Seeking higher margins, CVS pursues generic gains

Drug Store News,  Oct 10, 2005  by James Frederick

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Generic drugs have been on an extended run. And with some $20 billion worth of branded pharmaceuticals coming off patent over the next year alone, the federal government poised to begin absorbing huge drug-spending costs with the launch of Medicare Part D drug benefits in January, the continued assault on drug costs by health-plan sponsors and the steady aging of the baby boom generation, the continuedgrowth of the generics segment seems all but guaranteed.

That fact isn't lost on CVS pharmacy executives. The company is among the most aggressive in its efforts to shift patients to me-too versions of expensive branded drugs wherever possible, for reasons both altruistic and practical. Yes, they save CVS customers and their health plan providers money. But they also mean higher profits.

"The U.S. population is aging, health care costs are rising and pharmaceuticals remain often the most cost-effective form of treatment," the company noted in its last annual report. "Meanwhile, patents are set to expire ... and our pharmacies will be stocked with lower-cost generic equivalents as they become available."

CVS chairman, president and chief executive Tom Ryan foresees plenty of growth potential in both the branded and generics marketplace. "Let me put this in perspecive," Ryan explained during, Iast month's Goldman Sachs Global Ketailing Conference in New York City. "From 2005 to 2009, $65 billion worth of brandedpharmaceuticals will come offpatent. People are always trying to figure out what that means for margins. We make more penny profit on generics than we do on brands, even though generics prices are about $70 to $75 less."

Although as much as $23 billion wo-rth of branded drug patents are due to expire in 2006, CVS executives are expecting about "$12 billion to $16 billion that will impact our P&L in 2006," Ryan noted. And while, every 1 percent shift to generic utilization shaves about $300 million from CVS top line, a proliferation of generic drugs means rising profits. In general, retailers make $5 more per script with generics vs. branded.

Couple this with rising generic prices, and there is an especially attractive outcome for drug retailers," Merrill Lynch research analyst Patricia Baker observed in a recent report on CVS.

Lehman Brothers retail analyst Mered ith Adler agrees. Coupled with the continuing turnaround of the 1,100 former Eckerd stores CVS acquired last year, improvements in its core stores and healthy growth in its PBM business, she noted in a recent report, benefits from a wave of new generics over the next few years should lead to strong and steady earnings growth despite the dynamic elements of the external environment.

"Given the benefit to drug retailers' profitability from the large number of generic drugs forecast to become available in coming years, we are raising our earnings per share estimates for CVS in [fiscal year] 2006 and beyond," Adler notect.

Baker says generics, the aging population and the advent of Medicare Part D drug coverage for 41 million Medicare beneficiaries, will drive pharmacy sales at CVS in coming years. And despite the fact that "generics negatively impacted sales by 190 basis.points vs. 170 basis points in the first quarter," she noted, they also contributed to an increase in second quarter gross margins, to 26.5 percent of sales.

Generic impact:

at 9.7%, generics sales growth outpaced
the total RX market (8.3%)

                                   Generics    Branded    Total Rx

Percent of total scripts filled      56%         44%        100%
Average price per script            $28.74     $96.01      $63.59
Average gross margin                 54%         11%        20%
Average gross dollar profit         $15.52     $10.56      $12.78

Source: National Association of Chain Drug Stores/Lehman Bros.

estimates

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