Profits in the 2015 Fortune 500: Manufacturers vs. Wholesalers, PBMs, and Pharmacies

Time for my annual review of the latest 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 2015 Fortune 500 list contains eight drug channels companies—AmerisourceBergen, Cardinal Health, CVS Health, Express Scripts, McKesson, Omnicare, Rite Aid, and Walgreens.

Using the Fortune data, I explore the profitability and shareholder returns of the largest drug wholesalers, chain pharmacies, pharmacy benefit managers (PBMs), and pharmaceutical manufacturers. I compare these companies with the Fortune 500’s 11 pharmaceutical manufacturers and a separate survey of independent pharmacies. I doubt you will be hungry for more analysis in one hour.

THE COMPANIES

Here's our exclusive Drug Channels summary of the eight drug wholesalers, drugstore chains, and PBMs on the 2015 list. Next year’s list will have at least one fewer drug channels company.

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Here’s a companion table of the 11 largest pharmaceutical manufacturers on Fortune's 2015 list.

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Methods and sources are at the bottom.

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

Drug channel companies have higher revenues than pharmaceutical manufacturers, so they rank higher on the Fortune 500.This results from quadruple-counting of prescription revenues within the channel.

In 2014, average revenues for the eight drug channel companies were $87.2 billion, up 7% vs. 2013. Average revenues for the manufacturer group were $26.5 billion.

Six of the drug channel companies rank in the top 50 of the Fortune 500 list, while one manufacturer (Johnson & Johnson) made the top 50. The revenues of the 11 largest pharmaceutical manufacturers on the Fortune 500 list range from $74.3 billion (J&J) to $7.2 billion (Allergan). In March 2015, Actavis acquired Allergan. Since Actavis is based in Dublin, neither company will appear on the 2016 Fortune 500.

Note that the Fortune 500 rankings are based on sales revenues, which inflates the topline of a channel participant. Here's a reminder of how single prescription can hypothetically be counted as revenue by four different Fortune 500 companies:

• A manufacturer sells a pallet of WonderDrug to a wholesaler. The manufacturer reports the net revenue from the sale on its income statement.

• The wholesaler sells a case of WonderDrug to a pharmacy. The wholesaler reports the net revenue from the sale on its income statement.

• The pharmacy dispenses a WonderDrug prescription 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.

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

When their profits are measured by Return on Sales (= Net Income ÷ 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 low single digits for all companies in this group, regardless of their position in the channel (pharmacy, wholesaler, or PBM). In 2014, the average ROS for the Drug Channels group was a mere 1.4%.

In 2014, the drug manufacturers’ average profit as a percentage of revenues was a much more robust 22.7%. Thus, the ROS for the manufacturers was more than 16 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 is about one-quarter 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, or accounts receivable). For example, the value of product inventories and accounts receivables are more than 80% of the big three wholesalers’ current assets. (See Exhibit 39 of the 2014-15 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 2014, the group average was 3.3% (range: 1% to 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 11.8% in 2014. The manufacturer-to-channel ratio is only 3.6X 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 (probably) have higher profitability than the eight largest drug channels companies, including PBMs.

The 2014 NCPA Digest, Sponsored by Cardinal Health publishes 2013 financial and operating data submitted by pharmacy owners. It remains the only consistent source of independent pharmacy owners’ financial data. Last year, NCPA chose not to release the detailed financials. (I guess transparency is only good for everyone else.)

A little algebra plus some educated guesswork implies that average Return on Sales was 3.3% for 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 exceeding that of the public companies.

OBSERVATION #5: In 2014, investors earned comparable returns from both manufacturers and Drug Channels companies.

Both groups fared well in last year's stock market. Here are the average Total Return to Investors in 2014 as reported from Fortune's list:

• 8 Drug Channels companies: +30.3% (range: +20% to +48%)

• 11 Manufacturers: +30.0% (range: +5% to +91%)

A FEW TECHNICAL NOTES

• For consistency, all data are taken from Fortune's measurement of key financial metrics. A link to the methodology appears on the Fortune 500 main page. (Sorry, no direct link.) This year, the Fortune data are rounded to the nearest whole number, so there is a some loss of precision.

• 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, e.g., Allergan.