Wednesday, May 18, 2011

Drug Channel Profits in the 2011 Fortune 500

It's time for my annual review of the latest Fortune 500 list. This annual review gives you perspective on the relative profitability of the largest drug wholesalers, chain pharmacies, pharmacy benefit managers (PBMs), and manufacturers. I also compare this group to independent pharmacies.

Key observations:
  • The biggest drug channel companies are much bigger (in revenues) than pharmaceutical manufacturers—but this is a misleading comparison. It also leads to a "pennies in profit" fallacy, when in fact drug channels companies are quite profitable.

  • Median profitability of drug channels companies was up slightly in 2010. Profitability of the channel companies is about half of the profitability of pharmaceutical manufacturers when using a more appropriate metric such as Return on Assets.

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

  • Investors once again earned higher returns from the drug channels group in 2010 as well as over the past 10 years.
Please post any questions or reactions as comments. The technical notes are at the bottom.
THE COMPANIES

Here are the nine largest drug wholesalers, pharmacy chains, and PBMs on the 2011 list along with Fortune 500 rank and links to the financial data as reported by Fortune:
Here's a handy summary of the data for these nine companies. (Click to enlarge.)

You can also view the the 12 largest pharmaceutical manufacturers on Fortune's 2011 list. (The profit data for Allergan is missing for some reason, so I eliminate their data in the computations below.)

REVENUES

The channel intermediaries are much larger than the manufacturers. Median revenues for the nine drug channels companies were $67.4 billion in 2010 versus $17.3 billion for the manufacturers. Three companies—McKesson, Cardinal Health, and CVS Caremark—are in the top 25 of the Fortune 500 list, while the highest ranking manufacturer (Pfizer) only reached #31. For comparison, the 12 largest pharmaceutical manufacturers on the Fortune 500 list have revenues ranging from $67.8 billion (Pfizer) to $4.5 billion (Genzyme).

Note that the Fortune 500 rankings are based on sales revenues, so that double-counting artificially inflates the top-line of a channel participant. For instance, a single prescription’s revenue could be counted at least four times in the Fortune 500 rankings:
  1. When a drug is sold by a manufacturer to a wholesaler;
  2. When a drug is sold by a wholesaler to a pharmacy;
  3. When a drug is sold by a pharmacy to a consumer; and
  4. When a pharmacy receives reimbursement from a PBM.
PROFITS

As you can see in the table above, 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 weighted average ROS (not shown) for the Drug Channels group was 1.7% in 2010, up slightly from 2010's weighted average of 1.4%.

In contrast, weighted average profit as a percentage of revenues in 2010 was 15.3% of revenues for the eleven drug manufacturers(range: 1.9% to 36.5%). Thus, the manufacturer-to-channel ratio is 8.9X, i.e., ROS for the manufacturers was about nine times the ROS for drug channels companies.

However, ROS is a flawed measure of profitability for channel intermediaries due to the revenue double-counting. A 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 4.5% (Range: -6.3% to +11.2%). As always, Rite-Aid is bringing up the rear.

The ROA figures for drug channel companies is more comparable to the pharmaceutical manufacturers, whose median profits as a percent of assets was 10.0% in 2010. The manufacturer-to-channel ratio is now only 2.2X for ROA (versus 9X for ROS). The difference in part reflects the innovation/risk premium associated with the expensive, risky, and time consuming business of drug discovery. Drug Channels companies wouldn’t exist unless drug manufacturers actually created valuable products.

INDEPENDENT PHARMACIES

The 2010 NCPA Digest provides the following data for independent pharmacies in 2009 (the most recent year available):
  • Average ROS = 3.3%
  • Average ROA = 19.6%
In other words, the business of independent pharmacy is more profitable than the big public companies, including the PBMs. As I wrote in January, Owning a Pharmacy is Still Pretty Profitable. Oddly, the independent pharmacy's trade association continues to complain about PBM profits.

INVESTMENT RETURNS

Investment returns reflected last year's good stock market performance. Here are the median Total Return to Investors in 2010 as reported from Fortune's list:
  • 9 Drug Channels companies: +9.1% (Range: -41.5% to +32.4%)
  • 11 Drug Manufacturers: +2.8% (Range: -16.2% to +45.3%)
Once again, investors in drug channels did better than investors in drug makers, both in 2010 and over the 2000-2010 period. Just another demonstration of the power of generics, which benefit the channel but hurt brand-name manufacturers.

A FEW TECHNICAL NOTES
  • All data come from 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 (Average Operating Income / Estimated Average Assets) using data from the 2010 NCPA Digest.

10 comments:

  1. AnonymousMay 18, 2011

    Please provide more detail on how drug channel revenue is double counted.

    If you are a wholesaler only #1 applies "When a drug is sold by a wholesaler to a pharmacy"

    If you are a Pharmacy, revenue is split between patient pay and PBM pay but not double counted.

    PBM Revenue is only from plan sponsors.

    If you total $ across multiple companies in different channels than you will be double count but not within a single company.

    So why is ROS not comparable between individual mfgs and individual drug channel companies?

    ReplyDelete
  2. AnonymousMay 18, 2011

    I was going to ask the same question.

    ReplyDelete
  3. Here's how a single prescription can be counted as revenue by four separate companies:

    1. Pfizer sells a pallet of Lipitor to Cardinal Health. Pfizer reports revenue from the sale on its income statement.

    2. Cardinal Health sells a case of Lipitor to Walgreen. Cardinal reports revenue from the sale on its income statement.

    3. A Walgreen retail pharmacy dispenses a Lipitor prescription to a patient. Walgreen is reimbursed via a combination of the patient's co-payment and reimbursement from Express Scripts. Walgreen reports the revenue from the prescription on its income statement.

    4. Express Scripts reports the reimbursement paid to Walgreen as "Network Revenue" on its income statement.

    Q.E.D.

    The situation is more complex when the pharmacy and PBM are the same company. In this case, the combined entity must net out the transaction to give an accurate picture of its financial position. Thus, CVS Caremark reports "intersegment eliminations" to account for having items 3 and 4 on its consolidated income statement. See my discussion of this issue at the bottom of CVS CEO: Papa Don’t Preach, I’m Keeping My PBM.

    Adam

    ReplyDelete
  4. AnonymousMay 18, 2011

    Adam, I dont quite understand that, albeit on paper, independents may LOOK profitable, but in reality due to cash flow (and to keep the business running), holes along the way need to be plugged up from SOMEWHERE.

    So I find it hard to believe that you can say independents are 'profitable' in reality. If that WERE the case, why have so many IPs closed?

    ReplyDelete
  5. Well, the latest data show that the number of independent pharmacies is growing, not shrinking. So they've got that goin' for them...

    See Surprise! Independents Not Vanishing.

    A

    ReplyDelete
  6. AnonymousMay 19, 2011

    Independents are indeed growing in numbers,but not for their glamour nor their profitability.

    Druggists are looking for job security in today's world. With RP supply in much greater excess than demand, it's pretty simple to see where salaries are heading.....and probably long overdue.

    Folks are looking to simply control their own destiny, even at a lower pay rate.

    ReplyDelete
  7. AnonymousMay 20, 2011

    Not sure that you answered question #1. With the exception of CVS and maybe WAG, companies do not double count. So why is ROS, not applicable. A sale is a sale, but if you look at assets these different types of companies have completely different types of assets required for business. Therefore I would think RAS is not a fair comparison across channels.
    I am sure I am missing something. Please clarify.

    ReplyDelete
  8. Correct, companies do not double-count. I was referring to double-counting across firms. A sale is a sale, but ROS can be a misleading metric when comparing relative profitability in a channel system b/c of the revenue stacking down the channel, i.e., the double counting.

    For example, wholesalers have gross margins of about 3%, but about 40-45% of that gross margin drops to the bottom line. The top-line revenue is artificially inflated b/c so much brand-name drug revenue flows through the wholesaler.

    Hope that clarifies. If not, email me privately.

    Adam

    Adam

    ReplyDelete
  9. Correct, companies do not double-count. I was referring to double-counting across firms. A sale is a sale, but ROS can be a misleading metric when comparing relative profitability in a channel system b/c of the revenue stacking down the channel, i.e., the double counting.

    For example, wholesalers have gross margins of about 3%, but about 40-45% of that gross margin drops to the bottom line. The top-line revenue is artificially inflated b/c so much brand-name drug revenue flows through the wholesaler.

    Hope that clarifies. If not, email me privately.

    Adam

    Adam

    ReplyDelete
  10. AnonymousJune 29, 2011

    I was going to ask the same question.

    ReplyDelete

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