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LANDLORDS ADJUST TO BIG CHANGES IN THE DRUG RETAILING LANDSCAPE

BY ED McKINLEY

The number of community pharmacies in the United States has held nearly steady over the past decade. But that seems to be about all that has not changed in this business.

The drug chains themselves have developed a fondness for freestanding stores, and their mail-order customers have bypassed physical stores altogether. Supermarkets and mass merchants have doubled the number of pharmacies they operate, while the ranks of independents with just a store or two on Main Street have shrunk by a third. Meantime, though a shortage of pharmacists has eased a bit, they remain in high demand as the volume of the country’s prescriptions continues to climb. Margins have stabilized at low levels after years of downward pressure, and the relative uniformity of prices has helped make convenience the industry’s Holy Grail.

While grocery stores increasingly imitate drugstores, chain drugstores are looking more like grocery, convenience and soft-goods stores by beefing up their “front-end” (that is, nondrug) offerings. The additional merchandise and services have made these stores strong enough to outgrow in-line locations in strip centers. They have moved first to pads out front and then onto high-traffic corners that are not in the shopping centers at all, observes Terry S. Brown, CEO of Columbia, S.C.-based Edens & Avant, which owns and operates 220 grocery-anchored centers.

“It’s been a pretty dramatic evolution over the last 15 years,” said Brown.

The need for space to accommodate drive-through windows has been behind this migration to outparcels and freestanding locations too, says Michael E. McCarty, CLS, president of the Community Center Division of Simon Property Group. “I’m sure the drive-though builds loyalty,” McCarty said. “It’s convenience, and a customer can drive up in her robe with a sick child in the car. It says, ‘The store cares about me.’ ”

All-night neighbor
The higher visibility of freestanding shops can showcase those drugstores that stay open 24 hours a day, bringing a new level of convenience to shoppers and providing a vital service to people in need of medicine at night, says Karen Ramos, a spokeswoman for Boise, Idaho-based Albertsons, which operates both supermarket pharmacies and freestanding drugstores.

Building freestanding stores also allows drug chains to locate as close as possible to their customers’ homes, says McCarty. “They want to be where you live,” he said. This is possible, Brown says, because it’s easier to find an acre of land for a single store than to find the 12 to 20 acres needed for a community center.

The migration from in-line sites has reached an advanced stage and will probably be “complete” within five years, Brown predicts. “If you own a freestanding pad anywhere adjacent to a shopping center,” Brown said, “the highest and best uses today would be a bank [or] a drugstore.”

To be sure, none of this means that the book is entirely closed on drugstores in strip centers. “They’re still an important part of our centers,” said Mary Lou Fiala, president and COO of Regency Centers, Jacksonville, Fla., which operates 262 grocery-anchored centers. “Some of them are still on endcaps, and there are still a few in-line, but most want to be on outparcels.”

Meanwhile, in-store pharmacies at supermarkets, discount stores and wholesale clubs have taken up the slack for those drugstores that have already exited strip centers.

But for all their recent scarcity in centers, the overall number of chain drugstores has stayed fairly flat. Last year they still accounted for 42 percent of the retail pharmacy business. Independent drugstores (those with three stores or less) followed at 18.8 percent, and mail order was third with 17.2 percent, while the supermarkets controlled 12.3 percent and mass marketers 9.6 percent, according to the Alexandria, Va.-based National Association of Chain Drug Stores.

The number of U.S. retail pharmacies dropped a little from 57,405 in 1991 to 55,200 in 2002, says Laura Miller, a senior economist at the association. Over that period chain drugstores increased from 18,607 to 20,346, supermarket pharmacies rose from 4,796 to 8,851 and mass-merchant pharmacies climbed from 3,589 to 6,254. Only the independent drugstores declined, from 30,503 to 19,749.

These channels carved up a market valued at a total $203.1 billion in sales last year, up 11 percent from $182.7 billion in 2002, says Miller’s report for NACDS, whose members include drug chains, supermarkets and mass merchants. The number of prescriptions during that one-year period rose 2.4 percent to 3.2 billion.

At your convenience
Drugstore chains are forced to compete on convenience, because they cannot compete on price. The cost of prescription drugs outpaces inflation, with new drugs being introduced at ever-higher prices, Miller says.

Gross margins in the prescription drug business have fallen from 28 percent in 1990 to about 20 percent now, because insurance companies, pension plans and pharmacy benefit management companies set the prices. These third parties wield tremendous power; they pay for 74.7 percent of prescriptions today, compared with just 26.1 percent in 1990. And margins have been unchanged for about two years, she adds.

Still, the market is showing phenomenal growth, according to Tom Goetzinger, a senior stock analyst at Chicago-based financial research firm Morningstar.

“It’s probably the fastest-growing and the steadiest area of retail over the last 10 years and more than likely could remain so over the next 10 years,” said Goetzinger, “given the utilization rate of prescription drugs, the aging population, the fact that there are more drugs out there and the fact that they are the most effective form of health care.”

Besides the retail pharmacies, there are about 20,000 additional pharmacies maintained today in hospitals, nursing homes, federal institutions, clinics and prisons, says Katherine Knapp, dean of the College of Pharmacy at Touro University, Vallejo, Calif.

Deerfield, Ill.-based Walgreen Co. wins high praise among drug chains (SCT, November 2003).

“Walgreens is by far the best one out there, because they generate more prescriptions per store per day than anybody else,” said Goetzinger.

Volume is vital in the drug business, Goetzinger says. With the third-party payers controlling the retail prices, and the pharmaceuticals companies determining the wholesale side, retailers can grow only by filling more prescriptions. And they can do that only by concentrating on convenience and customer service, he says. Shoppers are responsible for the same co-payment no matter where they have a prescription filled, so Walgreen has pursued them by taking the lead in building freestanding stores near shoppers’ homes and being first to build drive-throughs, Goetzinger says. Store count has grown to 4,414 nationwide, the company reports.

In his book Winning at Retail, Will Ander holds Walgreen up as an example of what works. Ander, a senior partner at McMillan/Doolittle, a Chicago-based consulting firm, suggests that merchants pick an area and excel in it, like having the “biggest” or “hottest” stores. Walgreen earns distinction for being among the “quickest” — meaning it makes getting to and from its stores easier by using two-lane pickup windows at some of its stores, among other things.

Walgreen broke a fundamental rule of merchandising when it introduced the drive-up, notes Ander. But the company is smart enough to know that convenience trumps add-on sales in the drugstore business, he says, so now its customers need not navigate aisles of high-margin cosmetics and flashy impulse items just to reach their primary destination: the pharmacy.

Though Walgreen beats Woonsocket, R.I.-based CVS in terms of the pharmacy “experience,” Ander says, CVS holds a slight lead in the “shopability” of the merchandise section in the front of the store.

And CVS made the right move by buying 1,260 Eckerd pharmacies from J.C. Penney this year, says John Heinbockel, an analyst at Goldman Sachs. (The Jean Coutu Group bought the remaining 1,600 Eckerd stores.) The purchase by CVS swells its store count to more than 5,400 and gives it a presence in the Southeast, says Ander. Turning those newly acquired units around will take time, of course, but building that many stores would have taken 10 to 15 years, he says.

Harrisburg, Pa.-based Rite Aid Corp. drew praise for its front-end operations. Heinbockel credits CEO Mary Sammons with turning around that side of the chain’s business by “understanding how that store ought to look and how it ought to cater to their core customer and merchandising it that way.”

NACDS ranked Eckerd as the fourth-biggest drug chain before the recent sell-off, and Albertsons was fifth. Albertsons’ 2,516 stores fall into three categories: supermarkets, freestanding drugstores and combination supermarket-drugstores. And many of its supermarkets have pharmacy departments too. Besides its own name, Albertsons operates under banners that include Acme, Osco, Sav-on, Shaw’s and Super Saver.

Other drug chains and their NACDS store counts include Medicine Shop (1,100 stores), Longs Drugs (470) and Brooks Pharmacy (333).

After Albertsons, the top supermarkets with pharmacy departments are Kroger Co. (with 1,860 units), Safeway (1,223) and Bruno’s (828). And among the mass merchants, Wal-Mart leads with its 3,566 pharmacies, followed by Kmart (1,513) and Target (1,225).

Druggist wanted
All these stores are competing for a tight supply of pharmacists. The shortage became most critical in about 2000, the year many pharmacy schools were changing their degree programs to require one more year of study than before, says Touro University’s Knapp — and this on top of a 1999 year-on-year rise in prescriptions of 9 percent. (Demand is rising now at a more manageable 2 percent annually, because of higher co-payments and a greater number of Americans who lack health insurance, she says.)

Though studies indicate that the number of pharmacists is likely to rise by about 9 percent to 144,508 by 2010, it remains to be seen whether they can keep pace with a prescription rate set to leap 47 percent.

Further, observers say no one can predict the future of an industry whose wild cards include the federal government’s Medicare prescription drug benefit, the reimportation of drugs from Canada and pension plans that specify mail-order drugs.

For Simon’s McCarty, however, uncertainty holds promise.

Once drugstores reach the saturation point, he speculates, chains may look for a niche in malls by filling prescriptions at kiosks or finding some other innovative way to grow. “Who knows?” he muses. “We may be doing lots of business with them again.”