Monday, April 27, 2009

Drug Channel Profits in 2009’s Fortune 500 list

Spring must be here, because it's time for my annual review of the Fortune 500 list.

The subject of profits comes up frequently in reader comments on the blog. This review will give you some facts and perspective on the profitability of the largest drug wholesalers, chain pharmacies, and pharmacy benefit managers (PBMs). And to keep things spicy, I also compare this group to independent pharmacies and manufacturers.

Key conclusions

  • By a conventional metric (revenues), the biggest drug channel participants are substantially larger than pharmaceutical manufacturers.

  • The profitability of drug channels companies looks better when compared to manufacturers using an appropriate metric such as Return on Assets rather than Return on Sales.

  • The profitability of a typical independent pharmacy is well above the median profitability of the nine largest drug channels companies.

  • Investors earned greater average total returns from the manufacturer group last year, but better returns from the drug channels group over the past 10 years.

I hope you enjoy the details below. Please post any questions or reactions as comments and I'll try to respond. The technical notes are at the bottom.

THE COMPANIES

Here are the nine largest drug wholesalers, pharmacy chains, and PBMs that on the 2009 Fortune 500 list along with rank and links to the financial data as reported by Fortune:

  1. McKesson (MCK): 15

  1. Cardinal Health (CAH): 18

  2. CVS Caremark (CVS): 19

  3. AmerisourceBergen (ABC): 26

  4. Walgreen (WAG): 36

  5. Medco Health Solutions (MHS): 45

  6. Express Scripts (ESRX): 115

  7. Rite Aid (RAD): 100

  8. Omnicare (OCR): 392

For comparison, the nine largest pharmaceutical manufacturers on the Fortune 500 list have revenues ranging from $63.7 billion (Johnson & Johnson) to $15.0 billion (Amgen). There is a $10 billion gap between Amgen and the 10th largest drug maker (Gilead).

REVENUES

The channel intermediaries are much larger than the manufacturers. Median revenues for the nine drug channels companies were $59 billion in 2008 versus $23 billion for the manufacturers. Three companies – McKesson, Cardinal Health, and CVS Caremark – are in the top 20 of the Fortune 500 list, while the highest ranking manufacturer (J&J) only reached #46.

This perhaps surprising observation derives from the fact that the Fortune 500 rankings are based on sales revenues, so there is substantial double-counting of dollars among the drug channels companies. For instance, revenue from the same prescription could be counted at least three times by companies on this list if:

  • the drug is sold by a wholesaler to a pharmacy;

  • the drug is sold by a pharmacy to a consumer; and

  • the pharmacy receives reimbursement from a PBM.

The manufacturer's revenue could also be included in all three situations.

PROFITS

As you can see in the table below, Return on Sales (ROS; profit as percent of revenues) was in the low single digits for all companies in this group, regardless of their position in the supply chain (retail pharmacy, wholesaler, or PBM). The median ROS for the Drug Channels group is 2.2%.

(CLICK TO ENLARGE TABLE)

In contrast, median profit as a percentage of revenues in 2009 was 19.3 percent of revenues for the nine drug manufacturers (range: -10% to 33%). Thus, the manufacturer-to-channel ratio is 9X, i.e., median ROS for the manufacturers was nine times the median ROS for drug channels companies.

However, ROS is a flawed measure of profitability for channel intermediaries due to the revenue double-counting. The more meaningful metric is Profits as a % of Assets, a.k.a., Return on Assets (ROA). ROA relates ROS to the balance sheet assets required to generate an income statement profit. The biggest part of a drug channels company's balance sheet are current assets (cash, product inventory, or accounts receivable), whereas the biggest assets of a pharmaceutical manufacturer tend to be long-term assets such as intangible assets, goodwill, or physical plant, property, and equipment.

The profitability of companies in the Drug Channels universe looks much more attractive on this basis. The group median is 5.3% (Range: -9.4% to +14.1%). I bet you can guess which company is at the bottom.

The ROA figures for drug channel companies are now closer to the pharmaceutical manufacturers, whose median profits as a percent of assets was 11.5 percent in 2009 (Range: -7.1% to 17.8%). The manufacturer-to-channel ratio is now only 2.2X for ROA (versus 9X for ROS). In my opinion, the higher ratio for drug makers reflects a risk-return tradeoff. The additional profitability for manufacturers can be considered an innovation/risk premium. Discovering and developing new medicines is expensive, risky, and time consuming.

INDEPENDENT PHARMACIES

The 2008 NCPA Digest provides the following data for independent pharmacies in 2007 (the most recent year available):

  • Median ROS = 3.0%

  • Median ROA = 14.8%

In other words, the profitability of the typical independent pharmacy is well above the median for the nine largest drug channels companies. Just some facts to ponder the next time you hear independent pharmacists pleading poverty. And no, I'm not bashing anybody here – I'm impressed.

INVESTMENT RETURNS

Investment returns for everyone were dismal in 2008 as measured by the median Total Return to Investors for 2008 reported in Fortune's list (and as measured by the performance of my 201K retirement plan).

  • 9 Drug Channels companies: -27.2% (Range: -88.9% to +24.7%)

  • 9 Drug Manufacturers: -12.7% (Range: -45.7% to +24.4%)

Unlike 2007, the drug channels group fared worse than manufacturers. However, the drug channels group still has better average 10 year total return than manufacturers.

A FEW TECHNICAL NOTES

  • All analyses rely on Fortune's (admittedly crude) measurement of key financial metrics for consistency.

  • I only include Drug Channels companies that earned a majority of their revenues from pharmaceuticals. This criterion excludes other retail formats with pharmacies (supermarkets and mass merchants). I do not separate the revenues from each company's various lines of business.

  • The ROA for independent pharmacies is computed as (Median Operating Income / Median Assets) based on data on page 15 of the 2008 NCPA Digest.

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5 comments:

  1. scripkillaApril 27, 2009

    I'm impressed also with the independents. I am not an independent owner, but I see there are lots of business decision differences at play. For example, I think we can all agree that TODAY a typical independent is a nitch success story. Most have at least evolved to doing both RX and DME business. They run on average leaner in salaries (probably by 1 FTE pharmacist at least), so overhead isn't as high as with a chain/store. There is something to be said about a smaller player's ability to price shop wholesalers, localize contracts, etc. Maybe they add up to more than we give them credit for? For every chain store in the green, they have one down the street in the red (volume, volume, volume!) - cannabalizibng each other. We all get paid the same rates for the most part, so it comes down to 1)cost of goods sold 2)overhead 3)marketing $$. The independent doesn't have the scale to expand like a chain does, but is it a bad thing? Let them keep absorbing the losses. It's capitalizm, so the best service provider should keep the business..right? LOL, easier said than down, but it's an optomistic paradigm.

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  2. I would say that the independent pharmacies increased relative profit is also a function of risk/reward. The risk is heavily concentrated on the individual owner rather than the shareholders.

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  3. Wonder how just the prescription portion of the business would look for each player. For example, chains using the pharmacy as a lost leader to increase sales in other departments. If you examine just the prescription filling portion, does it pay for itself or does it require "other sources" to operate?

    A couple questions:
    1) on a typical prescription (filled by a retail pharmacy) and processed thru a pbm, How does that financial data show up under the pbm? (they dont buy the drug or fill the prescription-in the case of a self-insured plan)

    2)In the big picture of Healthcare, if retail pharmacy has to rely on "front end items" to stay in business, shouldn't more scutiny be applied to the wholesalers and pbms?

    I've posted here before and I'm dismayed by the practices of the pbm's, especially where they are used as a claims processor to self-funded plans (ie they have no risk). I've seen them charge 10 times as much to the plan vs what they pay the pharmacy. Why do they think that could continue as a business model? I think the public outrage at these practices would be overwhelming if they found out.

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  4. Why is walmart absent?

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  5. Wal-Mart is absent because I only include Drug Channels companies that earned a majority of their revenues from pharmaceuticals.

    Adam

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