The Competitive Dynamics along the Drug Supply Chain

For more information on the drug supply chain and related companies, please go to http://healthcare.morningstar.com/ for a subscription to the Healthcare Observer, where our health-care team presents a detailed analysis of which industries in the drug supply chain hold the strongest position.

What is the Drug Supply Chain?

Surprisingly, drugs change hands several times from the original manufacturers to the patients. Along this path, several industries serve as middlemen offering both physical distribution and financing for the drugs. The major players include drug companies, distributors, retail pharmacies, pharmacy benefit managers (PBMs), payors and patients. Each of these players strives to negotiate deals from suppliers and customers in order to maximize their profits.

Economic Moats and Competitive Advantages within the Drug Supply Chain

At Morningstar, we analyze the economic moats of companies to help determine valuation. When we think about the pharmaceutical supply chain, we see a relatively fixed amount of value between manufacturing facilities and patients. Innovation and demographic trends do provide a strong tailwind for the entire sector, but above-market growth within the supply chain can generally only come to one middleman at the expense of another. Thinking about competitive advantages, and how they are changing over time, is critical to understanding where the value of the supply chain will accrue over time, and which companies will flourish while others decline.

We conclude that the PBM industry is the most likely to be experiencing widening moats, while the distributors are the most likely to be experiencing declining moats. Of course, valuation is the factor that matters the most when making investment decisions. Interestingly, our valuation assessment is the exact opposite of our opinion on moat trends. We currently think the distributors represent the most attractive valuations while the PBMs look the least attractive to us.

PBMs Growing in Power

We currently assign no economic moat to the independent PBMs, Medco and Express Scripts. We have long been skeptical of their competitive advantages. However, the sale of WellPoint’s PBM seems to be a clear indication that MCOs do not represent a meaningful competitive threat to PBMs over the next five to ten years. Scale advantages are apparently significant, and pharmacy benefit management expertise not easily replicable. We think the PBM industry is headed in the direction of a three-firm oligopoly over the long run, and we would generally view PBMs’ competitive advantages as at least stable, and likely increasing. However, as of this writing both stocks carry our 3-star rating, indicating that we think the PBMs are about fairly valued by the market.

Retailers Offer Stability

We think CVS Caremark and Walgreen both have stable, narrow moats. Competitive dynamics for the Caremark PBM business are similar to those for the independent PBMs. The narrow moats derive primarily from the retail business, where recognizable brand names, purchasing scale, and extensive, established store bases provide a sustainable competitive advantage for both companies, in our opinion. Both companies face significant threats, such as reimbursement pressure and growing competition (increasingly based on price) from Wal-Mart, mail-order pharmacies, and pharmacies embedded in grocery stores and other big-box retailers. However, CVC Caremark and Walgreen also benefit from slow-changing consumer behavior patterns, secular growth trends such as the generics wave and changing demographics, new opportunities in clinics and related services, and their ability to steal market share from less efficient independent pharmacies. For now, we think these factors balance to result in a stable moat trend. We think these leading retail pharmacies are marginally undervalued.

Distributors Losing Steam 

Finally, we are most concerned about the narrow moats of pharmaceutical distributors, which we think are in decline. Mail-order facilities and large chains are gaining market share at the expense of independent and small-chain pharmacies. These larger customers generally source their own generics and often handle the final leg of distribution to individual stores on their own. As they continue to build scale, their need for distributors declines, allowing them to either bring distribution in-house or extract ever more favorable terms from distributors. Inevitably, distributors’ higher-margin small customers are being replaced by lower-margin large customers.

Distributors still have the most scale, which gives them highly efficient cost structures. We also expect the decline of independent pharmacies to continue gradually over ten years or more. The generics wave and secular tailwinds also help to cushion the blow. These factors lead us to believe that distributors will continue to earn excess returns for a significant number of years into the future, even as we declare that their economic moats will eventually fade. AmerisourceBergen ABC remains one of our top picks in the distributor industry.

--Matt Coffina and Damien Conover, CFA, Morningstar