Tomorrow also marks the kick-off of a five year period when $80+ billion of branded revenues will face generic competition, as shown in Medco’s Latest Update on the Generic Wave.
What will this mean for the big three pharmaceutical wholesalers—AmerisourceBergen (NYSE:ABC), Cardinal Health (NYSE:CAH), and McKesson (NYSE:MCK)? My take:
- The substitution of brand-name drugs for generic drugs will reduce drug wholesalers’ revenue growth.
- Wholesalers, however, will benefit significantly from this wave since a majority of their profits come from generic drugs.
So, the next time a wholesale executive whines about “low profit margins,” you can whip out this article for a more fact-based discussion.
IGNORE GROSS MARGIN
Gross profit equals the revenues received by a wholesaler minus the costs of products (net of discounts and returns) bought from a manufacturer or another wholesaler. Gross profit measures the portion of revenues available for the operating expenses and operating profit of a wholesaler. It reflects how much a wholesaler is “paid” for taking on specific tasks and functions in the distribution system on behalf of customers and/or manufacturers.
Gross margin expresses gross profit as a percentage of revenues. We estimate that the industry-wide gross margin from core drug distribution was approximately 3.2% in 2011. Pharmaceutical wholesaling has very low gross margins compared with other wholesale distribution industries.
Using gross margin, overall profitability of pharmaceutical wholesalers appears very low when compared with revenues, i.e., three cents on the dollar.
But don’t be fooled. This traditional financial metric mask the underlying—and growing—profitability of the drug wholesaling business.
INSTEAD, LOOK AT GROSS PROFIT CONVERSION
Instead, comparing gross dollar profits with operating expenses shows how effectively a wholesaler converts gross profits into operating profits (Earnings Before Interest and Tax, EBIT).
The chart below shows EBIT as a percentage of Gross Profit (rather than revenues) during the past three years. The ratio has been increasing for each of the Big Three wholesalers, demonstrating their ability to retain more gross profit dollars by decreasing operating expenses and increasing gross profits from generic drugs. AmerisourceBergen and McKesson convert almost half of all gross profits into operating profits.
For a wholesaler, generic drugs yield more gross profit dollars per unit than brand-name drugs. As a result, wholesalers have the rare good fortune of simultaneously increasing gross profits while retaining a greater share as operating profits.
Exhibit 25 in my 2011-12 wholesaler report illustrates the financial interplay among revenues, gross profits, operating expenses, and operating profit using data from AmerisourceBergen. For instance, ABC has gross profits of about $2.5 billion in 2011, up from $2.0 billion in 2008. During this same period, the EBIT/GP metric increased from 40% to 48%. Very nice!
This metric also demonstrates how very small percentages translate into large dollar amounts. A one basis-point increase in EBIT margins for a company with $80 billion in revenues translates into an additional $8 million of operating profit. A 30-basis point increase equals $240 million in additional profit dollars.
A risk to this forecast is growing pressure on pharmacy profits from generics. More on that topic another time.
AND DON’T FORGET ABOUT ROIC
Return on Invested Capital (ROIC) is one of the most effective single measures of wholesaler profitability. ROIC measures a wholesaler’s efficiency at generating a return relative to the capital invested in its business. It includes both the cost of the assets employed as well as the cost to acquire those assets. Thus, it is a useful measure for illustrating the interplay between income statement measures and the balance sheet.
Here’s how the generic wave will boost ROIC for wholesalers:
- Wholesalers retain only about 40% of the product volume once a product goes generic, because large self-warehousing customers no longer purchase through the wholesale channel. These customers have lower EBIT margins for wholesalers. Thus, a wholesaler’s average EBIT margin will increase despite the reduction of volume.
- As the chart above projects, the generic wave will increase EBIT dollars by reducing the share of gross profit absorbed by operating expenses. Dollar increases in EBIT will improve Return on Invested Capital (ROIC) because EBIT appears in the numerator of the ROIC computation.
- The generic wave will decrease invested capital, the denominator of the ROIC computation. Since wholesalers purchase generic drugs at large discounts vs. brand-name drugs, the value of product inventory on a wholesaler’s balance sheet also declines for a given level of prescription volume.
Chapter Four of The 2011-12 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors explains:
- How wholesalers get compensated for their role in the drug distribution system
- Key profitability metrics and their interaction
- Differences in profitability for generic vs. brand drugs and large vs. small customers, as well as the underlying components of these profits