Baby Boomers, many of whom remember the drug culture of their youth, are still into pill popping — but this time it's the meds of the prescription variety.

The former hippies and their straighter peers are turning 60 now, and their influence is mighty: Boomers make up 28 percent of the population, control 70 percent of financial assets — and consume a full 75 percent of prescription drugs.

If U.S. health spending continues its more than 15 percent annual growth rates, the Rx drug market could jump to $750 billion by 2013, from $250 billion today, with Boomers accounting for $562.5 million of that total.

“It's the graying of America that's creating these opportunities,” says Richard Walter, president of Faris Lee Investments.

Looking for a piece of that high-priced action? Get in line.

With the entry of supercenters Wal-Mart, Target and Costco into the pharmaceutical business as well as the growing influence of online drug businesses — the fastest-growing sales channel — industry leaders Walgreens and CVS face ever-new challenges.

There is one thing the traditional chains have learned. If drugstores can't beat the competitors on price, they are banking on something on-the-cusp-seniors value even more: convenience. That means demographically astute real estate locations and larger, more upscale formats.

Drug divas

Which is the biggest traditional chain? Although CVS operates more stores, Walgreens led the sector with sales of $43.6 billion in 2005. CVS, with 5,471 stores and counting, raked in $37 billion, with Rite Aid a distant third at $17.1 billion. With both Walgreen's and CVS, prescription drug sales constitute 65 percent to 70 percent of sales. With independent pharmacies making up a shrinking 20 percent of stores, CVS and Walgreens are racing to expand in markets ripe with retirees: the South and California.

While CVS has pursued an acquisition strategy for growth, Walgreens prefers net new development. In 2004, CVS and the Jean Coutu Group bought Eckerd from J.C. Penney Corp. CVS paid $2.15 billion for 1,260 stores, mostly in the South and Midwest. In January of this year, CVS also acquired 705 stand-alone Osco and Sav-On locations from Albertsons for $2.93 billion, expanding CVS's presence to six new states and increasing its store count to 350 from 19 in the contested California market. Once the deal is completed this summer, CVS will operate more than 6,100 stores in the U.S.

Walgreens opens a store every 19 hours, with 475 more planned for this year (390 of them new rather than purchased, existing stores) and hopes to have 7,000 stores by the end of the decade. The average store is 11,000 square feet, carries 25,000 items and grosses $7.9 million in annual sales. Eighty percent are freestanding with 4,300 offering drive-through prescription service. Although sometimes perceived as your grandmother's favorite store, Walgreens claims to have more 24-hour stores than all the competition combined. It has strung together 31 consecutive years of record sales and earnings and management has a knack for choosing profitable locations, closing only 2 of 3,600 stores new stores built in the last 10 years.

Rite Aid has not fared as well. “They're working hard to come back from the edge,” says Bernard Haddigan, senior vice president and managing director of Atlanta-based Marcus & Millichap's National Research Group. Scandals rocked the company after its CEO Martin Grass and other executives were indicted for inflating corporate profits in the late 1990s. Falling credit ratings have inhibited expansion; Rite Aid opened only seven new stores in 2004. Although back in expansion mode, third-place Rite Aid is not well positioned. “Rite Aid can look and smell like the two bigger competitors with the exception of its balance sheet,” Haddigan says, “but to get to a closer level 3 behind [Walgreens and CVS], it will have to grow its sales per square foot and go from more in-line to freestanding stores. That's an expensive proposition.”

Location is key

In the late 1990s, drugstores began coming out of in-line shopping centers in search of freestanding locations, especially near busy intersections. Store formats ballooned from roughly 9,000 square feet to 12,000 square feet to offer more snacks and convenience groceries. With Wal-Mart positioned as the third-largest prescription drug retailer and online sales of maintenance drugs increasing, CVS and Walgreens had seen the writing on the wall: accessible, high-traffic real estate was the key to making the convenience model work. And it's working.

“It was hotter seven or eight years ago,” says Mike Caroll, executive vice president of real estate operations at New Plan Excel Realty Trust. “Then you had Eckerds, CVS, Walgreens and Rite Aid all competing for the same sites. You saw a great boom in pricing for corner locations, but it's backed off somewhat in recent years. Essentially, the sector has consolidated into two major players.”

What is a store going for these days? A two-year-old, 13,000-square-foot Walgreens on a busy Los Angeles boulevard recently sold for $6.8 million, according to CoStar Realty Information.

“Historically the corner lots had been fast food and gas stations,” says Gwen MacKenzie, vice president of real estate investments at Sperry Van Ness. “When Walgreens and CVS pushed into California, they really established the prototype of the freestanding drive-through pad on the corner. But these sites were so hard to find that they drove the prices up astronomically. If you don't have pockets as deep, then you don't stand a chance.”

Drug stores both fear and rely on the continued dominance of the supercenter. If more shoppers look to Wal-Mart and Costco for groceries, there is market share to be gained by being faster. A typical stop at Target might take an hour. Sure, you save money, but would you shop there if you just needed a prescription filled, some toothpaste and milk? Not if the average visit to Walgreens takes seven minutes.

“That's why they're coming out of the strip centers to have drive-throughs,” says Walter of Faris Lee. “It's a defensive position against Wal-Mart or Target to be able to provide that convenience. Therefore they can pick up margins on their goods over and above the less convenient providers.”

With the convenience model, location trumps price. With prescription drugs still accounting for the lion's share of drugstore sales, and insurance covering roughly 90 percent of prescription drug costs, convenience rather than bargain-basement pricing will drive traffic and sales.

The loser? “It's really getting dicey out there for grocery operators,” says Haddigan, who also owns a CVS. “They're getting attacked from all sides. A few years ago the gold standard in retail was food-anchored shopping centers. The luster is gone because there is so much pressure for groceries. Walgreens and CVS have positioned themselves so well that they've taken a bite out of the grocery dollar as well.”

Research by Dan Fasulo, director of market analysis at Real Capital Analytics, shows that the sales volume of shopping centers containing at least one of the top seven drug stores has grown to more than $3 billion in 2005 from $482 million in 2002. On the other hand, Willard Bishop Consulting estimates that traditional grocery stores percentage of overall food sales will decline to 46.3 percent by 2009 from 52 percent in 2004.

For the real estate investor

Analysts are sanguine about the sectors' top two. In April 2006, CVS had 10 buy ratings, six hold and zero sell ratings. Walgreens had 13 buys, four holds, and zero sell ratings. Not much room for doubt. With such solid numbers, prices are high and cap rates relatively low. “With CVS and Walgreens, they're in a league of their own,” says Haddigan.

“These things are very stable since the leases are typically 20 years with four- or five-year options,” says Haddigan. So even if you have a tremendous amount of volatility over the next cycle, the leases are so long that for investors, they're not going anywhere.”

The Boulder Group's extensive 2005 research on the net lease drugstore market shows just how popular the big drug chains have become with real estate investors, calling them “the main staple of 1031 transactions in the net leased market.” Walgreens, CVS and Rite Aid make up 99.5 percent of available drugstores with an average purchase price of $4.3 million and a 7.0 percent average cap rate. Average cost per square foot was $326 in 2005, nearly $100 higher than the overall retail sector of the national net lease market.

Currently, Walgreens leases 80 percent of its stores. According to Lyle Darnell, vice president of development for the Southeast at Edens & Avant, “CVS is doing a lot of self-development, taking ownership of real estate, bundling it up and selling it especially with smaller markets.”

Locking out competition

So how easy is it to penetrate a developed market? U.K.-based giant Tesco is trying to crack the U.S. convenience store market, starting in California with a $453 million effort. With no brand recognition and a very competitive grocery market, prospects are up in the air — although Tesco holds its own against Wal-Mart in the U.K. MacKenzie says Tesco will be looking for the premium corner locations that the drugstores and supercenters haven't already landed. “In any big city with high traffic, there are only a few prime corners and once they're gone, they're gone,” she says. “These things usually have 20 year leases, so if you get in early, you can build things up and shut people out.”

“I could certainly see the Rite Aids of the world being swallowed up,” says Walter. Indeed, given Rite Aid's difficulty financing stand-alone and corner locations, will they eventually say “uncle” and sell? And would acquisition of their stores really benefit Walgreens or CVS, or even Tesco?

Too much, too fast?

Eugene Fram, a professor at the Rochester Institute of Technology, estimates 20 square feet of retail exists for every American, up from 5 square feet in the 1970s. Is there too much retail out there to sustain this level of expansion? Can Walgreens continue its streak of 15-percent yearly sales growth?

“It seems like there are many open markets to get into without chains cannibalizing their own stores,” says Darnell. “I don't see them beating each other to death.”

Jay Bastian, senior vice president of acquisitions at Commercial Net Lease Realty, agrees. “They know that moving across the street from a competitor in a good market gives them a good volume store.”

And many of CVS's “new” stores are actually Eckerds, Oscos and Sav-On stores acquired in recent deals, with a new sign slapped on the store front. What looks like potential over expansion is, in reality, a mix of consolidation, new store construction and retail Darwinism.

So the meek continue to suffer. The drugstore sector seems bound to end up like book store retail, where two behemoths, Barnes & Noble and Borders, dominate the landscape. “When you look at any retail,” says MacKenzie of Sperry Van Ness, “it always seems to be the first and second players who survive and the rest just morph into something else or disappear.”

CALIFORNIA DRUGSTORE CONSTRUCTION
Company 1998 2000 2001 2002 2003 2004 2005 2006 Planned Under-way Total
Albertsons Drugstores
Completions/Projects 0 0 0 8 8 5 3 1 0 0 25
S.Q. Ft. (Ths) 0 0 0 126 126 77 52 23 0 0 404
CVS Pharmacy
Completions/Projects 0 0 0 0 0 0 1 1 0 1 3
S.Q. Ft. (Ths) 0 0 0 0 0 0 11 30 0 13 54
Longs Drugstore
Completions/Projects 0 4 10 15 5 2 0 0 2 4 42
S.Q. Ft. (Ths) 0 75 209 300 86 28 0 0 31 68 797
Rite Aid
Completions/Projects 0 9 3 1 0 2 4 1 2 1 23
S.Q. Ft. (Ths) 0 155 51 24 0 43 58 14 36 18 399
Sav-On/Albertsons
Completions/Projects 0 7 8 16 12 6 5 0 0 2 56
S.Q. Ft. (Ths) 0 130 121 242 190 92 88 0 0 30 893
Walgreens
Completions/Projects 1 9 17 31 11 14 16 3 10 5 117
S.Q. Ft. (Ths) 15 130 296 469 175 220 241 41 146 75 1808
Sources: Marcus & Millichap Research Services, Dodge

Plan D Is Plan C — For Consolidation

The Bush administration's senior drug plan leaves seniors — and mom-and-pops — scramblind.

To many mom-and-pop pharmacies, the administration's Plan D stands for death.

With Walgreens already acquiring about 200 mom-and-pop operations every year, the rate could accelerate rapidly because the controversial and confusing senior drug plan, Medicare Part D, is leaving smaller drugstores languishing in the lurch.

It can take months to get private-plan reimbursements, and while large chains can afford the delay, the financial strain on independents can be fatal.

The new prescription drug plan went into effect Jan. 1, largely to allay concerns that prescription drug costs were becoming unaffordable. The plan calls for the 43 million eligible seniors to choose from more than 40 private insurance plans. Pharmacies theoretically fill recipients prescriptions and receive payment from insurance plans, which are then reimbursed by Medicare. However, most descriptions of Plan D implementation include the word “disaster”.

“With all the delays in getting approvals, the bigger stores were just giving out prescriptions based on customer service issues,” says Sperry Van Ness's Gwen MacKenzie. “But some of the small independents could have really been crippled. It's difficult imagining them surviving.”
MW