Duane Reade Sale Reflects “Industry Issues”: Rx-To-OTC “Shifts” Cited

Market shift from Rx-to-OTC products is among pharmacy industry issues cited by the retail drug chain Duane Reade in explaining its decision to sell to the private equity firm Oak Hill Capital Partners.

"We have Rx-to-OTC shifts cutting back revenues strongly in a number of primary products," Duane Reade CEO Anthony Cuti said during a Dec. 24 analyst conference call.

"It's not an economic issue. It's an industry issue," Cuti said. "We have an industry that is undergoing significant change and is having significant forces applied against it."

The presence of OTC versions of Claritin (loratadine) and Prilosec (omeprazole) in 2003 has had an impact on the Rx markets for antihistamines and proton pump inhibitors. Insurers have taken various measures to reduce coverage in these categories and encourage use of the OTC options through efforts such as couponing.

"For the first time in our history, we've seen an industry whose script count growth has been cut in half in one year," Cuti continued. "That's not just Duane Reade...Everyone in the industry has felt the impact."

Other factors include "drug reimportation [and] mail order," Cuti said. "We have state Medicaid programs cutting reimbursement," he added. "We have an oncoming Medicare program in 2006. All of those issues needed to be addressed."

"The fundamental issue was how are we going to address the changing pharmaceutical environment."

Oak Hill will pay $17 per share in cash for the New York City-area drug chain, a 22.8% premium over the average closing price of Duane Reade's common stock for the last 30 trading days. The total value of the deal is more than $700 mil., including payment of debt, the company said.

The acquisition is expected to close in the second quarter of 2004.

Duane Reade's board retained Bear Stearns in April to review "strategic alternatives" for the chain. The retailer's board vetted several offers between May and November, Cuti said.

The company was pushed to make the move because investors were unwilling to make the improvements needed to assure long-term profitability, he maintained.

"There are a lot of different directions that can be taken in response to those issues, but they are directions that require risk. And classically, risk costs money in the near term with longer-term potential," Cuti said.

"We have seen a shareholder group that doesn't really care to rationalize short-term losses for long-term gains."

Transfer of company ownership to a private equity firm could free up Duane Reade to make acquisitions, said Cuti, who will remain the company's CEO.

While Duane Reade is not large enough to acquire the Eckerd drug chain, it is possible that some Eckerd stores could become available for purchase.

Eckerd owner J.C. Penney retained Credit Suisse First Boston to evaluate opportunities to sell or spin-off (¹ (Also see "Eckerd Drug Put On Sale By J.C. Penney; Potential Milestone In Retail Market" - Pink Sheet, 20 Oct, 2003.), p. 8).

"We've always said that there are certain Eckerd assets that are attractive to us, and they remain attractive at a reasonable price," Cuti stated. He noted that Duane Reade previously has approached J.C. Penney about acquiring its New York-area assets without success.

He added that CVS "was being touted as, first, a deal that would be offered in its entirety and then, however, it split up as a result of buyer interest." CVS has shown interest in buying a "piece" of Eckerd at the right price.

"The word was if that type of first transaction could not be consummated, then we would be called as part of a group that might take a piece," Cuti added.

While Duane Reade currently wants to avoid "a program which is dilutive in the first year," Oak Hill "may have a longer horizon."

"They may say, it doesn't have to be non-dilutive in the first year. Maybe it could be a three-year payback and that's okay."

Fourth quarter revenues from the Duane Reade's 239 stores likely will be in the range of $355 mil., falling short of the company's guidance of $362 mil. to $367 mil. for the quarter, the company said.