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WIKI ANALYSIS
Cardinal Health is one of three major players in the $252 billion pharmaceutical distribution industry. To react to slower growth in branded drug prices, Cardinal recently changed its compensation system to fee-for-service, resulting in steadier cash flow. The company is currently using the bulk of its free cash flow to repurchase its common stock and restructure itself to become more profitable in the long run. Out of the three large pharmaceutical distribution companies, Cardinal is the most diversified, insulating it more against possible risk in the distribution business.
A variety of factors have affected the pharmaceutical distribution industry. The shift from branded to generic drugs allows distributors to gain higher profit margins, but threatens the total market sales of pharmaceuticals. Changes in health care policy--especially Medicare--can result in a larger volume of drugs being purchased, but threaten with cost controlling and transparency. As the U.S. population grows older, there will be a higher demand for pharmaceuticals. However, there is also the longer-term threat that providers and manufactures may one day be able to cut out the middlemen distributors.
Business Overview
Headquartered in Dublin, OH, Cardinal Health is a holding company founded in 1979. Its main business is pharmaceutical distribution, which generates roughly half of Cardinal’s earnings. As a wholesaler, Cardinal is an intermediary, or middleman, between manufacturers and providers (e.g. pharmacies). The company mainly warehouses and distributes branded and generic drugs, and also offers additional services to both manufacturers and pharmacies. These include logistic solutions, storing and tracking supplies, and managing returns and recalls on products.
Cardinal is the most diversified company in the pharmaceutical distribution sector. Besides distributing branded and generic drugs, Cardinal also:
- Distributes medical and surgical supplies and provides limited services
- Manufactures a wide range of commonly used medical and surgical supplies
- Provides clinical technologies and services for hospitals to manage medications; this mostly entails storing and tracking specialty supplies and preventing hospital-acquired infections
| Fiscal Year | % Operating Margin | Revenue ($ Billions) |
| 2003 | 2.2% | $56.7 |
| 2004 | 1.7% | $65.1 |
| 2005 | 1.1% | $74.9 |
| 2006 | .9% | $81.4 |
| CAGR | 13% |
Switch to Fee-for-Service Compensation
The entire pharmaceutical distribution industry has undergone significant changes in recent years, as the compensation system changed from forward buying to fee-for-service payment. Before the transition, wholesalers profited by speculative buying of pharmaceuticals. After distribution, they could sell the pharmaceuticals to providers at a higher cost as prices inflated. Profit margins shrank, however, as the growth in the price of branded pharmaceuticals slowed. Distributors are now reimbursed by fee-for-service payments, as customers negotiate contracts to pay a certain fee for deliveries and additional services. These changes result in a steadier, more controlled cash-flow for distributors. Currently, price inflation still accounts for about 20%-30% of profit margins.
This transformation, along with SEC inquiries and changes in health care, wrought turbulent times in the pharmaceutical distribution industry. Distributor stocks fell more than 36% in 2002, and hit bottom in 2004. However, as investors gained confidence in the new compensation system, distributors’ stocks have rallied, outperforming the S&P 500 by about 11% since 2004.
Share Repurchasing
Cardinal Health sold its Pharmaceutical Technologies and Services (PTS) segment to the Blackstone Group (BX) in 2007 for net proceedings of $3.1 billion. The company announced that much of the cash from this transaction, as well as a large portion of free cash flow, would be used to repurchase shares.
| Fiscal Year | Shares Repurchased ($m) |
| 2002 | $308 |
| 2003 | $1,192 |
| 2004 | $1,500 |
| 2005 | $500 |
| 2006 | $1,500 |
“One Cardinal Health” Initiative
Cardinal Health is currently in the midst of a restructuring effort which is expected to boost operating profits annually by about $500 million. The initiative is expected to be complete by the end of fiscal year 2008 and will aim to improve the long-term value of the company by focusing on internal operations. Cardinal had been an aggressive acquirer over the last decade, but with its new inward focus, the management has said it wants to stay away from large mergers or acquisitions.
Key Customers and Suppliers
Cardinal Health’s main market is in the United States. The company depends heavily on several key customers and suppliers:
- CVS and Walgreens accounted for about 35% of total revenue combined
- Cardinal’s top five customers accounted for about 46% of total revenue
- 15% of Cardinal’s total revenue is from group purchasing organizations (GPOs)
- Pfizer, Cardinal’s largest supplier, accounts for about 9% of total supplies
- Cardinal’s top five suppliers accounted for about 33% of total revenue
Note: all statistics based on fiscal year 2006
Trends, Forces, & Risks
Historically, the most significant trend that has affected the pharmaceutical distribution business has been the volume and price of drugs purchased in the United States. Distributors benefit directly from a greater amount of pharmaceuticals consumed by the American public. Although total pharmaceutical market sales have been increasing for the past years, the growth has fallen from about 18% at the beginning of 2001 to 5% in 2005.
The decline in growth has been attributed to a number of factors that remain significant today. First, there was a shrinking number of “blockbuster drugs,” or popular, trendy pharmaceuticals, as patents expired and consumers purchased cheaper generic versions. Less expensive drugs result in lower total market sales, and less profit for distributors. Second, changes in health care such as tighter regulations and cost shifting to consumers have adversely affected total market sales.
Generic Drugs
The growth of generic drugs has caused total market dollar sales to drop, as consumers purchase the cheaper versions of branded pharmaceuticals. While total market sales for distributors also drop, distributors can earn profit margins over five times greater on generics than on branded drugs. With $13.6 billion in branded drugs sales losing patent protection in 2006 and a projected $69 billion in branded drug sales losing protection from 2007-2011, generic drugs’ effect on distributors is very significant.
Benefits
Because generics are much like normal commodities, they have a large reliance on wholesalers. Because wholesalers contract packages with multiple pharmaceuticals to their clients, they can essentially guarantee their clients as buyers for a generic drug. Therefore, wholesalers control a significant portion of the demand for any individual generic. Competition amongst generic manufacturers allows wholesalers to then extract better terms from the manufacturers, hence the much higher profit margins with generics than with branded drugs. Furthermore, generic distribution involves lower inventory and general operating costs.
Pitfalls
There is no guarantee that the pharmaceutical distribution business can maintain profits as the market shifts towards generic drugs. Although currently the generic drugs have a positive impact on the distribution industry, there are concerns that competition between generics could hurt profits. When competition causes prices to collapse, absolute earnings begin to fall, and sometimes distributors earn less with generics than they did previously with the branded version. This occurs when a generic drug’s price is about 3% of its branded version’s price.
Six Month Exclusivity
Sometimes after a patent for a drug expires, one generic is given a six month exclusivity period. During this time period, prices do fall because of the branded version’s competition with the single generic, but prices do not collapse. Six month exclusivity periods benefit drug distributors, and the majority of recent and upcoming generics have used them.
Take for example Prozac, a drug whose generic version was released in August of 2001:
- The generic was launched with a price three-fourths that of branded Prozac.
- By February 2002--at the end of the exclusivity period--it cost 37% of the branded price.
- After the exclusivity period, prices collapsed, and by July 2006 it cost 2.5% of the branded price.
As seen in this example, distributors can get much higher margins from generic drugs in the short term.
Possibility of a “Price War”
If distributors begin aggressively competing for the business of generics, profit margins will collapse on generic drugs. This circumstance would be detrimental to the entire industry, because generics already cause lower total market sales. Because the major players in the distribution industry understand this risk, it is unlikely that such a price war would occur.
Healthcare Policy
Any health care policy that affects the volume or price of pharmaceuticals purchased in the U.S. will most likely affect the distributor industry. A focus on health care by politicians nearing elections involving negotiating or even setting pharmaceutical prices could potentially have negative consequences for distributors. Medicare, which covers approximately 20% of Americans, has an enormous influence on the volume and price of drugs purchased. Any changes in Medicare or Medicaid policy should be closely monitored by investors for its effect on the total market sales of pharmaceuticals. Below are the two most prominent recent issues.
Medicare Part D
The government expects to spend over $700 billion on Medicare Part D over the next ten years. Part D boosts distributor volumes, because seniors' medical coverage is increased. Additional effects on distributors are:
- Accelerated generic penetration
- Distributors can provide new services related to Part D
Most likely, the distribution industry has already seen most of the volume benefits from Part D. In the longer term, these benefits may be offset by increased managed care, limiting volume of branded drugs, and/or tighter cost control.
AMP Transparency
Starting this year, Medicaid will pay providers using average manufacturer price (AMP) rather than average wholesale price (AWP). It is estimated that AMP is 70% lower than AWP for generics and 59% lower overall. This causes mostly retail pharmacies to be compensated less than previously with AWP, putting pressure on provider margins and ultimately pressuring distributor margins. Also, Centers for Medicare and Medicaid (CMS) will make monthly AMP information publicly available on the Internet. Increased transparency may pressure profit margins on generics. However, because distributor pricing already reflects a competitive market, there may be little to no effects.
Disintermediation
Last year, Wal-Mart announced it would sell nearly 300 drugs for $4 in its Tampa Bay stores. Wal-Mart buys most of its generics directly from manufactures, leaving out the middlemen distributors. The retail behemoth plans to go national with the prices initially offered in its Tampa Bay stores. Wal-Mart's actions could spur its competitors to expand the purchasing a broader portfolio of generics directly from manufacturers. This risk, along with the possibility of more mail-order penetration, could damage the distributors’ market.
However, distributors offer a range of services that are critical to both manufactures and providers, so disintermediation does seem very unlikely in the near future. Additionally, there has been a boom in biotechnology products; this should benefit distributors because these products are more complex to distribute (e.g., they have shorter shelf life and/or require refrigeration).
Aging Population
A larger senior citizen population benefits distributors, because seniors aged 65+ spend about four times more on health care per capita than the under 65 population. The Medicare-aged segment is expected to grow from 12% to 16% by 2020 and over 20% by 2050. The demographic shift towards an older population should benefit distributors, because a higher volume of purchased pharmaceuticals results in higher revenues. Below is a chart displaying the annual prescriptions medicine spending by age cohort.
Competition
Cardinal Health competes in the the pharmaceutical distribution market primarily with McKesson (MCK) and the AmerisourceBergen Corporation (ABC). All three companies are roughly the same size and offer the same basic products and services. Combined, the triumvirate account for 80% of sales in the distribution industry.
The entry barrier into the distribution business is very high, so it is unlikely that there will be any emerging players in the market. Cardinal Health is by far the most diversified company out of the three, making it more insulated from risks in the drug distribution business. However, competition is fierce in these segments, and earnings may be more volatile than in the drug distribution segment. Out of the three competitors:
- ABC has more of a focus on independent pharmacies, which need more services, but are susceptible to being put out of business by large retail chains such as CVS (CVS) and even Wal-Mart Stores (WMT).
- CAH and MCK have more of a market share in genetics than ABC
- ABC has a focus on specialty drugs; MCK’s specialty business is growing
- CAH has recently divested some of its specialty distribution
- CAH and MCK distribute a wide range of medical and surgical supplies and CAH's is more profitable
Below is a graph comparing the percentages of revenue from the different segments of the three major players. Notice that Cardinal Health is much more diversified than the other two.
| Company | Rx Distribution | Med/Surg Supplies | Provider IT | Automation Services | Long-term care pharmacy |
| ABC | 97% | n/a | n/a | n/a | 3% |
| CAH | 80% | 13% | 4% | 3% | n/a |
| MCK | 94% | 4% | 2% | n/a | n/a |
All three competitors have somewhat similar market shares and potential in the distribution business: 33% for MCK; 30% for CAH; and 22% for ABC. However, diversification of these three companies seems to be the main opportunity for growth and mounting competition. All three have attempted to further diversify their businesses over the past five years, as drug distribution margins remain below 2%, and margins in other segments are frequently in the double digits.
Cardinal Health has built a comprehensive portfolio of higher margin services over the past few years. At the beginning of fiscal 2007, it split into five reported segments (one has since been divested and will be excluded): 1) Clinical Technologies and Services; 2) Medical Products Manufacturing; 3) Supply Chain Services - Medical; and Supply Chain Services- Pharmaceutical. Cardinal Health recently divested the poorly performing Pharmaceutical Technologies and Services segment, selling it to the private equity company Blackstone Group (BX). The failure of this segment may be an indicator of the fiercer competition and trouble distributors will experience in diversifying.
McKesson Health's IT segment, Provider Technologies, currently its smaller diversification effort, is undergoing a restructuring effort. This includes an expansion of about 75-100 sales people in anticipation of growth in the IT technologies segment. This growth is expected because of increased government support and provider interest, due to IT's potential for cost cutting and improved patient safety.
While Cardinal Health and McKesson do compete with each other in medical and surgical manufacturing, their other diversified segments mainly compete with outside competitors. These competitors include: Owens & Minor (OMI) and Henry Schein (HSIC) in the manufacturing segment and Cerner (CERN) , Eclipsys (ECLP) , Allscripts Healthcare Solutions (MDRX) , and Computer Programs and Systems (CPSI) in information technologies. AmerisourceBergen is considered more of a "pure" player distributor, and its diversification is pretty minimal.
References
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