Where the Big Margins Are

Drug company investors get to enjoy such high gross margins that we often don't even think about them. Pfizer's (NYSE: PFE) margins clocked in at 85% in 2006, while GlaxoSmithKline rolled in at just under 79%. Even Amgen (Nasdaq: AMGN), whose biologics are generally more complex to make, managed margins of over 85% in 2006.

While it's nice to enjoy the high margins -- especially since they make up for all the cash that needs to be plowed into research and development -- there's little that drug companies can do to improve gross margins. Sure, economies of scale come into play as a drug reaches blockbuster status -- Merck's (NYSE: MRK) gross margins have slumped from the low-80% range to below 77% since pulling Vioxx in 2004 -- but, there's generally only so much improvement that a company can make when it starts from such a high point.

A mighty shift
Unless you've been selling other medical products as well. Check out this jump in gross margins that Baxter (NYSE: BAX) has produced over the last year and a half.

Some of the increase is due to the company becoming more efficient. But most of it comes from a shift away from selling low-margin medical products and instead focusing on high-margin drugs.

Its 9% sales growth last year was boosted by its biosciences division, which experienced a whopping 18% growth in sales year over year. That's quite impressive, especially when you consider the revenues the company lost when it returned marketing rights for the drug Benefix to Wyeth (NYSE: WYE). Those high-margin sales had an even larger impact on gross margins in 2007, after Baxter completed the sale of its low-margin transfusion therapies business to private equity companies last March.

Baxter isn't done with the gross margin improvements either. It expects a further increase in gross margins of 1%-1.5% this year.

I'm sure you can see where I'm going here, Fools. Those margin improvements are essentially free money. Baxter can use the cash to increase its dividend, buy back stock, or reinvest in R&D.

Personally, I'd rather see it plug it back into development of more drugs like its flu vaccine. That would allow the company to increase its gross margins even further in the coming years.

A couple more examples
Baxter isn't the only fringe drugmaker that's using the gross margin trick to allow the bottom line to grow faster than revenues.

Alpharma (NYSE: ALO) makes active pharmaceutical ingredients -- the raw materials for drugs -- and also has a large animal health division, but the company is trying to make a painless transition into a more traditional drugmaker role. It has one drug to fight pain on the market and recently licensed a second FDA-approved pain drug. It also has a third drug for treating pain in late-stage trials.

While Alpharma's gross margins will almost certainly increase as a result of the new drugs, its bottom line will be hurting for a little while. The launches are expensive, so SG&A expenses will skyrocket this year. Still, I think it's a good move for the mini-conglomerate.

Teva Pharmaceuticals (Nasdaq: TEVA) may be the king of the generic-drug makers, but it looks like it may be stepping further into the branded-drug business. The company already sells a multiple sclerosis (MS) drug, Copaxone, which made up almost 19% of its total sales in the third quarter, but it looks to be further expanding into biologics with its recent acquisition of CoGenesys. Teva claims the purchase was to increase its ability to make generics of biotech drugs, but the company's got to do something with CoGenesys' pipeline and its albumin platform.

More profit for investors
In this difficult and uncertain time for the market, finding companies that can make more for less seems like a recipe for success. Just be careful to invest in companies that put their newfound money to good use.