Drug Channel Profits in the 2011 Fortune 500

It's time for my annual review of the latest Fortune 500 list. This annual review gives you perspective on the relative profitability of the largest drug wholesalers, chain pharmacies, pharmacy benefit managers (PBMs), and manufacturers. I also compare this group to independent pharmacies.

Key observations:

• The biggest drug channel companies are much bigger (in revenues) than pharmaceutical manufacturers—but this is a misleading comparison. It also leads to a "pennies in profit" fallacy, when in fact drug channels companies are quite profitable.
  
  
• Median profitability of drug channels companies was up slightly in 2010. Profitability of the channel companies is about half of the profitability of pharmaceutical manufacturers when using a more appropriate metric such as Return on Assets.
  
  
• The profitability of a typical independent pharmacy is well above the median profitability of the nine largest drug channels companies, including PBMs.
  
  
• Investors once again earned higher returns from the drug channels group in 2010 as well as over the past 10 years.

Please post any questions or reactions as comments. The technical notes are at the bottom.
THE COMPANIES

Here are the nine largest drug wholesalers, pharmacy chains, and PBMs on the 2011 list along with Fortune 500 rank and links to the financial data as reported by Fortune:

• McKesson (MCK): 15
• Cardinal Health (CAH): 19
• CVS Caremark (CVS): 21
• AmerisourceBergen (ABC): 27
• Walgreen (WAG): 32
• Medco Health Solutions (MHS): 34
• Express Scripts (ESRX): 55
• Rite Aid (RAD): 100
• Omnicare (OCR): 371

Here's a handy summary of the data for these nine companies. (Click to enlarge.)

You can also view the the 12 largest pharmaceutical manufacturers on Fortune's 2011 list. (The profit data for Allergan is missing for some reason, so I eliminate their data in the computations below.)

REVENUES

The channel intermediaries are much larger than the manufacturers. Median revenues for the nine drug channels companies were $67.4 billion in 2010 versus $17.3 billion for the manufacturers. Three companies—McKesson, Cardinal Health, and CVS Caremark—are in the top 25 of the Fortune 500 list, while the highest ranking manufacturer (Pfizer) only reached #31. For comparison, the 12 largest pharmaceutical manufacturers on the Fortune 500 list have revenues ranging from $67.8 billion (Pfizer) to $4.5 billion (Genzyme).

Note that the Fortune 500 rankings are based on sales revenues, so that double-counting artificially inflates the top-line of a channel participant. For instance, a single prescription’s revenue could be counted at least four times in the Fortune 500 rankings:

1. When a drug is sold by a manufacturer to a wholesaler;
2. When a drug is sold by a wholesaler to a pharmacy;
3. When a drug is sold by a pharmacy to a consumer; and
4. When a pharmacy receives reimbursement from a PBM.

PROFITS

As you can see in the table above, Return on Sales (ROS; profit as percent of revenues) was in the low single digits for all companies in this group, regardless of their position in the supply chain (retail pharmacy, wholesaler, or PBM). The weighted average ROS (not shown) for the Drug Channels group was 1.7% in 2010, up slightly from 2010's weighted average of 1.4%.

In contrast, weighted average profit as a percentage of revenues in 2010 was 15.3% of revenues for the eleven drug manufacturers(range: 1.9% to 36.5%). Thus, the manufacturer-to-channel ratio is 8.9X, i.e., ROS for the manufacturers was about nine times the ROS for drug channels companies.

However, 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). ROA relates ROS to the balance sheet assets required to generate an income statement profit. The biggest part of a drug channels company's balance sheet are current assets (cash, product inventory, or accounts receivable), whereas the biggest assets of a pharmaceutical manufacturer tend to be long-term assets such as intangible assets, goodwill, or physical plant, property, and equipment.

The profitability of companies in the Drug Channels universe looks much more attractive on this basis. The group median is 4.5% (Range: -6.3% to +11.2%). As always, Rite-Aid is bringing up the rear.

The ROA figures for drug channel companies is more comparable to the pharmaceutical manufacturers, whose median profits as a percent of assets was 10.0% in 2010. The manufacturer-to-channel ratio is now only 2.2X for ROA (versus 9X for ROS). The difference in part reflects the innovation/risk premium associated with the expensive, risky, and time consuming business of drug discovery. Drug Channels companies wouldn’t exist unless drug manufacturers actually created valuable products.

INDEPENDENT PHARMACIES

The 2010 NCPA Digest provides the following data for independent pharmacies in 2009 (the most recent year available):

• Average ROS = 3.3%
• Average ROA = 19.6%

In other words, the business of independent pharmacy is more profitable than the big public companies, including the PBMs. As I wrote in January, Owning a Pharmacy is Still Pretty Profitable. Oddly, the independent pharmacy's trade association continues to complain about PBM profits.

INVESTMENT RETURNS

Investment returns reflected last year's good stock market performance. Here are the median Total Return to Investors in 2010 as reported from Fortune's list:

• 9 Drug Channels companies: +9.1% (Range: -41.5% to +32.4%)
  
• 11 Drug Manufacturers: +2.8% (Range: -16.2% to +45.3%)

Once again, investors in drug channels did better than investors in drug makers, both in 2010 and over the 2000-2010 period. Just another demonstration of the power of generics, which benefit the channel but hurt brand-name manufacturers.

A FEW TECHNICAL NOTES

• All data come from Fortune's (admittedly crude) measurement of key financial metrics for consistency.
• I only include Drug Channels 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 ROA for independent pharmacies is computed as (Average Operating Income / Estimated Average Assets) using data from the 2010 NCPA Digest.