Medco's Pumped About Generics

Generic drugs are not the flashiest products. They often carry low margins and are a constant threat to makers of patented pharmaceuticals such as Pfizer (NYSE: PFE). But for Medco Health Solutions (NYSE: MHS) higher sales of generic drugs are a reason to get excited.

Medco, whose clients include health benefits companies such as UnitedHealth (NYSE: UNH), is known as a prescription benefits manager (PBM). The firm, like its competitors Express Scripts (Nasdaq: ESRX) and CaremarkRx (NYSE: CMX), acts as an almost invisible player in the health-care field but fills the extremely important role of managing prescription drug benefits for millions of people.

Medco reported today that second-quarter earnings jumped 21% year over year to $127.3 million. Higher gross margins helped drive this improvement, which in turn were helped by generic prescriptions increasing as a percentage of total scripts to 45.5% from 43.3% in last year's second quarter.

Generics utilization is a positive sign because, thanks to the buying power of its industry-leading mail-order pharmacy operation, Medco can wrangle larger discounts on generics than on branded drugs. The company encourages doctors and plan participants to switch from branded pharmaceuticals to generic equivalents, and then it fills the generic prescriptions via the mail, bypassing retail pharmacies. As a result, Medco gets to keep profit it would otherwise have to split with retail outlets. Not surprisingly, its strategy makes it an archenemy of retail pharmacies in places such as CVS (NYSE: CVS).

Medco's stated purpose is to help control drug expenses for its clients. However, Medco and the PBM industry have been mired in controversy over allegations that such companies actually inflate costs. These claims arise in part from PBM's relationships with branded drug makers, under which many receive rebates in exchange for meeting pharmaceutical manufacturers' sales and market share targets. Medco itself recently settled several lawsuits, and Caremark remains under heavy scrutiny.

Ultimately, though, the need to keep drug costs down may be the PBM sector's salvation. And Medco's proven ability to bolster generic utilization and improve profitability using its mail-order pharmacies makes it a winner with investors and health-care plans.

Fool contributor Brian Gorman is a freelance writer in Chicago. He does not own shares of any companies mentioned in this article.