Drug Channel Profits: 2010 Edition

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

Key observations:

• The biggest drug channel companies are substantially larger (in revenues) than pharmaceutical manufacturers. Revenues at the 9 largest companies were up almost 8% in 2009 versus total industry growth of 5.1% (per IMS).
  
• Median profitability of drug channels companies was down slightly in 2009. Profitability compares favorably to manufacturers when 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—and even exceeds average PBM profitability.
• Investors earned higher returns from the drug channel group in 2009 as well as over the past 10 years.

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 on the 2010 list along with Fortune 500 rank and links to the financial data as reported by Fortune:

• McKesson (MCK): 14
• Cardinal Health (CAH): 17
• CVS Caremark (CVS): 18
• AmerisourceBergen (ABC): 24
• Walgreen (WAG): 32
• Medco Health Solutions (MHS): 35
• Rite Aid (RAD): 89
• Express Scripts (ESRX): 96
• Omnicare (OCR): 347

Here's a handy summary of the data for these nine companies. (Click to enlarge.)


You can also see Fortune's list of the the 12 largest pharmaceutical manufacturers.

REVENUES

The channel intermediaries are much larger than the manufacturers. Median revenues for the nine drug channels companies were $61.8 billion in 2009 versus $21.1 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 #33. For comparison, the 12 largest pharmaceutical manufacturers on the Fortune 500 list have revenues ranging from $61.9 billion (Johnson & Johnson) to $4.4 billion (Biogen).

This revenue effect occurs because the Fortune 500 rankings are based on sales revenues, so there is double-counting within the channel. For instance, a single prescription’s revenue could be counted at least four times:

1. A drug is sold by a manufacturer to a wholesaler;
2. A drug is sold by a wholesaler to a pharmacy;
3. A drug is sold by a pharmacy to a consumer; and
4. A pharmacy receives reimbursement from a PBM.

I have seen this revenue disparity play out in wholesaler-manufacturer contract negotiations. When you’re running a company in the Fortune Top 20, then you might perceive anyone below the C-level at a manufacturer as “middle management.” I suspect that placing high in the Fortune 20 is also helpful when benchmarking executive compensation.

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 median ROS for the Drug Channels group was 2.1% in 2009, down slightly from 2.2% in 2008.

In contrast, median profit as a percentage of revenues in 2009 was 19.8 percent of revenues for the nine drug manufacturers (range: 4.6% to 49.1%). Thus, the manufacturer-to-channel ratio is 9.4X, i.e., median ROS for the manufacturers was more than nine times the median ROS for drug channels companies.

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 4.6% (Range: -35.0% to +8.0%). Once again, Rite-Aid is bringing up the rear.

The ROA figures for drug channel companies are now closer to the pharmaceutical manufacturers, whose median profits as a percent of assets was 11.4 percent in 2009. The manufacturer-to-channel ratio is now only 2.5X 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 2009 NCPA Digest provides the following data for independent pharmacies in 2008 (the most recent year available):

• Average ROS = 3.2%
• Median ROA = 14.7%

In other words, the business of independent pharmacy is more profitable than the big public companies. In fact, the average ROS for the PBMs was only 3.0%. Yup, independent pharmacies are more profitable than PBMs!

No surprise if you recall my still-unrefuted Shhhh! Owning a Pharmacy is Very Profitable.

INVESTMENT RETURNS

Investment returns were outstanding as markets bounced back from their March 2009 lows. Here are the median Total Return to Investors for 2009 reported in Fortune's list:

• 9 Drug Channels companies: +51.2% (Range: -12.6% to +387.1%)
• 12 Drug Manufacturers: +10.0% (Range: -26.2% to +86.3%)

Last year’s results reflect the recent historical pattern in which investors in drug channels have done better than investors in drug makers. Just another demonstration of the power of generics, which benefit the channel but hurt brand-name manufacturers. The 10 year performances are closer, but channels still win.

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 (Median Operating Income / Median Assets) using data from the 2009 NCPA Digest.