McKesson (NYSE: MCK) is one of the world's largest corporations and the leading company in the $252 billion pharmaceutical distribution industry, with revenue nearly reaching $109 billion in fiscal 2010. McKesson distributes ethical and proprietary drugs, health and beauty care products, pharmacy hardware, and medical and surgical supplies throughout North America. McKesson also provides enterprise-level software solutions to hospitals and other healthcare organizations. In the past, McKesson operated on a buy/hold business model but recently shifted to a fee-for-service business model in order to eliminate the company's dependency for profit on drug price inflation.
A variety of factors have affected McKesson and others in the pharmaceutical distribution industry. The shift from branded to generic drugs as branded drugs lose their patents, thus allowing distributors to benefit from both higher profit margins and higher total sales by volume. 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.
McKesson has diversified outside of pharmaceutical and medical supplies businesses through its healthcare software and information technology offerings. Although this segment accounts for only approximately 2% of McKesson's revenue currently, it is by far McKesson's most profitable business. The market for healthcare IT is large and fragmented (the top 17 firms in the healthcare IT industry collectively hold only approximately 40% of the market), and there is potential for McKesson to build on its leading market share in this high-margin sector.
McKesson is a distributor of goods and services for the healthcare industry. The company generates its business almost exclusively in North America, with approximately 93% of its revenue generated domestically and the majority of international revenue coming from Canada. McKesson's operations are divided among three business segments:
The overwhelming majority (95%) of McKesson's revenue is generated by this operating segment. Through the Pharmaceutical Solutions segment, McKesson distributes pharmaceuticals and other healthcare products to national retail pharmacies, independent retail pharmacies, and healthcare organizations and institutions. This segment also provides pharmacy equipment and management and operations solutions to pharmaceutical manufacturers and pharmacies.
McKesson has refocused the Medical-Surgical Solutions segment on supplying products and services to higher-margin alternate-site healthcare customers, which include physicians' offices, surgical centers, clinics, and long-term care facilities. Margins in these alternate-site markets are more than double that of the traditional drug distribution margins of 1-2%. When McKesson consummates the divestiture to OMI, margins should continue to improve in the magnitude order of percentage points.
Provider Technologies is McKesson's smallest operating segment by revenue but generates the highest operating margin of all three segments. This operation provides a wide range of software and IT services for healthcare organizations such as hospitals, physician offices, homecare providers, and pharmacies. Examples of solutions include clinical management, revenue cycle management, automation, and enterprise imaging. McKesson also provides outsourcing services through this segment so that healthcare organizations can focus on providing care to their customers while McKesson takes over their information processing and systems operations
McKesson's customer based is comprised of healthcare organizations such as retail pharmacies, hospitals, clinics and homecare providers. The company depends heavily on a small number of customers; McKesson's ten largest customers account for approximately half of total revenue, and its top customer, CVS Caremark Corporation (CVS), generates about 11% of total revenue. Thus McKesson bears the risk of large revenue swings if a key customer leaves for a competitor such as Cardinal Health (CAH). Given that the company operates in a highly competitive industry, it is not uncommon for customers to switch distributors to get better prices or service.
In the past McKesson and the other pharmaceutical distributors, Cardinal Health and AmerisourceBergen, operated on a buy/hold business model under which a company would purchase drugs from manufacturers in large quantities based on what their own pricing models predicted would happen to the value of the drugs. Then McKesson would sell the drugs to its customers for--hopefully--a higher price than that paid for the drugs.
However, McKesson and its competitors have switched their business model to a fee-for-service (FFS) model. Distributors now have arrangements with manufacturers that provide fees and/or discounts to distributors for meeting certain levels and requirements. Although the shift to FFS has cut down on the influence of drug price inflation on McKesson’s margins, price inflation still accounts for approximately 20-25% of McKesson’s profits.
Generic drugs have a compound benefit of being priced lower for consumers--leading to higher demand--and higher margin for distributors compared to branded drugs. Thus, while total revenue may decrease due to lower pricing, generic drugs allow pharmaceutical distributors such as McKesson to become more profitable from an absolute value and margin perspective. It is estimated that patents on nearly $70 billion worth of branded drugs will expire in the next five years, which could result in a large shift in the generic/branded drug mix in the pharmaceutical market and improve McKesson's bottom line.
However, 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 key inflection point occurs when a generic drug’s price is about 3% of its branded version’s price.
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:
As seen in this example, distributors can get much higher margins from generic drugs in the short term.
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.
The healthcare IT market is currently estimated to be worth approximately $20 billion. This sector lacks any dominant players and is characterized by intense competition and fragmentation. McKesson is considered the leader in healthcare IT with an estimated 22% share; however the top 17 firms in the market collectively control only 40% of the market. McKesson has steps towards consolidating its leading position by acquiring several healthcare IT companies that produce software and solutions for healthcare facilities. These acquisition targets include:
As a member of the healthcare industry, McKesson is influenced by healthcare policy adopted by the US government. If legislation is enacted that affects the pricing of drugs or the volume of medication and healthcare supplies purchased through Medicaid and Medicare, it greatly affects McKesson and the other pharmaceutical distributors. Medicare especially is relevant to McKesson's business because it covers approximately 20% of the US population; also, through Part D of Medicare the federal government expects to spend over $700 billion on prescription drugs in the next ten years. Changes in Medicare, particularly in prescription drug coverage are incredibly important to the pharmaceutical industry and distributors such as McKesson.
Another trend that may affect McKesson significantly is a change in the way Medicaid purchases medication for patients. Rather than using the average wholesale price for drugs as has been the practice in the past, Medicaid will begin using average manufacturer price to purchase pharmaceuticals. AMPs are significantly lower than AWPs, which could drive down margins on drugs and subsequently the profit McKesson makes as a distributor.
As the abnormally large "baby boomer" generation reaches senior citizenship a larger group of citizens will fall under the coverage of Medicare than ever before. Also, those who do not draw upon the benefits of Medicare are more likely to spend more on pharmaceuticals and other healthcare services than younger US citizens. Thus overall spending in the pharmaceutical industry is expected to surge significantly as the baby boomers age and retire, which could benefit manufacturers, distributors, and retailers alike.
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).
McKesson is one of three companies in a virtual oligopoly in the pharmaceutical distribution industry. McKesson's two competitors are Cardinal Health (CAH) and AmerisourceBergen Corporation (Holding Co) (ABC). Although these three companies dominate the pharmaceutical distribution market, McKesson holds a significant lead in the industry in terms of revenue (almost $93 billion as opposed to Cardinal Health's $81 billion and AmerisourceBergen's $61 billion). The three corporations all compete as distributors in the healthcare industry but McKesson competes directly with Cardinal Health and AmerisourceBergen in slightly different markets.
While McKesson and Cardinal Health and 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.