Profits Are Hidden in the Prescription Drug Supply Chain

Depending on how you look at them, pharmacy-benefit managers are either low margin middlemen that fight to reduce drug costs or highly profitable intermediaries that earn more when drug prices rise.
 Pharmacy-benefit managers are hired by businesses such as insurers that pay for drugs to negotiate lower prices with pharmaceutical companies. When Express Scripts Holding reports fourth-quarter earnings on Tuesday, analysts expect a margin of just 4.7%, according to FactSet. Rival companies owned by CVS Health and UnitedHealth Group report similarly low margins.
 But a closer look shows the business is far more attractive than those low margins would suggest. Included in Express Scripts' revenue is the cost of the underlying drugs they sell. Thus Express Scripts generated gross profit of just $1.8 billion on total sales of $24.7 billion in the third quarter. Gross profit is revenue minus the cost of goods sold, but nothing else.
 In general, however, the pharmacy-benefits manager doesn't actually take delivery of the drug. That means these companies don't spend much on fixed assets, which keeps selling and administrative costs, as well as depreciation and amortization charges, very low.
 Analysts at Bernstein tried to get a better picture of how profitable these companies are by excluding the cost of the drugs that are included in their revenue. The analysts compared the rate at which gross profit converts into earnings before interest, taxes, depreciation and amortization for pharmacy-benefits managers and other pieces of the drug supply chain, including drug distributors, insurers and pharmacies.
 By this analysis, pharmacy- benefit managers are exceptionally profitable; 85% of their gross profit converted into Ebitda over the past two years. Drug distributors converted 46% of their gross profit, while health insurers and pharmacies achieved about 30%.
 The analysts say these companies benefit from “lack of transparency and misaligned incentives.” Historically those dynamics have been great news for shareholders.
 But now those dynamics have attracted new competition. Anthem, is starting its own pharmacy-benefits manager. Potential competition could come from other sources, like the announced nonprofit joint health-care venture between Amazon. com, Berkshire Hathaway and JPMorgan Chase.
 Pharmacy-benefit managers would only get this attention if their business was attractive. It may not be for much longer.  

—Charley Grant


Big Earnings
Rate at which drug supply chain converts gross profit into Ebitda*

*Earnings before interest, taxes, depreciation and amortization
Source: Bernstein



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