Generic Drugs Set to Improve Margins at Drug Stores

usman is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

For U.S. markets, the expiring patents and increasing demand and availability of generics are going to be some of the crucial elements affecting the future profitability of drug store operators. This trend was seen in the recent results reported by Walgreen (NYSE: WAG) and Rite Aid (NYSE: RAD).

The substantial effects that the increase in the market share of generic drugs (in both prescription and over the counter market) will have on drug retailers have brought this particular segment in the limelight. Within the segment, I will be looking at some of the top drug retailers in the U.S. including Walgreen, Rite Aid, CVS Caremark (NYSE: CVS) and Express Scripts (NASDAQ: ESRX).

Margins and revenues

According to the most recent quarterly reports, all the above-mentioned companies have experienced an increase in their gross margins. CVS Caremark experienced the largest increase in its gross margin (from 16.6% in March 2012 to 18% in March 2013), while the slowest growth in margins was experienced by Walgreen (increasing by only 26 basis points).

Despite the increasing margins, the companies have experienced a decline in revenues from drug sales. For instance Rite Aid and CVS Caremark experienced a loss in revenues by 2.7% and 0.11%, respectively. Although Walgreen’s revenues increased on a year on year basis, the increase can largely be attributed to the acquisition of USA drug and BioScrip assets and the increase in the number of retail locations of the company by 2.6%. The increase in the revenue of Express Scripts was also due to the acquisition of Medco Health Solutions.

The generic prescription rate has seen a hike for all the companies. The generic dispensing rate or the generic fill rate increased from 78.1% in 2012 to 81.2% in 2013 for CVS Caremark, while a similar increase (from 77.7% to 81.3%) was experienced by Express Scripts. This is the primary reason why the companies have experienced higher margins in the recently reported figures. For drug store operators, generics have significantly higher margins as a percentage of sales than the branded drugs.

Despite the consistently higher margin of generics, the substantially lower price of generic drugs means that the overall profitability of drug retailers suffers. As a considerable portion of drug store costs is fixed, the lower dollar margins mean that the companies will experience lower net profits and returns. Since, for all four companies, the vast majority of revenue is derived from drug sales, a shift towards generic drug means that the companies will face added pressures in expanding revenue and profits.

Does this means the end of road

Overall, the drugstores industry has seen a substantial slowdown in its growth. However, this slowdown in revenues is compensated with improving margins that are generated through the sale of generic products. As new regulations take full effect, the focus of the healthcare sector will see a shift toward substantial cost cutting because cost effective healthcare services would receive an added attention from the Medicaid and Medicare services. This means that a large portion of new prescription in the industry will be for cheaper alternatives to branded drugs.

Furthermore, the introduction of the generic substitution regulation will continue to play a vital role in promoting generic drugs in the U.S. economy. These trends mean that the future of drugstores will see an ever increasing quantity of generic sales as compared to brand name drugs. Despite the lower prices of generics, the substantially greater margins offer a unique growth opportunity for the companies.

As the regulations come into effect, an estimated 32 million residents will be added into the insurance coverage. Thus, despite declining revenues and profits (in dollars), the increasing number of insured will definitely increase the number of new prescriptions. This will somewhat compensate for the reduction in revenues as the public shifts towards generic drugs. The increase in revenues will be further aided by the increase in prescriptions coupled with the higher margins on generic products.

Conclusion

In my analysis above, I have shown that the outlook for the drugstore industry is moderate as the decline in revenues from the use of generics will be somewhat offset by an increase in the number of prescriptions (either through the increase in the number of insured or through the expansion of retail network). Furthermore, as the industry saturates, companies will look for growth opportunities through acquisitions. Companies rich in cash will certainly outperform the rest; however, the gains in the industry are expected to be achieved over the long run. Therefore, this sector is a buy for me and within the discussed companies I would recommend Walgreen for value investors as it has better margins and higher yields, and for growth investors I would recommend buying Express Scripts because it has high cash flows to fund growth, better margins and a more diversified business.

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usman iftikhar has no position in any stocks mentioned. The Motley Fool recommends Express Scripts. The Motley Fool owns shares of Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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