Tuesday, February 01, 2011

Drug Wholesaler Outlook: Revenues Down, Profits Up

Larry Marsh and his team at Barclays Capital have just published a very creative analysis of how the upcoming generic wave will affect the big three drug wholesalers—AmerisourceBergen (NYSE:ABC), Cardinal Health (NYSE:CAH), and McKesson (NYSE:MCK). He’s given me permission to share the high level results with the Drug Channels audience.

Their conclusions:
  • Wholesalers’ revenues will decline year-over-year in FY2013. This will be the first ever decline in top-line revenues for these companies. Note that the analysis doesn’t include any potential future acquisitions.

  • Operating profit will grow dramatically. Wholesalers will benefit as more-profitable generic drugs replace brand-name drugs. See the chart below.
The overall profitability story will be even better than Barclays estimates. As I discuss below, metrics such as Return on Invested Capital (ROIC) will also get a boost as wholesaler inventories shift to lower-cost generic drugs. You can learn more about pharmaceutical wholesalers and their business models in The 2010-11 Economic Report on Pharmaceutical Wholesalers.

The Barclays analysis builds upon the following two observations:
Barclays created product-level, wholesaler-specific models based on multiple inputs: wholesaler market share, channel of distribution for the branded product, wholesaler customer mix, profit margins for branded and generic formulations, and many other factors. These models were used to estimate wholesaler gross revenue, gross profit, operating expenses, and operating profit. Operating profit is defined to be Earnings Before Interest and Taxes (EBIT).

The chart below summarizes the estimated operating margin (Operating Profit as a percentage of Revenues) expansion for the wholesalers in FY2010 vs. FY2013. Very nice.
However, operating margin is a flawed measure of profitability for wholesale intermediaries because 97% of a wholesaler’s revenues are pass-through dollars. A more meaningful metric is Return on Invested Capital (ROIC), which relates after-tax Operating Margin to the balance sheet assets required to generate an income statement profit.

As a result, the profit story will be even better than the figures shown above because the Barclays analysis omits the balance sheet benefit of the generic wave. Here's the intuition:
  • A wholesaler purchases physical inventory in anticipation of selling products to its customers and also extends credit to those customers after delivery. Thus, product inventory and accounts receivable are a majority of the total assets on a wholesaler’s balance sheet.

  • Wholesalers purchase generic drugs at large discounts versus brand-name drugs. The dollar value of both product inventory and receivables on a wholesaler’s balance sheet declines after a generic launch.

  • Profitability computations such as ROIC increase as the value of the denominator assets (inventory and A/R) decreases for a given level of prescription volume.
There are lots of interesting questions embedded in the model’s assumptions. Will generic margins remain at historical levels? Will further retail consolidation alter the volume assumptions? Will wholesalers retain their role in the drug channel? Will ongoing drug shortages help or hurt wholesaler profits? And so on.

Everyone has an opinion on the answers to these questions. I found the Barclays model to be extremely useful for organizing the uncertainty.


  1. Did the model assumptions include the impact of a cost plus pharmacy reimbursement methodology ?
    AWP for generic drugs have historically been anywhere between 100-1000% above acquistion costs.
    The pharmaceutical supply chain will need to adapt to a new pricing floor or ceiling depending on your affilations (provider , payor , wholesaler or manufacturer)

  2. More like 100 - 3000%

  3. How long will it be until retail pharmacy begins to explore fee for service negotiations with manufacturers and take brand drugs direct? The manufacturers would benefit and the retailers could justify a fee for self distribution and thus a lower net price (even after the cost of capital and expense). The retailers could choose the best manufacturers with the best fees and let the wholesalers keep the low fee accounts? The generic profit compared to brand profit for wholesalers is out of balance and eventually will come back into balance with reimbursement pressure