Concerns Over McKesson's Rite Aid Exposure Being Lifted

Investor concerns about the risks to drug distributor McKesson Corp. (MCK) from struggling customer Rite Aid Corp. (RAD) appear to have dissipated, helped by the retail pharmacy chain's recent debt refinancing.

Wall Street had been concerned earlier this year that McKesson faced risk from debt-laden drug store operator Rite Aid, its second-largest customer and previously the subject of bankruptcy speculation. Moody's Investors Service in March named Rite Aid a "bottom rung" company likely to default on its debt.

Easing credit markets, however, are working in Rite Aid's favor, with the retailer recently refinancing about $1.9 billion of debt, including a major portion of its September 2010 maturities. That gives Rite Aid more time to improve operations, as its next major debt maturities are more than five years away.

Rite Aid shares, changing hands at $1.25 on Wednesday after the company posted its eight straight quarterly loss amid higher same-store sales Tuesday, are trading at more than six times their all-time low of 20 cents on Feb. 23.

McKesson shares, at $43.58, are up nearly 16% since May 1, trading roughly in the middle of their 52-week range. The Standard & Poor's 500 index is up only 3.4% since May 1.

While McKesson and its peers are not free from industry and economic pressures, including some margin erosion in customer pricing, the company's Rite Aid exposure no longer appears to be a big worry for investors.

"It's a different place since Moody's put Rite Aid on its bottom-rung list of companies at risk for default on their debts," Wall Street Strategies analyst Brian Sozzi said.

The recent rally in Rite Aid shares reflects a reduced concern in the market about funding, and "by extension, the pressure on McKesson shares have eased. The debt refinancing is in fact a positive for McKesson in that Rite Aid slipping into default is temporarily removed from the equation," he said.

"Now, I do think McKesson will have to work with the company very closely on contract pricing, which may correlate to lower margins on the deal structure. This would be consistent with what we have seen across the drug distributor sector during the recession ... which is greater price concessions," Sozzi said.

"But McKesson is a trusted partner of Rite Aid, and its ability to stick with the company through such a difficult time suggests to me a contract worth north of 10% of total revenue is not in danger of disappearing, especially in light of the debt financing," he said.

While the default risk has abated, McKesson could see some weakening in its Rite Aid account as the chain closes stores in its effort to find firmer footing. Rite Aid closed 86 stores and opened 10 in its fiscal first quarter, and has plans to close more stores this year.

Sanford Bernstein analyst Helene Wolk, who covers McKesson and not Rite Aid, agreed that the debt refinancing removes a near-term risk. Longer term, possible operating difficulties or market share erosion for Rite Aid pose modest, manageable risk for McKesson, "and I believe this issue is well appreciated by investors," she said.

Robert W. Baird analyst Eric Coldwell, who had considered earlier market concern over a possible Rite Aid bankruptcy to be overdone, said this week that he sees no remaining Rite Aid overhang for McKesson.

Meanwhile, McKesson and competitor Cardinal Health Inc. (CAH) are expected to make price concessions as they work to renew contracts this year with their mutual largest customer, drug store chain and pharmacy benefits manager CVS Caremark Corp. (CVS). A Cardinal executive this month said his company was at "very late stages" of negotiations with CVS Caremark.

-By Dinah Wisenberg Brin, Dow Jones Newswires, 215-656-8285; [e-mail]