Untangling the Pharma Supply Chain

We prefer to view the pharmaceutical supply chain--which includes retail pharmacies, pharmacy benefit managers, or PBMs, pharmaceutical wholesalers (distributors), brand-name and generic drug manufacturers, patients, and payors such as managed care organizations, or MCOs, employers, and governments--holistically. While we don't have any recommendations in this space currently, we think  Express Scripts  and  Medco Health Solutions  are high-quality companies with expanding economic moats, and are worth keeping an eye on in case a buying opportunity presents itself.

Dispensing: Retail and Mail-order Pharmacies
Patients are the ultimate consumers of pharmaceuticals. In general, patients fill their prescriptions through either a retail pharmacy, or a mail-order pharmacy. Retail pharmacies include independent pharmacies, small chains, large chains such as  Walgreens (WAG),  CVS (CVS), and  Rite Aid (RAD), and pharmacies embedded in other retailers, including grocery stores such as  Safeway  and  Kroger (KR), and mass merchandisers such as  Wal-Mart (WMT) and  Target (TGT). The largest mail-order pharmacies are owned and operated by pharmacy benefit managers such as CVS Caremark, Medco, and Express Scripts.

While there will likely always be demand for all of these dispensing outlets, there has been a general trend of independent pharmacies losing market share to mail-order and large chain pharmacies. To help their most profitable customers remain competitive, pharmaceutical wholesalers have established networks of independent pharmacies to help them achieve scale efficiencies, for example in branding, merchandising, IT systems, and PBM network participation. The primary wholesaler-operated independent pharmacy networks are  AmerisourceBergen's (ABC) Good Neighbor Pharmacy,  McKesson's (MCK) Health Mart, and  Cardinal Health 's (CAH) Leader and Medicine Shoppe International.

Independent pharmacies aren't alone in facing increasing competitive pressure. Pharmaceuticals represent a small percentage of sales for supermarkets and mass merchandisers, but a pharmacy can increase customer loyalty and generate foot traffic that boosts sales to other parts of their stores. This gives general retailers an incentive to be aggressive in pursuing pharmacy market share through promotions such as Wal-Mart's $4 generics program.

Additionally, all retail pharmacies are under reimbursement pressure from pharmacy benefit managers, who have significant bargaining power, owing to their long and growing membership rolls. As patients' first point of contact with the pharmaceutical supply chain, PBMs have also been directing patients to their own mail-order pharmacies. We expect mail-order penetration to increase over time, as scale drives down the cost, as patients become more comfortable with mail-order, and as PBMs shift their focus to mail-order over generics penetration as the generics wave reaches its latter stages.

Distributing: Pharmaceutical Wholesalers
Pharmaceutical distribution is dominated by three firms nationally: McKesson, Cardinal Health, and AmerisourceBergen. Most pharmaceuticals that don't pass through one of the big three wholesalers are distributed directly. In particular, generics manufacturers frequently distribute drugs directly to the warehouses of large chain pharmacies and the mail-order facilities of PBMs. The pharmacies then handle the last leg of distribution:  to individual pharmacies in the case of retail chains, and to patients' homes in the case of mail order.

Pharmaceutical distributors earn low-single-digit margins, which makes scale and efficiency paramount, providing a barrier to entry. On the other hand, both pharmacies and drug manufacturers continue to consolidate. Larger customers and suppliers can extract better pricing from wholesalers and bring more distribution activities in-house. This is most evident in the case of Cardinal Health, which counts CVS Caremark and Walgreen as its largest customers. In fiscal 2009, Cardinal earned 0.4% operating margins from bulk deliveries to customer warehouses�80% less than the 2% margins it earned on non-bulk deliveries.

Having large customers can be a mixed blessing for distributors. On the one hand, they face potential margin pressure. On the other, they can grow revenues along with their customers. The key for wholesalers is to provide distribution services more cheaply than the customer can handle distribution itself. AmerisourceBergen has benefited from Medco's market share gains in recent quarters, while at the same time Medco has increased the level of service it receives from AmerisourceBergen. Transitioning to daily deliveries from its wholesaler helped Medco trim its inventories by about 30% in 2009.

Financing: Pharmacy Benefit Managers
Though a relative newcomer to the pharmaceutical supply chain, pharmacy benefit managers have proven themselves to be a force to be reckoned with. In fact, the independent PBMs Medco and Express Scripts are the only supply chain participants who we consider to have a positive economic moat trend, indicating that competitive advantages are increasing over time.

PBMs administer drug benefits on behalf of payors such as employers, governments, and managed care organizations, or MCOs. Managed care organizations often operate their own PBMs in addition to contracting with an unaffiliated PBM for some of their members. The primary role of PBMs is to reduce drug spending. This is accomplished in a variety of ways, including negotiating rebates with brand-name drugmakers, managing a formulary, creating financial incentives for consumers to switch to lower-cost generic drugs, negotiating discounts with a network of retail pharmacies, operating mail-order pharmacies, clinical interventions such as step-therapy programs, and communicating with patients about lower-cost drug options.

Even though barriers to entry are low in this business, large PBMs have several advantages, such as improved bargaining leverage over pharmaceutical manufacturers and retailers, scale efficiencies in operating their mail-order facilities, and the ability to invest in innovative programs such as comparative effectiveness research. The three largest PBMs�Medco, Express Scripts, and CVS Caremark�provide drug benefits to more than half of the U.S. population. Combined, they managed 2.2 billion adjusted prescriptions in 2009 (prescriptions are adjusted for the fact that mail-order scripts usually include a 3-month supply). Other large PBMs are generally owned by managed care organizations.

While all of the pharmaceutical supply chain middlemen have benefited from the ongoing generics wave, PBMs appear to be benefiting more than most. The generics wave is still in its early stages, with mega blockbusters like Lipitor, Plavix, and Zyprexa set to lose patent protection in the next few years. Because there is so much money to be saved by switching patients from brand-name to generic drugs, payors are generally happy to pass a small portion of these savings on to PBMs.

Increasing generic penetration has been a major driver of earnings growth for the PBMs. Medco's generic penetration rate increased to 67.5% in 2009 from 46.3% in 2004. While generic penetration will eventually approach a natural limit, perhaps around 80%, we see plenty of opportunity for the PBMs to continue creating value for customers. For example, we expect the PBMs to increase their focus on mail-order penetration, management of specialty drugs, and personalized and evidence-based medicine as the generics wave peters out.