The pharmacy space historically has low margins, as major drug companies inflate prices to a level that leaves very little pricing power for pharmacies. However, thanks to the patent cliff, a paradigm shift is occurring, and for major pharmacies Rite Aid , Walgreen , and CVS Caremark , 2014 could be quite transformational.

The patent cliff
According to a February 2011 research report by Evaluate Pharma, approximately $133 billion in brand-drug sales will lose patent protection during a six-year period between 2011 and 2017. This period has been labeled the patent cliff by many who follow the sector.

Obviously, big pharma benefits the least from the patent cliff. However, pharmacies are among those that benefit most, as generic drugs pay higher premiums to pharmacies. Not to mention, pharmacies have much more pricing power on a drug that cost $30 versus $200 for a 30-day supply.


Why do generics boost pharmacy margins?
Investors can find a mention of new generic drug introductions in all three major pharmacy companies in their quarterly reports, as a reason for margin growth. Check out a few quotes from management of each pharmacy, showing the effect of generics to each business.

 "This quarter (fiscal first quarter 2014) saw a significant shift in the generic wave from a peak in introductions in the first quarter last year to a trough." --- Walgreen CEO Greg Wasson 

Investors should note, from the quote above, that margins are affected greatest when new generics are introduced. This is the point that drastic price changes are implemented and pharmacies set new prices after buying generics in bulk. Because although Walgreen's new generic introductions slowed in the fiscal first quarter, net income increased 68% versus revenue growth of 5.8%, thus showing significant margin expansion as a result of the generics introduced in the prior quarters.

"The influx of new generic drugs was a key driver of our year-over-year profit growth across the enterprise" - CVS Caremark CEO Larry Merlo on first quarter 2012 conference call

Merlo clearly states that during this influx period, new generic introductions drove profits.

Lastly, from Rite Aid CEO John Standley:

We recorded our 11th consecutive quarter of year-over-year growth in adjusted [earnings before interest, taxes, depreciation, and amortization]. Our total of $342 million represents an all-time company record for the second quarter (2013) and an improvement of $123 million over the second quarter of last year. Key drivers were the continued benefit of new generic medications on our pharmacy gross margin.

2014: An exceptional year ahead?
It's safe to say that when new generic drugs are introduced to the market, pharmacies surge with margin improvements. With that said, let's revisit this $133 billion in brand-drug sales set to lose patent exclusivity between 2011 and 2017.

Clearly, pharmacies have seen the effect of the patent cliff to some degree with the patent losses of Lipitor, Seroquel, Plavix, and Suboxone during the last few years. However, very few analysts and investors are talking about the fact that 2014 will be the biggest year of the patent cliff, with nine different blockbuster patent expirations.

Company

Drug

Annual Sales

AstraZeneca

Nexium  

$4.9 billion

Eli Lilly

Cymbalta

$4 billion

Teva

Copaxone 

$4 billion

AstraZeneca

Symbicort 

$3.1 billion

GD Searles

Celebrex 

$2.5 billion

Novartis

Sandostatin 

$1.3 billion

Merck

Nasonex 

$1.3 billion

AbbVie

Trilipix 

$1.1 billion

Eli Lilly

Evista 

$1 billion

Total

 

$59.2 billion

In 2014 alone, more than 40% of Evaluate Pharma's estimated $133 billion in brand-drug sales will lose patent protection. Moreover, if we look further, Abilify ($4.6 billion) and Gleevec ($4.3 billion) are expected to lose patent protection in 2015, then Crestcor ($6 billion) and Benicar ($2.5 billion) in 2016.

A good year to invest in pharmacies?
With generic drugs, large pharmacies buy the products in bulk from manufacturers, then have more pricing power. Hence, new generic introductions cause significant margin expansion when blockbuster drugs lose patent protection. Take a look at operating margin improvements in 2012 and a comparison to the last 12 months.

 

Walgreen

CVS

Rite Aid

2012 Operating Margin

4.8%

5.5%

(1.5%)

Last 12 Months Operating Margin

5.2%

6.4%

3.7%

As you can see, in an industry with particularly low margins, all three major pharmacies saw large boosts to operating margins. Clearly, Rite Aid saw the greatest improvement while Walgreen improved the least.

Now, the question looking forward is whether all these billions in new generic-drug introductions will once more drive margins higher. If we use conference calls and the quotes from management, then the answer is yes. Hence, 2014 might be yet another good year for pharmacies.

Final thoughts
While Walgreen and CVS Caremark have produced marginal growth over the last year, Rite Aid has not grown revenue at all, yet its stock has increased more than 300%. This implies that margin expansion alone has the ability to drive gains in the pharmaceutical space and is reason to be bullish.

Therefore, while CVS Caremark and Walgreen are growing faster than Rite Aid, the latter definitely has the most to gain. Moreover, Rite Aid trades at just one-third of its peers on a price/sales basis, further adding to the notion that it has the most to gain...and the least to lose. With that said, Rite Aid might trade the highest on future margin improvements, but the sector as a whole could soar higher.

Stay on top the latest news
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The article Will 2014 Lead to Higher Margins for Pharmacies? originally appeared on Fool.com.

Brian Nichols owns Rite Aid. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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