Generic introductions increase Rx volume, hurt profit

Drug Store News,  Nov 12, 2007  by Drew Buono

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Once the 180-day exclusivity period for a generic drug disappears, pharmacy retailers experience a significant drop in profits as more generic manufacturers begin producing the drug, thereby decreasing its price and profit margin. The most recent example of this collapse in profit is reflected in Walgreens' third-quarter earnings, which were dramatically lower than expected thanks to overall generic price erosion, and, in particular, cholesterol-reducer Zocor losing exclusivity during the quarter.

Walgreens shares fell 15 percent, or $7.08, on Oct. 1 from their Sept. 28 close, to $40.16, the biggest drop in 27 years. The news was hard to swallow because Deerfield-based Walgreens is known for making lots of money from generic drugs. Last year the company had a 14.4 percent profit with generic drug introductions, compared with when only the brand was on the market, $433 million compared with $379 million according to Citi Investment Research.

Walgreens' profit decline opened a rare window into the importance of generics to a drug chain's bottom line and to the massive clout insurers and drug-benefit firms have these days. Zocor was a huge seller as a brand, racking up sales of more than $4 billion in 2005, its last full year without a generic rival. That made it the biggest-elling drug to convert to generic in Walgreens' history. Generic copies became available at the end of June 2006.

In the early months of a generic's debut, pharmacy chains pile up revenues. Insurers force their members to switch to the generic as a cost-cutting move. Not only are patients switching from brand Zocor to its generic, simvastatin, but they also are switching from such brandname cholesterol reducers as Lipitor and Crestor, which do not have generics on the market yet. The revenue then tapers off, however, as more generic versions enter the market and insurers press drug makers to reduce pricing even more.

That's exactly what happened earlier this year, as multiple manufacturers began selling generic copies and drug chains were forced to accept lower payments from insurance companies and pharmacy-benefit companies who pay the pharmacy retailers.

The magnitude of the pricing changes was harsh. Walgreens made up to $60 in gross profits per prescription of generic Zocor last year after paying the manufacturer, estimated Derek Leckow, an analyst with Barrington Research Associates. But that fell to about $20 per prescription in the fiscal fourth quarter that ended Aug. 31.

The full impact of generic price drops, the bulk of which came from Zocor, cost Walgreens "between $40 million and $60 million in lost gross profit," the company said. Normally when a generic loses its edge, drug retailers rely on other maiden generics to pump up revenues. But the void left in Zocor's wake was too huge to offset. "Something this big in generic drugs has never happened," Leckow said.

At the same time, private insurers were putting on the pressure to reduce pricing. "We use enormous purchasing scale to drive big discounts from drug makers," said Mark Merritt, chief executive of the Pharmaceutical Care Management Association, a Washington-based lobby that represents the pharmacy benefit management industry.

That, in turn, puts pressure on Walgreens. But, this works the same for all the big chains. Last year for example, Walgreens and its main competitor, CVS, produced equal results with the profits they had from generic introductions during and after the 180-day exclusivity period, according to Citi Investment Research. Both made $250 million in profits during the exclusivity period, and each had $183 million in gross profits after the six-month period was over. Rite Aid and Longs showed similar results; each made more money during the period of exclusivity than after it ended. Generic competition can have a major effect on a pharmacy's profits, and Zocor, being one of the world's top-selling drugs, showed how much of an effect it can have in just one quarter of business.

"Because the manufacturer's price dropped, the reimbursement we get from insurance companies also dropped," Walgreens spokesman Michael Polzin said.

Meanwhile, the sales volume of simvastatin, generic Zocor, tripled in Walgreens' fiscal fourth quarter, the company said. Yet gross profits were flat compared with the year-earlier period when the first Zocor generic became available and insurance reimbursement was higher.

Moreover, the additional sales translated to additional expenses for Walgreens.

"You have your added cost of your pharmacy staff filling all of these prescriptions, and you are not getting any profit dollars from it," Polzin said.

In the fourth quarter, Walgreens' cost of selling, occupancy and administration, which include filling prescriptions, jumped 15 percent to $3.15 billion from $2.73 billion. The undisclosed extra costs in staff and related costs to fill prescriptions came on top of Walgreens already aggressive store expansion (opening a new store every 16 hours) and investments in opening retail clinics in more stores. So, fourth-quarter earnings dropped to $396.5 million, or 40 cents a share, well below the 47-cent consensus estimate of analysts.