"Generic Wave" to Drive Cardinal Health's Profitability in Coming Years

Cardinal Health (NYSE: CAH  ) and pharmaceuticals distributors of its ilk will have few better friends over the coming years than generic drugs.

The so-called "generic wave" -- created by scores of brand-name drugs whose patents are expiring between this year and 2015 -- is expected to be a huge boon to drug wholesalers like Dublin, Ohio-based Cardinal, boosting sales, but more importantly driving profits.

"Generic drugs are much more profitable for wholesalers than traditional branded drugs," said Adam Fein, president of Pembroke Consulting and operator of the insightful Drug Channels blog. "That's a surprise to many people because branded drugs are so much more expensive."

The generic wave could mean big money for Cardinal and top competitors AmerisourceBergen (NYSE: ABC  ) and McKesson (NYSE: MCK  ) . Fein estimates that over the next five years, more than $100 billion of branded-drug revenue will be lost to generic competition.

The reason for generics' enhanced profitability for Cardinal is simple: clout. Cardinal and its competitors have it, and generics manufacturers -- who are often competing with many other generic companies for prized distribution deals -- don't. Fein puts it more succinctly: "Generic drugmakers must offer significant price concessions to win supply contracts with large wholesalers."

In contrast, with a branded drug, there's just one manufacturer, meaning that drugmakers can't undercut each other on price, and that means that distributors like Cardinal can negotiate only razor-thin margins on branded drugs.

"There are concessions [generics] manufacturers who are looking to win a position," acknowledged Craig Cowman, senior vice president of sourcing for Cardinal's pharmaceuticals segment.

The numbers certainly bear that out. While just 10 percent of the sales for Cardinal's pharmaceuticals distribution business come from generics, a staggering 50 percent of the business' profits come from generics. (A Cardinal spokeswoman stressed those numbers apply to the company's pharmaceuticals distribution business, not its larger pharmaceuticals segment.)

And Cardinal's generic sales are headed up. In its last two quarters, year-over-year sales of generics have jumped 19 percent and 13 percent, respectively. Generic sales have climbed by double-digit rates for five consecutive quarters, the spokeswoman said.

"Generics are an important growth driver for us, and we see the opportunities that exist over the next several years as positive for the market," Cowman said in an understatement.

A recent key acquisition illustrates the emphasis Cardinal's management has placed on growing its generics business. In November, Cardinal struck a $1.3 billion deal to buy New York-based drug distributor Kinray. The Kinray acquisition expanded Cardinal's base of independent retail pharmacy customers by 40 percent, to about 7,000.

Small, independent pharmacies are important customers for Cardinal because that's where the Ohio company's generic profits live. Through Cardinal's SOURCE Generics program, the company negotiates deals with generics manufacturers on behalf of its retail customers. That's good for Cardinal because independent pharmacies provide higher margins, and good for small pharmacies because Cardinal can pool its purchasing power and negotiate lower generic prices than the pharmacies could on their own.

Big pharmacies like CVS and Walgreens, on the other hand, have enough size to bypass Cardinal and directly negotiate their own contracts with generic drugmakers. For big customers, Cardinal essentially just loads and delivers generics, a much lower-margin business.

While the next few years of generic sales look likely to be very kind to Cardinal, Cowman warned that predicting with any accuracy the ebbs and flows of the generic wave could be a futile pursuit. A number of factors play a role in determining how valuable a particular generic will be to Cardinal, particularly the number of manufacturers producing a given generic, and how complex (and hence expensive) it is for manufacturers to produce a generic version of a drug.

"It could be that a very large and valuable branded drug doesn't translate into a large and valuable generic," Cowman said.

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