Eroding retail margins resulting from Americans’ growing use of generic drugs, along with increased competition, are some of the factors affecting the profits of drugstore chains, according to Zacks’ recent report on Wal-Mart and the drugstore industry.

“Competition will remain stiff in the pharmacy segment, as other retail businesses continue to add pharmacy departments, and as other low-cost pharmacy options come on-line,” stated the report. Discount retailers, in particular, have made substantial inroads in gaining market share over the last year, the report added.

Major drug chains have experienced margin contractions steadily since Wal-Mart has gotten into the retail generic drug market. In its first fiscal quarter, Wal-Mart reported a 5.9 percent increase in comparable store sales and said that health and wellness products and grocery items were among the biggest contributors to its sales growth.

Drug chains with a high debt burden are likely to have a tougher time in the coming months. For example, Rite Aid’s acquisition of Brooks Eckerd stores in 2006 increased its debt burden and interest expense. “The company has also shut down many stores, as it reported a loss in the latest quarter,” according to Zacks.

The growing trend towards generic drugs is beneficial for retail pharmacy in the short term, because it provides better retail margins. However, the growth of generics is expected to slow over the next year. For example, Walgreens announced that its June, 2009, comparable pharmacy sales were negatively affected by 4.4 percentage points, owing to generic drug introductions that occurred over the past year. At the same time, the chain’s June pharmacy sales increased 11 percent in June, while comparable pharmacy sales increased 5.8 percent.

Zacks also holds a negative outlook about the industry because state and local governments and large employers are proposing drug reimportation schemes, “in an effort to manage escalating healthcare costs”, the report stated.

The drugstore industry’s negative outlook over the next year is linked to factors that are hampering retail sales as a whole. For all types of retailers to deliver better-than-expected earnings in the months ahead, the upside will have to come from an improvement in sales growth, according to Zacks.

“This is unlikely, because there are simply too many headwinds for the consumer to overcome,” according to a statement in Zacks' recent retail report. These “headwinds” include wealth destruction from the meltdown in the housing and equity markets, as well as higher unemployment, which has reduced discretionary income.

In addition, financial institutions are tightening credit standards and reducing or eliminating credit lines. The stricter lending environment is reducing the consumers' ability to borrow and spend. In past recessions, consumers relied heavily on credit cards to finance spending. In the current downturn, consumers are not resorting to use of credit cards as much as they did in the past. In fact, financial institutions are reducing credit limits, increasing interest rates, and canceling accounts.

Without the ability to take on more debt, consumers are spending less in retail stores, saving more of their income, and paying down credit card balances, according to Zacks.