One of the best ways to find Foolishly good stocks is by considering whether companies have scalable businesses and whether end markets are growing or shrinking. In health care, this means looking for companies benefiting from rising demand tied to larger, longer-living, and increasingly insured populations.
While drug and biotech companies are discovering new treatments with life-changing outcomes, the nature of their business means even those companies hitting the jackpot with billion-dollar blockbusters will eventually find market share threatened by generics and next-generation drugs.
This win-and-lose dynamic makes investing in drug companies risky. But, you may be able to offset some of that risk by owning drug distributors, too. Why? Because companies like Omnicare (UNKNOWN: OCR.DL ) are uniquely positioned to capture greater sales and profits regardless of who cures cancer.
A big and growing market
Baby boomers represent one of the biggest demographic opportunities in decades for health care. As boomers are growing older, the number of people over 85 is expected to grow a compounded 2.9% annually. The over 65 population is expected to grow a compounded 1.5%. Both rates are far better than the 0.4% compounded growth expected for those under 65.
This is important because a larger population of older Americans will consume increasingly more branded and generic drugs. That has industry experts predicting drug spending will climb 6.5% annually from 2015 through 2022, according to the Centers for Medicare and Medicaid Services, or CMS. That's good news for Omnicare because the company is the largest drug distribution player in the long-term care market where a lot of that spending will occur.
But, while Omnicare is big it's not the only player. PharMerica Corporation (NYSE: PMC ) -- formed in 2007 from the merger of Kindred Healthcare's pharmacy business with a AmerisourceBergen subsidiary -- is the second largest player, with 15% market share. Omnicare tried to acquire PharMerica in 2011, but was rebuffed amid worries over regulatory hurdles tied to post-merger market share. As a result, Omnicare and PharMerica continue to battle head to head for long-term care contracts.
To gain the upper hand, Omnicare is helping facilities meet new regulatory requirements through a suite of tracking and reporting solutions. Those value added solutions are building a wider and deeper moat for competitors to cross and the strategy appears to be working. The company won a key contract from longtime PharMerica customer Kindred Healthcare this past summer. And Omnicare's customer retention climbed 1.2% year-over-year to 93.8% in the third quarter.
The higher retention rate and new contracts helped Omnicare grow the number of beds served in facilities by 2,000 in the third quarter. That marks the second consecutive quarter of bed growth and helped lift Omnicare's quarterly long-term care segment sales to $1.22 billion from $1.218 billion last year. That's the first quarter for segment year-over-year sales growth in six quarters.
Growth while you wait
While you're waiting for the Omnicare's long-term care opportunity to develop, you're also benefiting from the company's exposure to specialty drugs -- one of the fastest growing areas of drug research and development.
As a percentage of all drug sales, specialty drug sales are expected to grow from 23% in 2011 to 42% in 2016. Some of that growth will come thanks to new introductions. 42% of all drugs in pipelines are specialty drugs, and 50% of approved drugs were specialty drugs in 2011, up from 25% in 2008.
To capture the shift toward specialty medication, Omnicare's Specialty Care Group segment has embraced a fee-for-service model designed to manage the introduction and delivery of these drugs directly to patients and doctors. That solution is compelling to both cost-cutting big pharma companies and cost-sensitive emerging biotech firms.
The increasingly complex protocols associated with these specialty drugs, and the challenges of identifying and reaching the right patients, means more drug makers are signing up. As a result, Omnicare's specialty care segment sales reached $361 million in Q3, up 29% from $280 million last year.
Omnicare thinks the offering may also help it win business providing end-to-end support for orphan drugs, which are increasingly a focus of drug companies and in biosimilars, too.
The Foolish final take
Across both the long-term care and specialty segments, sales at Omnicare grew 5.3% to $1.6 billion. That helped the company grow adjusted EPS to $0.91 per share from $0.86 last year. Importantly, the company is kicking off solid cash flow which is supporting dividends and buybacks. Omnicare has $506 million in cash, or $4.91 per share, and following the purchase of $81 million in shares last quarter, $129 million remains under the existing buyback authorization.
But Omnicare doesn't come without its own set of headwinds. Growth in nursing homes has been weaker than assisted living as consumers have become increasingly cost conscious following the recession. And, the company has been operating under clouds tied to allegations of kickbacks to long-term care facilities dating back to 2004. In late October, the company announced a $120 million tentative settlement with the Department of Justice tied to a whistleblower complaint by former employee Donald Gale. Other cases may still need resolving, too. But its biggest competitor faces similar problems. In August, the Department of Justice filed suit against PharMerica saying it allegedly dispensed controlled drugs without valid prescriptions and caused false claims to Medicare for them.
That said, if Omnicare's settling cases free it to focus more attention on expanding into independent and assisted living facilities and win more specialty drug business, then you may discover that aging boomers make Omnicare a solid long term investment. Particularly, if its main rival PharMerica continues to stumble.
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