The Pharmacy Services Industry has historically been viewed as a safe haven for investors seeking steady growth and preservation of capital. However, things have changed a bit in recent times, owing to the aging of the American population and an altered industry landscape. These stocks now have more of a growth profile than they had in the past. There is much opportunity for expansion, with billions of dollars in business up for grabs. But there is also greater competition, coming from every direction, as even non-traditional channels are looking to get in on the act. Below, we discuss an evolving industry and provide a guide as to what to consider before committing funds here.

A Transformation

Traditionally, this industry has been divided into two main categories: pharmacy services, which consists of pharmacy benefits managers, or PBMs, (along with clinical services providers), and large drug chains. Although both groups distribute prescription drugs to consumers, they differ in that PBMs are mail-order operations and chains sell from storefronts. The numerical arrays on the Value Line pages of companies in these groups are largely similar. However, the pages of PBMs, which are somewhat more capital intensive, list capital spending per share and depreciation, and the pages of drug chains include the number of stores and gross margin.

Lately, the dividing lines of these two categories have become less clear. For a number of years, drug chain stores have recognized an increasing threat to their business share from the PBMs. Also, the chains have eyed the attractive PBM market with particular interest. Indeed, many chains have launched their own PBMs. Pressure to stay competitive has prompted some in the industry to think outside the box and use acquisitions to gain access to a bigger scope of business.

Financial Flexibility

Given the industry dynamic of assimilation, it's important to consider a company's position in the merger & acquisition arena. Cash flow and financial strength are two key indicators. Ideally, the cash flow of companies wishing to combine should be sufficient to fund existing operations and to take advantage of growth opportunities. Too, the merged capital structure should not be overburdened with debt. There must also be well-defined benefits to a union.

Deals should offer greater scale in terms of geographic market coverage and offered services. Acquisitions, if done successfully, may provide quick, economical access to new markets, some with challenging barriers to entry. Well-executed combinations can immediately add to earnings. The traditional alternative of new store development entails high start-up costs and may take a few years to pay off in net-profit growth. Either way, it is imperative that pharmacy services companies have the financial wherewithal to expand their footprint.

M&A activity will probably remain fairly intense going forward, as stockholders are pressuring companies to boost their return on investment. In the past, most have shied away from the acquisition game, but many have recently changed their tune. The inability of small entities to adequately address increased operating costs has created the opportunity for large players to step in and gain access to previously untapped markets that would otherwise be difficult or expensive to break into.

While many underperforming operators are looking to mergers as a way to boost growth, others are still relying on more traditional industry methods to strengthen their businesses. But the environment is growing more hostile for those who resist consolidation, with bidding wars over prospective takeover targets more commonplace than ever before. That said, the consolidation trend might well open some doors for small, struggling players. Industry behemoths seek the advantage of scale, though, if they stand to gain too great a presence in a certain market, antitrust regulators may call for the divestiture of some assets.

Business Mix

Within the business description on the Value Line page, investors will find a company's mix of pharmacy and general merchandise sales. A heavy weighting of wide-margined pharmacy business is vital to a company's well being. Pharmacy business is less sensitive to economic cycles, and a sales slowdown here could indicate a serious problem. The prescription growth rate is another noteworthy figure in measuring the health of a company, and it is gaining prominence. Demographics point to a rise in the number of Americans aged 65 and older over the next two decades. Increasingly, Baby Boomers will require medical care and pharmaceuticals, auguring well for the industry's sales and earnings prospects. The largest pharmacy services providers are best positioned to reap the coming rewards.

Cost Risk

Pharmacy companies have to deal with significant overhead, and operating margins are relatively thin. Expense management is extremely important. Serious missteps could potentially cost a company hundreds of millions of dollars. Cost control is particularly significant when an operation is undergoing considerable expansion, which can involve many moving parts. Companies with wide operating margins obviously have more cushion for error.

PBMs have an added cost risk. They are subject to extensive, costly business disclosure laws. Recently, regulators have intensified their examination of business practices, especially with regard to arrangements with drug manufacturers. Some claim that companies misappropriated savings that should have been passed along to consumers. Investigations can lead to more stringent regulation, having a measurable, negative impact on operating margins and earnings.