ABC/CAH/MCK: US Generic Inflation Continues in 1Q15

Richard

On a sales-weighted basis, prices (paid by retailers) for US generics rose 4.7% in 1Q15, substantially faster than in 4Q14 (0.5%), and on par with the average pace of inflation (5.1%) seen since early 2013

All else held equal, generic price inflation aids the gross margins of drug wholesalers (e.g. ABC, CAH, MCK), thus the healthy generic inflation observed in 1Q15 is a bullish early indicator for these names’ 1Q15 results. Despite carefully trying, we observe no correlation between generic manufacturers’ participation in US price inflation and either the quality of their immediate earnings or their relative share price performances

In a February note we showed that US generic inflation isn’t about supply disruptions or small numbers of manufacturers producing the products whose prices inflate. Instead, we found two patterns: one in which manufacturers of products with very low prices inflated these products’ prices toward the median price for all generics (explaining ~75% of inflation); and, another in which manufacturers of products with median prices but very low volumes (and thus very modest sales) inflated these products’ prices beyond the median (explaining the remaining ~25% of inflation). Inflation in 1Q15 also is explained by these two patterns, thus whatever’s driving inflation continues apace

A plausible explanation is that generic manufacturers, having fallen to near historic low levels of financial performance (e.g. ROA, GM), are cooperating to raise the prices of products whose characteristics (low sales due to either very low prices or very low volumes) accommodate price inflation. An alternative and/or over-lapping explanation is that wholesalers, who benefit from generic inflation and who have recently taken responsibility for the majority of US generic purchasing, are at the very least passive with regard to generic inflation

If inflation is explained largely by strapped generic manufacturers cooperating, then it can’t last very long – the manufacturers’ financial results are improving, and the number of manufacturers required to cooperate is far too large for the cooperative spirit to remain stable

Conversely, to the extent generic inflation is the result of wholesalers’ actions, generic inflation is likely to continue until and unless such actions are challenged

We intend to publish an index of US generic inflation at least quarterly, and anticipate that as long as the inflationary trend continues, that US wholesalers’ gross margins will expand, with commensurate gains in earnings

For our full research notes, please visit our published research site

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