Anyone who reads this column regularly will have been unsurprised to read that the Co-operative Group is considering the sale of the pharmacy business, as well as moving towards practical measures to dispose of the farm operations. Private papers that indicated as much were revealed to the House of Commons Treasury Select Committee and have been reported here.
There was also serious discussion about the future of the pharmacy business at the recent Ways Forward conference in Manchester. Many of those attending were interested in whether a bid could be put together for a co-operative buy-out of the pharmacy operation if it came on the market.
Euan Sutherland, as Group CEO, has instituted a wide-ranging clear-out of senior executives and also of internal structures. As part of this, the food, pharmacy and electrical divisions were brought together into a single retail division, led by Steve Murrells, who previously led major change programmes at Tesco and Sainsbury but has been with the Group since 2012.
While we know that full year results for the Group for 2013 will be bad, we will have to wait until the end of this month to learn the details. For the present, the most recent trading figures for the pharmacy business were revenues of £379m for the first half of the year and £764m for the full 2012 year. This converted into first half 2013 trading profits of £14m and full year 2012 profits of £28m. As former Group CEO Peter Marks told the Treasury Select Committee, this represents working on tight margins.
According to last year’s first half report, the most challenging factor in a modest financial situation was pressure on prices from the NHS. Profits were also damaged in the short-term by investment in improving stores under the branch transformation programme, along with enhanced staff training. Other investment also took place, with five new outlets in health centres. In addition, a three year dispensing contract was won to supply two prisons, while five hospital outpatient dispensing contracts were won in 2012. The report concluded: “Underlying prescription growth was market leading at 2.2% and over-the-counter sales showed real signs of improvement.”
Co-operative Pharmacy is a big business in its sector – it is the UK’s third largest pharmacy chain, with about 750 stores and 6.500 staff. The biggest pharmacy chain is Alliance Boots, which has in excess of 2,500 outlets, followed by Lloyds Pharmacy, with more than 1,600 shops. Other large chains are Rowlands, with more than 500 outlets and Superdrug, which has pharmacies in one in four of its 800 stores.
These competitors probably represent the most likely bidders for the Co-op Pharmacy business. Alliance Boots is the product of a 2007 merger between the Boots chain, which was itself suffering from declining profit margins through supermarket competition, and the rival Alliance UniChem retailer. It is now jointly owned by the giant private equity firm KKR, the Italian investor and entrepreneur Stefano Pessina, who built Alliance UniChem, and the US pharmacy retailer Walgreens.
Alliance Boots has been formed using a textbook private equity approach. This has involved merger in order to reduce competition, improve buying power and increase economies of scale, alongside ruthless cost cutting. It has been criticised both for its use of zero hours contracts and complex transactional arrangements that have substantially reduced its tax liabilities.
Lloyds Pharmacy is the second largest UK pharmacy chain and a subsidiary of Celesio, a German based listed company that operates internationally. It was 75% acquired last month by McKesson, a US-based pharmaceutical and health systems provider, which is already a supplier to the NHS. The Lloyds Pharmacy business has its own board, with former Labour health secretary Alan Milburn being one of its senior advisors.
All the UK pharmacy businesses have suffered from declining profits through two simultaneous pressures. One is the extent to which supermarket chains such as Tesco, Sainsbury and Asda have moved into the supply of over the counter products, often at cheaper prices than those offered by specialist pharmacies. The second issue is the impact of NHS reforms, which have put pressure on margins of pharmacy products, along with a greater move towards generic, rather than branded, drug products.
Given these pressures, a trade sale to a competitor is the most likely preferred outcome for the future of Co-op Pharmacy. However, this raises the question of whether the competition authorities would accept this. Competition policy can lead to interventions where a merger will lead to insufficient competition within an area, eroding choice and potentially leading to an increase in prices. This concern can be mitigated in the case of national chains that promise to operate national pricing practices, avoiding the risk of price hikes in any particular locality.
In the case of the Boots and Alliance merger, conditions were imposed by the competition authorities. These led to the divestment of just under a hundred outlets, but still left the merged business with more than 2,500 stores. A merger between, say, the Lloyds and Co-operative pharmacies would produce a chain slightly smaller than this, so competition policy would not necessarily be a barrier to a merger of this kind. Competition authorities might, though, require some store disposals to enhance local competitive markets.
This leads us to the most difficult aspect of any deal negotiations – the price. For a listed company, the market value of the company is the price per share, times the number of shares issued. A premium will be paid according to the synergies on offer to the buyer – these may be opportunities to reduce costs through corporate integration, improved buying power and the ability of the buyer to move quickly into markets that are otherwise difficult to enter.
Due diligence will (we hope, but not always as we know from the Britannia experience) reveal otherwise unknown factors that may reduce the market value of the business. Consideration will also be given to the debt and cash positions of the target company.
However, these calculations are of little use in the case of a business that is not a listed company. This applies to either a private company or to a mutual business. Here the normal advice is to make comparisons with other businesses. However, none of Co-operative Pharmacy’s competitors is an obvious comparator. These operate broader product ranges, or operate internationally, for the most part.
My personal, very rough and ready, rule of thumb for purchase price is around ten times’ annual profit – putting the so-called ‘enterprise value’ of the Co-operative Pharmacy at around £300m. However, this is such an unsophisticated measure that little attention should be paid to it!
Whatever price is put on it, I am not optimistic that the movement can raise the sums required. One option that could be considered would be via a members’ bond, the proceeds of which might be used to fund the acquisition. (The Group considered the issue of a members’ bond to save the Bank from effective demutualisation.) This option, though, fails to deal with the reality that the pharmacy business is a low margin operation, whose main potential value lies in the hands of its competitors.
Interestingly, the pharmacy business sits at the heart of questions about ethical practices. Co-operative Pharmacy, unlike some of its competitors, has refused to sell e-cigarettes, though this is currently under review. While some commentators regard e-cigarettes as an ethical product that helps move smokers away from the more unhealthy traditional cigarette, others see them as a way of attracting a new generation to a product that is still, objectively, unhealthy.
But British visitors to the United States will be aware that the ethics debate can potentially go much wider than that. While UK pharmacies tend to focus on the sale of healthy products, in the US a wide variety of health-damaging products are sold alongside medicinal drugs and health products. With the growing interest of US companies in the UK pharmacy sector, we may find there is a strong debate over what a pharmacy retailer should be selling, or not selling. Whether the Co-operative will be at the heart of that debate we are likely to find out over the coming weeks and months.