.50 in March of 2016.
AmerisourceBergen shares rose 4.4 percent to $50.42 in midday trading.
Cardinal Health said in a statement it has been planning to mitigate the possible contract loss. Cardinal is still targeting fiscal 2014 earnings from continuing operations that are at least similar to fiscal 2013’s expected range of $3.42 to $3.50 per share. It said the contract expiration would not affect fiscal 2013 earnings.
Moody’s Investors Service placed Cardinal’s debt on review for a downgrade, noting that it was one of the company’s two largest customers and worth 21 percent of its 2012 sales.
Cardinal also has a contract with drugstore CVS Caremark Corp that expires this year.
Cardinal CEO George Barrett said in an interview that the company has expanded its business to include distribution to growing ambulatory and surgery centers as well as clinics.
“No one ever likes to lose a customer. We’re obviously in a very competitive business and we’ve been thinking about this and really planning how to balance our business,” Barrett said.
Shares of Walgreen were up 6 percent at $45, their highest since June 2011, when the company announced its contract dispute with pharmacy benefits manager Express Scripts Holdings.
Walgreen on Tuesday separately reported better-than-expected second-quarter earnings. It reported net income of $756 million, or 79 cents per share, up from $683 million, or 78 cents per share a year earlier. Sales were flat at $18.65 billion.
AmerisourceBergen’s contract includes the distribution of branded, generic and specialty drugs to retail stores, mail order and specialty pharmacies.
“Alliance Boots and AmerisourceBergen are experts in pharmaceutical supply chain distribution,” Walgreen CEO Greg Wasson said on a conference call. “We are very good at it, but the combination of what they both do to improve our supply chain, take that off of our hands, and improve our service levels is really the opportunity that we are excited about.”
The move will give Walgreen access to better rates on specialty drugs used to treat diseases like cancer, rheumatoid arthritis and multiple sclerosis, which have higher profit margins but are also more expensive to keep on hand. More and more of these drugs are becoming available in oral pill form.
“A network of 8,000 stores could never have those drugs in stock. They couldn’t afford to carry them,” BB&T analyst Andrew Wolf said.
Getting the drugs in daily deliveries from the AmerisourceBergen may also mean lower prices for Walgreen which will not have to pay a mailing fee, he said.
Walgreen’s deal to buy a stake of AmerisourceBergen comes at a time when the U.S. healthcare industry is in the midst of an overhaul. President Barack Obama’s Affordable Care Act aims to cut the rise in spending on healthcare, and levies taxes and regulations on most healthcare companies.
“It’s a trend of everyone having to be larger to compete in the new world, post ACA,” said Les Funtleyder, a strategist at investment firm Poliwogg. “You’ll see increasing tie-ups between industries that might not have always been tied up.”
Amerisource has a market capitalization of about $11 billion. If the pharmacy chains fully exercise their rights, they will together be the biggest shareholder in Amerisource, based on current share holdings. They will hold up to two board seats.
Amerisource said the deal, effective September 1, was expected to contribute about 20 cents in earnings per share in fiscal 2014 ending September.
But during a conference call the company also said it expected its profit margins to be pressured because of the deal.
Amerisource said it now expected earnings of $2.96 to $3.06 per share from continuing operations in fiscal 2013 ending September, down from its previous forecast of $3.06 to $3.16.
The company expects incremental brand revenue of at least $2 billion in September and raised its revenue growth forecast to 8-11 percent for the fiscal year.
It had previously forecast revenue growth of 6-9 percent. Amerisource had revenue of $79.49 billion in fiscal 2012.
Additional reporting by Ransdell Pierson and Phil Wahba in New York, and Siddharth Cavale, Vrinda Manocha and Esha Dey in Bangalore; Editing by Saumyadeb Chakrabarty, Chizu Nomiyama, Bernadette Baum and Kenneth Barry