Wednesday, June 05, 2019

Profits in the 2019 Fortune 500: Manufacturers vs. Managed Care vs. Pharmacies, PBMs, and Wholesalers

Time to dive into our 12th (!) 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.

Fortune’s 2019 list contains only six drug channel companies: AmerisourceBergen, Cardinal Health, CVS Health, McKesson, Rite Aid, and Walgreens Boots Alliance.

Consolidation and vertical integration have transformed the channel—and the Fortune rankings. Below you will see our list of the companies that disappeared from the roster. We therefore have added to our analysis the four managed care and insurance companies on the list that operate PBMs.

Using the Fortune data, I explore the profitability and shareholder returns of the largest drug channel and managed care companies. I compare these companies with the Fortune 500’s eleven pharmaceutical manufacturers and with a separate survey of independent pharmacies.

These data remind us that many multi-billion-dollar businesses profit as drugs move through the U.S. reimbursement and distribution system. Enjoy our swim through this crazy complexity.

MEET THE COMPANIES

Below is our detailed Drug Channels summary of the drug wholesalers, drugstore chains, managed care companies, insurers, and PBMs on the 2019 Fortune 500 list. See the methodology section at the end of this article for help in interpreting these data and notes on our company selection criteria.

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Three important items:
  • The chart’s second column identifies each company’s primary role(s) in the channel. Most companies also play other roles in the system beyond those listed.
  • Many of the companies have business relationships with other companies. For example, wholesalers supply the retail, mail, and specialty pharmacies of the drugstores and PBMs.
  • Two significant vertical transactions—CVS Health’s acquisition of Aetna, and Cigna’s acquisition of Express Scripts—were concluded late in 2018. The figures for CVS Health and Cigna therefore primarily reflect their financial results prior to these transactions.
Here are the drug channel companies that have vanished from the Fortune list since our first review, in 2008:
  • Catalyst Health Solutions (merged with SXC to form Catamaran, which was acquired by UnitedHealth Group’s OptumRx business)
  • Express Scripts (acquired by Cigna)
  • Longs Drug Stores (acquired by CVS Health)
  • Medco Health Solutions (acquired by Express Scripts)
  • Omnicare (acquired by CVS Health)
  • PharMerica (acquired by Walgreens Boots Alliance and the private equity firm KKR)
Here’s a companion table of the 11 largest pharmaceutical manufacturers on Fortune’s 2019 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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ADAM’S OBSERVATIONS

Here are five takeaways from the 2019 Fortune list.

OBSERVATION #1: Drug channel and managed care companies are much larger than manufacturers.

Drug channel companies have higher revenues than pharmaceutical manufacturers, so they rank higher on the Fortune 500. For 2018, average revenues for the six drug channel companies were $144.9 billion and $84.8 billion for the managed care companies. Average revenues for the manufacturer group were $30.8 billion, or about one-fifth of the channel companies' average.

Six of the drug channel and managed care companies rank in the top 20 of the Fortune 500 list. However, none of the manufacturers made ranked that high on the 2009 list. Global revenues of the 10 largest pharmaceutical manufacturers on the Fortune 500 list range from $81.6 billion (J&J; #37) to $6.7 billion (Regeneron; #450).

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. The managed care companies also include a portion of revenues from provider healthcare services.

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 2019 Economic Report on U.S. Pharmacies and Pharmacy Benefit Managers:

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Consider UnitedHealth Group, which had revenues of $226.2 billion in 2018. For 2018, revenues at its OptumRx subsidiary were $69.5 billion. Interpreting the OptumRx figure is challenging, because:
  • it includes a combination of prescription revenues from its own mail/specialty pharmacies plus external retail network pharmacies.
  • It is reported net of rebates.
  • It excludes the value of members’ out-of-pocket payments from revenues from retail network dispensed prescriptions, but includes the value of these member payments from prescriptions dispensed by its in-house pharmacies.
  • It includes revenues of $39.4 billion (57%) from services provided to other subsidiaries, e.g. UnitedHealthcare
Here’s another important distinction: 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.

By contrast, manufacturers report net revenues after gross-to-net discounts and rebates to third-party payers. In 2018, these discounts and rebates totaled $166 billion, which reduced manufacturers' gross revenues. See our analysis of the bubble’s size and composition here: www.GrossToNetBubble.com.

Note that I have included revenue per employee computations in the analysis. As you can see, revenue per employee averaged $2.6 million at the drug channel companies, $1.1 million at the drugmakers, and $0.9 million at the managed care companies. The drug channel companies require a lot more revenue to generate the 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 single digits for all companies in this group, regardless of their position in the channel (pharmacy, wholesaler, PBM, or managed care).

In 2018, the average ROS for the drug channel group was 1.3%, down from 2.2% in 2017. Managed care companies’ average ROS was a healthier 3.5%. In 2018, the drug manufacturers’ average profit as a percentage of revenues was much higher, at 23.9%.

OBSERVATION #3: When measured by Return on Assets, drug makers’ profitability looks much more comparable to that of other industry participants.

ROS is a flawed measure of the profitability of revenues that pass through channel and insurance intermediaries. A more meaningful metric is Profits as a % of Assets, a.k.a., Return on Assets (ROA). When profits are measured by ROA, channel and managed care company profitability is 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 accounts for more than 90% of the Big Three wholesalers’ current assets. (See Section 5.2 of our 2018-19 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors.) Receivables, goodwill, and cash account for the majority of balance sheet assets on a managed care companies’ balance sheet. 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 2018, the drug channels group average was 3.8%, down from 4.9% in 2017. In 2018, the managed care group average was 4.3%.

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 11.5% in 2018. The manufacturer-to-channel ratio was 18X based on ROS, but only 3X based on ROA. The chart below summarizes the average profit metrics.

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As I see it, the difference reflects partly the innovation/risk premium associated with the expensive, risky, and time-consuming business of drug discovery. Pharmacies, wholesalers, PBMs, and insurers wouldn’t exist if manufacturers had not created valuable and innovative drugs.

Note that the figures above show the unweighted average. With enough time and resources, we could compute a weighted average of these companies. However, I suspect that the conclusions would be similar to those using the unweighted figures.

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—or higher than—that of the largest public drug channel companies.

In Independent Pharmacy Economics Keep Deteriorating, we examined 2017 financial and operating data submitted by pharmacy owners.

A little algebra plus some educated guesswork suggests that in 2017, average Return on Sales was 1.9% 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 2018, investors earned very poor returns from drug channel companies.

Last year's stock market was another bad one for investors in drug channel companies. Here are the average Total Return figures for 2018 as reported by Fortune’s list:
  • 6 Drug channel companies: -24.3% (range: -64.0% to -3.7%)
  • 4 Managed care companies: +4.3% (range: -41.1% to +27.5%)
  • 11 Manufacturers: +4.2% (range: -38.6% to +40.3%)
Investors were rattled by the Trump administration’s focus on drug channel companies, a slowdown in drug list price inflation, the prospects for a world without rebates, states' legislation to change PBM business models, and the possibility that the gross-to-net bubble could pop. Amazon’s PillPack acquisition didn’t calm any nerves.

NOTES FOR NERDS

  • A company’s 2019 Fortune ranking is based on its reported 2018 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. I can’t find a link to Fortune’s methodology. Note that GAAP accounting may not reflect the true underlying operating performance of a business.
  • I have included only those companies that earned a majority of their revenues from pharmaceuticals and/or operated businesses focused on pharmaceuticals. I did not separate the revenues from each company's various lines of business.

    These criteria excluded retail formats with pharmacies (supermarkets and mass merchants). It also excluded managed care companies and insurers on the Fortune 500 that outsourced PBM operations to other businesses for 2018. Two of these companies—Anthem and Centene—are transitioning to internal PBMs and may appear in a future analysis.
  • 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 continues the site’s proud tradition of incredibly annoying autoplay videos. Oy.

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