Tuesday, June 21, 2016

Profits in the 2016 Fortune 500: Manufacturers vs. Wholesalers, PBMs, and Pharmacies

Time for my annual review of the new Fortune 500 list. Every year, this is one of my favorite posts, because its helps us to “follow the dollar” and understand how drug channel intermediaries make money.

The 2016 list contains seven drug channels companies—AmerisourceBergen, Cardinal Health, CVS Health, Express Scripts, McKesson, Rite Aid, and Walgreens. Assuming the Rite Aid-Walgreens deal happens, it will be six companies next year.

Using the Fortune data, I explore the profitability and shareholder returns of the largest public drug wholesalers, chain pharmacies, and pharmacy benefit managers (PBMs). I compare these companies with the Fortune 500’s 11 pharmaceutical manufacturers and a separate survey of independent pharmacies.

It’s politically fashionable to bash drug makers. These data remind us that many other multi-billion dollar businesses make some gold as drugs move through the U.S. reimbursement and distribution system.


Here's our exclusive Drug Channels summary of the seven drug wholesalers, drugstore chains, and PBMs on the 2016 Fortune 500 list. Omnicare exited the list following its acquisition by CVS Health. See the methodology comments at the bottom for help in interpreting these data.

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Here’s a companion table of the 11 largest pharmaceutical manufacturers on Fortune's 2016 list. Baxalta, which was spun out of Baxter last year, is new to the list. Allergan dropped off the list following its acquisition by Actavis. Since Actavis is based in Dublin, neither company appears on this year’s list.

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OBSERVATION #1: Drug Channels companies are MUCH bigger than manufacturers.

Drug channel companies have higher revenues than pharmaceutical manufacturers, so they rank higher on the Fortune 500. In 2015, average revenues for the seven drug channel companies were $115.0 billion, up 15% vs. 2014. Average revenues for the manufacturer group were $26.2 billion, or less than one-fourth of the drug companies' average.

Six of the drug channel companies rank in the top 25 of the Fortune 500 list, while only one manufacturer (Johnson & Johnson) made the top 50. The revenues of the 11 largest pharmaceutical manufacturers on the Fortune 500 list range from $70.1 billion (J&J) to $6.1 billion (Baxalta).

Quadruple-counting of prescription revenues within the channel is the most important factor behind this disparity. Consider how a single prescription can hypothetically be counted as revenue by four different Fortune 500 participants in the drug distribution and reimbursement system:
  • A manufacturer sells a pallet of a drug to a wholesaler. The manufacturer reports the net revenue from the sale on its income statement.
  • The wholesaler sells a case of the drug to a pharmacy. The wholesaler reports the net revenue from the sale on its income statement.
  • The pharmacy dispenses a prescription for this drug to a patient. The pharmacy is reimbursed via a combination of the patient's copayment and reimbursement from PBM. The pharmacy reports the revenue from the prescription on its income statement.
  • The PBM reports the reimbursement paid to the pharmacy as "Network Revenue" on its income statement.
The flow of money is illustrated in Follow the Dollar: The U.S. Pharmacy Distribution and Reimbursement System. Since the Fortune 500 rankings are based on sales revenues, this system pushes channel participants to the top of the list.

There is another key distinction that many people do not consider: Manufacturers report net revenues after gross-to-net discounts and rebates to third-party payers. In 2015, these discounts and rebates totaled more than $115 billion, which reduced manufacturers' gross revenues by more than 27%. See Key Insights on Drug Prices and Manufacturer Rebates from the New 2015 IMS Report.

By contrast, manufacturers’ rebates to PBMs and other third-party payers do not flow through wholesale or retail channels within the U.S. distribution and reimbursement system. For brand-name drugs, revenues for wholesalers, pharmacies, and PBMs are therefore based on the Wholesale Acquisition Cost (WAC) list price, not the net selling price. For more on the implications of this important distinction, see Drug Prices, Manufacturer Rebates, and the Risk to Channel Economics.

Note that I included a a revenue per employee computation in this year’s analysis of the Fortune data. As you can see, revenue per employee averaged $2.7 million at the drug channels companies, but only $1.1 million at the drug makers.

OBSERVATION #2: Drug channels companies have much lower return on sales.

When their profits are measured by Return on Sales (= Profit ÷ Sales), the profits of wholesalers, PBMs, and pharmacies are a small fraction of manufacturers’ profits. As you can see in the table above and chart below, Return on Sales (ROS) was in the single digits for all companies in this group, regardless of their position in the channel (pharmacy, wholesaler, or PBM). In 2015, the average ROS for the Drug Channels group was 2.8%.

In 2015, the drug manufacturers’ average profit as a percentage of revenues was a much more robust 22.3%. Thus, the ROS for the manufacturers was about 8 times the ROS for drug channel companies.

OBSERVATION #3: When measured by Return on Assets, drug channels companies’ profitability looks much better.

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). When profits are measured by ROA, channel company profitability was much closer to pharmaceutical manufacturers.

ROA relates ROS to the balance sheet assets required to generate an income statement profit. The biggest part of a drug channel company's balance sheet is current assets (cash, product inventory, or accounts receivable). For example, the value of product inventories, accounts receivables, and cash were more than 90% of the big three wholesalers’ current assets. (See Exhibit 43 of our 2015-16 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors.) In contrast, the biggest assets of a pharmaceutical manufacturer tend to be long-term, such as intangible assets, goodwill, and physical plant, property and equipment.

The profitability of companies in the Drug Channels universe looks much more attractive this way. In 2015, the group average was 6.6%. The ROA figures for drug channel companies now look closer to those of the pharmaceutical manufacturers, whose average profit as a percentage of assets was 10.7% in 2015. The manufacturer-to-channel ratio was less than 2X for ROA. The chart below summarizes the average profit metrics.

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The difference reflects partly the innovation/risk premium associated with the expensive, risky, and time-consuming business of drug discovery. Pharmacies, wholesalers, and PBMs wouldn’t exist unless manufacturers created valuable and innovative drugs.

OBSERVATION #4: Independent pharmacies have profitability comparable to the largest public drug channels companies, including PBMs.

The 2015 NCPA Digest, Sponsored by Cardinal Health publishes 2014 financial and operating data submitted by pharmacy owners. It remains the only consistent source of independent pharmacy owners’ financial data. Unfortunately, NCPA chose not to release the detailed financials. (I suppose its policy is “Transparency for thee, not for me.”)

A little algebra plus some educated guesswork implies that average Return on Sales was 2.8% for these smaller pharmacies. Private pharmacies don't always manage based on the same return metrics as a public company. The independent pharmacy data, however, continue to show profits comparable to or exceeding that of the public companies.

OBSERVATION #5: In 2015, investors earned comparable returns from both manufacturers and Drug Channels companies.

Last year's stock market was far worse than previous years. Here are the average Total Return to Investors in 2015 as reported from Fortune's list:
  • 7 Drug Channels companies: +6.9% (range: -4.5% to +16.4%)
  • 11 Manufacturers: +5.2% (range: -9.8% to +25.3%)
Both groups did better in 2015 than the S&P 500 index, which finished down about 1% for the year.

  • For consistency, all data are taken from Fortune's measurement of key financial metrics, which appear to be derived from Generally Accepted Accounting Principles (GAAP) reporting. A link to the methodology appears on the Fortune 500 main page. (Sorry, no direct link.) 
  • Note that GAAP accounting may not reflect the true underlying operating performance of a business. This year, AmerisourceBergen’s figures show the most notable discrepancy, which was driven by the non-operating expenses related to its hedging of the Walgreens Boots Alliance warrants. See Section 9.5.1. of our 2016 Economic Report on Retail, Mail, and Specialty Pharmacies .
  • I include only those drug channel 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 Fortune 500 list excludes companies incorporated outside the U.S. Large domestic subsidiaries drop off the list after being acquired by a foreign company.

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