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:

• An unprecendented volume of brand-name drugs will lose exclusivity and face generic competition between now and 2013. See Medco's Generics Outlook: Party On, Dudes!
  
  
• The majority of drug wholesaler profits come from generic drugs. See Wholesaler Profits: Brand vs. Generic Drugs.

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.