Profit from America's pill poppers

Americans have taken to cheap drugs in a big way, with 81% of them preferring generic medicines to brand-name equivalents. All good news for the industry's middlemen, says Eoin Gleeson. Here, he looks at the market and picks the best bet in the sector.

Nobody wants to take a chance with their health. So the idea of taking generic rather than branded drugs doesn't appeal much to those who fear they'll be exposed to cheap, knock-off medication. Even some doctors remain sceptical, particularly in France and Spain, which have the lowest penetration of generic drugs in the world.

There are few such fears in America. Americans have taken to cheap drugs in a big way. Last week, a poll conducted by Harris Interactive found that 81% of American consumers prefer generic prescriptions to the brand-name equivalents an increase of 13% since October 2006. And the way they shop for drugs is changing too. Instead of popping to the local pharmacy or drug chain, they are picking up cheaper drugs at Wal-Mart, or ordering them through the post.

This plays straight into the hands of the industry's middle-men, the pharmacy benefit managers. These companies negotiate discounts with drug makers before selling to drugs programmes run by corporations or the state, handling 80% of all prescriptions filled in the States. The automated mail-order business is thriving as they fill prescriptions for cash-strapped consumers. They are also winning corporate clients, who can save money by filling recurring prescriptions in 90-day batches at a reduced per-pill cost.

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The slumping economy will cause overall pharmacy sales to grow just 1% in 2009, according to data tracker IMS Health. But as these drug dispensers sell greater volumes of cheaper generic drugs, their underlying profits are growing fast, says Jacob Goldstein in The Wall Street Journal. That's because generics have far higher margins than branded drugs.

Medcohealth, for example, just reported a 32% jump in profits. CVS Caremark has seen its profit margins escalate nicely from 4% to 7.1% in the last four years alone. And with $70bn of branded blockbuster drugs set to lose their patents before 2012, these firms will get a lot more bang for their buck in the years ahead.

With their focus on lowering costs and raising quality, pharmacy benefit managers are also central to Barack Obama's health reforms. That's in part because he wants to lift the proportion of generic drugs used in public programmes. But it's also thanks to the huge drugs databases they control. Drug distributers such as CVS Caremark hold a wealth of information on America's drug habits, says Matthew Boyle in BusinessWeek. They know, for example, how disciplined patients are about taking their pills, a big issue for the health system.

About one-third of all patients who start a drugs programme never renew a prescription, either because they stop feeling sick, they forget, or because they want to save money. This burdens the health system with a huge number of unnecessary hospital visits. For example, the annual bill for treating diabetes in hospitals could disappear if patients simply took their medicines, says Boyle.

But climbing into bed with government brings problems too. Dispensing firms could be mired in a lot more regulation, says Jake Berzon on Seeking Alpha. And there's sure to be more scrutiny of some of their more shady practices, such as taking kickbacks from big pharma to push high-cost drugs onto their customers, which has seen lawsuits taken out against some providers in the past.

But with America's new found enthusiasm for generic drugs, and US pharmacy sales rising 4.1% in the last quarter, compared to a 5.1% plunge in total retail sales, the business looks solid. We look at a promising play below.

The best bet in the generic drugs sector

CVS Caremark (NYSE: CVS) is an oddity. It's a pharmacy benefit manager (PBM) and pharmacy retail business, with the biggest chain of drug stores in the country. It fills over one billion prescriptions a year and has more than 7,000 locations across 40 states.

With pharmacy chains coming up against competition from mail order and Wal-Mart, the stockmarket has marked down retail chains such as CVS Caremark and Walgreen. So CVS Caremark is now valued on a forward p/e of 8.9 considerably cheaper than rivals Medcohealth (forward p/e of 14) and Express Script (15.6). But while its pharmacy business saw sales slip by 4.9% in January, its PBM business is thriving, thanks both to rising rebates on generic drugs bought in bulk from pharmaceutical firms and the higher dispensing fees generated from its mail-order business.

The acquisition of retail group Longs Drugs also boosted revenue in the last quarter, while earnings per share from existing operations rose 19.8%. The firm's PBM business has so far not become a larger share of prescriptions filled at CVS retail pharmacies, and there are currently no visible benefits from the two companies combining, says drug analyst Dr Adam Fein of Pembroke Consulting. Though CVS Caremark may try to rectify this in the future. CVS is also a drugs data Goliath, says Matthew Boyle in Business Week. So it is uniquely placed to benefit from Obama's drug compliance reforms.

Eoin came to Money Week in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.

Eoin acts as managing editor of MoneyWeek's newsletters.