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TWST: You’ve told us in the past that the success of the drug distribution industry is tied to the growth of the pharmaceutical industry. What are you predicting for the growth of pharmaceuticals over the next six to 12 months?

Dr. Yaffe: Last year, the US pharmaceutical industry grew 13% to 135 billion. By way of background, between 1980 and 1993, on an annualized basis, this industry grew at an 11% rate. From 1993 to 1995, when the industry was under the scrutiny of the Clinton administration, it grew at about a 7% rate. Then from 1996 to 1999 it grew way above the trend at a 15%-18% rate for a host of reasons, including solid unit growth, a record number of blockbusters introduced, and relatively few drugs coming off patent. We’re forecasting the industry to grow at an average rate of roughly 10% over the next four years, so there will be a slowdown in the overall growth rate. Part of that is due to this upcoming patent expiration cycle, which, while it’s a negative for the drug companies, is a positive for the drug distributors.

TWST: How does this translate into growth for the drug distributors?

Dr. Yaffe: We think that the drug distributors’ revenues in their core drug distribution business will grow at about 1% higher than the rate of the growth of the US drug industry. So on a revenue basis they’ll average about 11%-12% growth beginning in the second half of this year when the patent expiration cycle really starts to kick in. As a result of higher gross profit margins on generic drugs, we expect overall gross profit margins to either decline at a lesser rate than in previous years or potentially even increase. In addition to the gross profit margin benefit of the patent expiration cycle, we also expect to see continued SG&A expense leverage as a result of facility consolidation and improved inventory management systems. From 1990 to 2000, the overall number of drug distribution centers shrank by 17%. This consolidation, coupled with better inventory management systems, led to a 16.7% annual increase in sales per distribution center from 1993-2000, and we expect this trend to continue.

TWST: Moving on to AmeriSource (NYSE:AAS), why do investors need to own this stock today?

Dr. Yaffe: AmeriSource is one of the last pure drug distributors. The company gets incredibly high marks for its service capability. And that’s really what this industry is all about. Hospitals, especially, can’t afford to be without their pharmaceuticals. AmeriSource also does a significant amount of business, about 33% of its revenue, with the independent drugstores. And as I mentioned, that’s going to be increasingly important as we go into this patent expiration cycle where the companies will be able to either minimize the decline in gross profit margins or possibly even see improvement in gross profit margins. That’s very important for these companies because they operate on such wafer thin margins to begin with. AmeriSource’s core drug distribution revenues are growing between 17% and 21%, about 1.5 times the industry average. Cardinal’s (NYSE:CAH) core drug distribution revenues are growing in the high 20% range, a little more than twice the industry average. So these are two companies that are doing much better than the industry as a whole.