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Krishna K

This article refers to the drug wholesaler. For the broadcaster ABC, see Walt Disney Company (DIS).

Whereas the company's competitors have expanded into medical product manufacturing, healthcare information technology, and other services,^{[1] [2]} ABC remains focused on pharmaceutical distribution.

With over $69B in pharmaceuticals slated to lose patent protection from 2007-2011, lower cost generic drugs carry the very real potential to lower revenue and profits for distributors like ABC. Although ABC earns higher margins on generic drugs, the company earns significantly less in terms of absolute profit from generic drugs because of their lower prices.

Business Overview

Following the spin-off of their PharMerica Long-Term Care business, which provided pharmacy products and services to residents and patients in long-term healthcare facilities, ABC has three main business segments.^[3]

1. Pharmaceutical Distribution: ABC is an intermediary, or middleman, between drug manufacturers and providers (e.g. pharmacies). The company mainly warehouses and distributes branded and generic drugs to hospitals, pharmacies, clinics, and other customers. In 2007, this represented over $48B in operating revenue.^[4]
2. Specialty Distribution: representing over $12B in operating revenue in fiscal 2007, ABC's specialty pharmaceuticals business is the leader in oncology products and also a leading distributor of vaccines and other injectables. ^[5]
3. PMSI: provides home delivery of prescription drugs (through mail order and on-line pharmacy services) to patients under workers’ compensation programs. In 2007, this represented over $400M in operating revenue.^[6]

ABC 2007 Annual Report^[7]

Operating revenue of $61.7 billion in fiscal 2007, increased 9% from the prior fiscal year due to growth in all business segments. Operating income of $820M in fiscal 2007 increased 9.5% from 2006. This increase was primarily due to an increase in compensation under fee-for-service agreements and the growth of generic drug distribution. Margins in the distribution business are very thin (ranging from 1-3%) -- therefore volume is very important for generating income.

ABC 2007 Annual Report^[8]

Trends & Forces

Declining growth of pharmaceutical sales

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 such as ABC 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 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.

Fee-for-Service Compensation leads to less volatile revenue

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 such as ABC would buy pharmaceuticals ahead of receiving any orders from pharmacies & hospitals, hold them, and hope that the demand and prices of these drugs would go up (primarily due to inflation) in the holding period. However, profit margins shrank 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.

Generic Drugs Drive margin growth, but may depress revenue

The growth of generic drugs represents both an opportunity and a threat for ABC. The drugs have margins up to 5 times higher than generic drugs of branded pharmaceuticals. Generic drugs are also much cheaper than their more exclusive counterparts. 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 can also have the potential to dramatically lower overall revenue growth in the in the pharmaceutical industry.

• 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.

Wal-Mart Threatens Drug Distribution Model

In 2006, 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 distributors such as ABC. Since then, Wal-Mart has expanded its $4 generic drug distribution to 16 states and nearly 360 drugs. ^[9] Given that Wal-Mart has over 4,000 stores in the US and a presence in nearly every major metropolitan market, it could have a major impact on the pricing and margins of generic drugs. This could lead other retail pharmacies to try to purchase generics directly from manufacturers, which would hurt ABC's generic distribution business.

Market Share

ABC competes in the pharmaceutical distribution market primarily with McKesson (MCK) and Cardinal Health (CAH). ABC has around 23% market share, trailing MCK and CAH. Combined, the triumvirate account for over 80% of sales in the distribution industry.

Competition

Below is a graph comparing the percentages of revenue from the different segments of the three major players. Notice that ABC is much less diversified than the other two.

References

1. ↑ MCK 10K 2007
2. ↑ CAH 10K 2006
3. ↑ ABC 10K 2007, Pg 4
4. ↑ ABC 10K 2007, Pg 2
5. ↑ ABC 10K 2007, Pg 3
6. ↑ ABC 10K 2007, Pg 4
7. ↑ ABC 10K 2007
8. ↑ ABC 10K 2007
9. ↑ Wal-Mart Pharmacy
10. ↑ CAH 10K 2006
11. ↑ MCK 10K 2007