Tuesday, June 12, 2018

Profits in the 2018 Fortune 500: Manufacturers vs. Wholesalers, PBMs, and Pharmacies

Time for my annual review of the Fortune 500 list. Every year, this is one of my most popular posts, because it helps us follow the dollar and understand how drug channel intermediaries make money. Our analysis also provides crucial background for understanding the Trump administration's drug pricing blueprint.

Fortune’s 2018 list contains the same seven drug channel companies that the 2017 list did: AmerisourceBergen, Cardinal Health, CVS Health, Express Scripts, McKesson, Rite Aid, and Walgreens Boots Alliance.

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 eleven pharmaceutical manufacturers and with a separate survey of independent pharmacies.

Alas, this may be our final review of the list, because by this time next year two companies—Express Scripts and Rite Aid—may no longer exist as independent public companies. In the meantime, let’s enjoy the crazy complexity of the U.S. drug distribution and reimbursement system.


Below is our detailed Drug Channels summary of the seven drug wholesalers, drugstore chains, and PBMs on the 2018 Fortune 500 list. See the methodology comments at the end of this article for help in interpreting these data.

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Two additional drug channels companies appear on the broader Fortune 1000 list: Diplomat Pharmacy (#556) and Fred's (#942). I have excluded them from the analysis, because of the large revenue gap between them and the seven included companies. Pharmerica appeared on last year’s list, but it was acquired by Walgreens Boots Alliance and the private equity firm KKR in 2017.

Here’s a companion table of the 11 largest pharmaceutical manufacturers on Fortune’s 2018 list. This year’s list includes AbbVie, Amgen, Biogen, Bristol-Myers Squibb Company, Celgene, Eli Lilly and Company, Gilead Sciences, Johnson & Johnson, Merck & Co., Pfizer, and Regeneron.

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Here are five takeaways from the 2018 Fortune list.

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

Drug channel companies have higher revenues than pharmaceutical manufacturers, so they rank higher on the Fortune 500. For 2017, average revenues for the seven drug channel companies were $131.1 billion, up 3.5% over the 2016 figure. Average revenues for the manufacturer group were $29.2 billion, or about one-fifth of the drug companies' average.

Six of the drug channel companies rank in the top 25 of the Fortune 500 list. By contrast, none of the manufacturers cracked the top 25. The revenues of the 11 largest pharmaceutical manufacturers on the Fortune 500 list range from $76.5 billion (J&J; #35) to $5.9 billion (Regeneron; #473).

Quadruple-counting of prescription revenues within the channel is the most important factor behind this disparity. Since the Fortune 500 rankings are based on sales revenues, this system pushes channel participants to the top of the list.

Consider how a single prescription could 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 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 a 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.
This flow of money and product is illustrated below in a chart from our 2018 Economic Report on U.S. Pharmacies and Pharmacy Benefit Managers:

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Many people do not consider another distinction: Manufacturers report net revenues after gross-to-net discounts and rebates to third-party payers. In 2017, these discounts and rebates totaled $153 billion, which reduced manufacturers' gross revenues. See www.GrossToNetBubble.com. That’s right—DCI now owns this domain!

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. This reality is the basis for many of the warped incentives discussed on Drug Channels—and is a crucial motivation for the Trump administration’s controversial drug pricing plan.

Note that I have included revenue per employee computations in the analysis. As you can see, revenue per employee averaged $2.8 million at the drug channel companies, but only $1.1 million at the drug makers. The drug channel companies require a lot more revenue to generate enough profit to cover salaries and overhead.

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

When measured by Return on Sales (= Profit ÷ Sales), the profits of wholesalers, PBMs, and pharmacies amount to a fraction of manufacturers’ profits. As you can see in the table above and chart below, Return on Sales (ROS) was in the low single digits for all companies in this group, regardless of their position in the channel (pharmacy, wholesaler, or PBM). In 2017, the average ROS for the drug channel group was 2.2%.

In 2017, the drug manufacturers’ average profit as a percentage of revenues was much higher, at 14.6%. The ratio has changed over time, as we discuss below.

OBSERVATION #3: When measured by Return on Assets, drug channel 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 is much closer to that of 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, and accounts receivable). For example, the value of product inventories, accounts receivables, and cash typically account for more than 90% of the Big Three wholesalers’ current assets. (See Section 5.2 of our 2017-18 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors.) The biggest assets of a pharmaceutical manufacturer, however, tend to be long-term and include such items as goodwill, physical plant, property, and equipment.

The profitability of companies in the drug channel universe looks much more attractive this way. In 2017, the group average was 4.9%. 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 6.3% in 2017. The manufacturer-to-channel ratio was much closer in 2017 compared with that of previous years. 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 if manufacturers had not created valuable and innovative drugs.

To measure the relative profitability of channel members, I prefer to compare gross profits with operating expenses. Gross profit reflects the value added by an intermediary in the distribution and reimbursement system. The ratio of gross profit to operating profits shows how effectively a channel intermediary converts gross profits from distribution into operating profits. Unfortunately, the Fortune list lacks the data to compute this non-GAAP metric.

OBSERVATION #4: Independent pharmacies’ profitability is comparable to that of the largest public drug channel companies.

We analyzed the 2017 NCPA Digest, Sponsored by Cardinal Health and examined 2016 financial and operating data submitted by pharmacy owners. It remains the only consistent source of independent pharmacy owners’ financial data, though NCPA now conceals the detailed financial data.

A little algebra plus some educated guesswork suggests that in 2016, average Return on Sales was 2.1% for independent pharmacies. Private pharmacies don't always manage their businesses based on the same return metrics as a public company. The independent pharmacy data, however, continue to show profits comparable to that of the public companies.

OBSERVATION #5: In 2017, investors earned very poor returns from drug channel companies.

Last year's stock market remained very bad for investors in drug channel companies. Here are the average Total Return to Investors figures for 2017 as reported by Fortune’s list:
  • 7 Drug channel companies: -9.3% (range: -76.1% to +19.4%)
  • 11 Manufacturers: +14.9% (range: -9.8% to +60.1%)
The channel companies were deeply affected by the market’s collective freak-out over the prospect of Amazon’s entering the industry. The overblown fear has died down, per my comments in Aprils’ news roundup. The combination of the Trump administration’s drug channel focus and negative fundamentals seems likely to scare away investors in 2018, too.

  • A company’s 2018 Fortune rank is based on its 2017 revenues.
  • 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.
  • I have included 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.

P.S. The Fortune 500 web page again features an incredibly annoying autoplay video. Seriously?!?

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