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Making money from drugs — legally

Dealing drugs can be a wonderfully profitable business.  Merchants have extreme pricing power, margins are phenomenal and customer demand is constant, if not insatiable. Well, at least that’s the case for illegal drugs – and the downsides are somewhat undesirable, to say the least! For those that deal in legal and medically important drugs, the situation is somewhat different.

Sure, pharmaceutical giants that hold patents over life-saving drugs also enjoy many of the same benefits, but for wholesalers and distributors the situation is usually less favourable. The Pharmaceutical Benefits Scheme (PBS), which ensures Australians have access to important medications at affordable prices, essentially removes any pricing power over those products..

Furthermore, ongoing PBS reforms combined with an increase in generic brand drugs, has seriously lowered the price we pay for medications and the subsidies provided by the government. That’s great news for consumers, but not so great for wholesalers.

Through adversity comes opportunity

Given the above, it might seem as though the pharmaceutical wholesale industry is one investors should avoid.  And while this is understandable for the most part, Australian Pharmaceutical Industries (ASX: API) warrants a closer look.

The business may be far from a household name, but it is one of the country’s longest running with its origins going back over a century.  Today, the company is one of the largest pharmaceutical distributors in the country, supplying around 4,000 pharmacies and generating over $3 billion in annual sales.

The fact remains, though, that a combination of neglect and structural reform has taken its toll on API.  It’s been a tough ten years for the business (and investors), and while mindful of Buffett’s maxim that “turnarounds rarely turn”, Australian Pharmaceutical Industries may just prove to be the exception to the rule.

Where is the growth?

Although the company exhibits remarkably stable revenues and pays a healthy 5.6% fully franked dividend, if investors are to do well long term, the key question is, as always, where will the growth come from?

Given the ongoing burden of PBS reforms, the group’s wholesale distribution business is unlikely to shoot the lights out anytime soon.  Indeed, revenues and profits here are likely to remain under pressure for the foreseeable future.  In part this will be offset by some significant efficiency improvements and cost savings.  Indeed, since taking the helm in 2006, CEO Stephen Roche has undertaken significant investment in this area.

However the real engine for growth, and the jewel in the API crown, is the Priceline Pharmacy franchise.  With a fast-growing network of 370 odd stores and a like-for-like performance that is the envy of many retailers, Priceline’s best days lay ahead.

As its pink motif may suggest, Priceline has a definite female focus and offers a broad range of cosmetic products.  It also boasts one of the largest and most successful loyalty programs in the country; the ‘Sister Club’ has over 4.3 million loyal members, who apparently tend to spend 50% more than non-members.

As with medication, cosmetics are, somewhat counterintuitively, highly resilient in the face of economic malaise. The so-called ‘lipstick effect’ is certainly a source of confidence when considering the resilience of sales for Priceline stores.

Foolish bottom line

The ongoing nature of PBS reforms have kept many investors away from Australian Pharmaceutical Industries.  In their caution, they may have just missed the bigger picture and created a wonderful opportunity for long term investors.  API not only offers an attractive and fully franked dividend, but shares in the business are actually trading well below their net tangible asset value (take note any Gordon Gekko style corporate raiders!)

While the regulatory burden under which the business operates makes for a far from efficient generation of profits, the critical nature of pharmaceutical wholesaling and distribution will ensure the viability of the business is not legislated away. In the meantime, the ongoing expansion of the Priceline business will fuel a respectable rate of growth; a fact not accounted for in the current pessimistic market price.

Where to invest $1,000 right now

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Andrew Page is a Motley Fool analyst. He owns shares of API. You can follow The Motley Fool on Twitter @TheMotleyFoolAu. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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