So, let's take a look at Cardinal's recently released annual 10-K filing for the fiscal year ending June 30, 2010. (You can download it from this page.)
Alas, the data show a company that's increasingly at the mercy of its two dominant customers. CVS Caremark’s retail pharmacy business and Walgreens (NYSE:WAG) are now half of Cardinal’s drug distribution business. Even more troubling, it looks like Cardinal lost substantial market share when we exclude its two mega-customers and account for inflation.
CEO George Barrett has been focusing Cardinal on regaining market share and reputation since he joined in early 2008. From what I hear, Cardinal is making slow progress, but it’s a long road back and competition from McKesson (NYSE:MCK) and AmerisourceBergen (NYSE:ABS) is intense. When sliced and diced in the right way, data from the 10-K reveal that the turnaround hasn’t happened yet.
THE JOY OF SEC
Before getting to the numbers, I want to rhapsodize for a moment about corporate filings with the Securities and Exchange Commission (SEC).
As you probably expect, I enjoy reading annual 10-K filings. Why? SEC filings are a fascinating source of competitive intelligence, although surprisingly few people bother to read them closely. I always suggest that pharmaceutical manufacturers do a deep dive into SEC filings before starting to negotiate a fee-for-service agreement.
While regulatory and legal requirements force companies to disclose important details about their business, this mandatory sharing leads to opaque and hard-to-decipher language and presentations. Put more poetically: A 10-K filing is like a bikini. What it reveals is interesting, but what it conceals is essential.
The table below uses publicly available data from the new 10-K to update Exhibit 23 (page 55) of The 2010-11 Economic Report on Pharmaceutical Wholesalers.
As you can see, CVS and Walgreens make up 50% of Cardinal’s drug distribution business, giving Cardinal the highest level of customer concentration among the Big Three drug wholesalers. Sales to CVS grew by 8% and sales to Walgreens grew by 3%, figures which are roughly consistent with each chain's same-store sales growth.
We can unpack sales to other customers by looking at additional disclosures from the 10-K:
- Revenue growth from Cardinal’s existing customers in its pharmaceutical segment was $3.4 billion, which includes volume and price appreciation.
- Based on the table above, we know that $2.1 billion came from CVS and Walgreens. Thus, there was a revenue gain of only $1.3 billion from all other retained customers.
- Cardinal reported net customer losses (“losses of customers in excess of gains”) of $1.3 billion, roughly equal to growth from existing customers.
Since prescription drug price inflation was about 4.4% from July 2009 to June 2010, this also means Cardinal actually lost more than $2 billion in market share during its last fiscal year.
ADDING INJURY TO INJURY
Most of Cardinal’s revenue from these two large, self-warehousing pharmacy chains comes from warehouse deliveries, which are minimally profitable.
Cardinal is the only wholesaler to report the profitability of its warehouse delivery revenues compared with its direct distribution revenues. It’s right up front on pages 3-4 of the 10-K. They helpfully estimate segment profit from bulk revenues (warehouse deliveries) versus non-bulk revenues (direct distribution) by allocating segment cost of products sold and segment SG&A expenses separately.
Alas, it’s not a pretty picture. The profitability of warehouse delivery (bulk) business for Cardinal was 0.26% (yes, 26 basis points) of revenues, while the profit of non-bulk business was a comparatively lofty 1.94% of revenues. The gap between the two has been growing over time.
Sure, there are sensible economic reasons to keep the business—working capital, incremental buy-side fees from manufacturers, executive compensation benchmarking, whatever. But Cardinal would surely prefer to be growing its business with smaller, higher-profit pharmacy customers. After all, Cardinal attributed $103 million in overall gross profit declines to “pricing changes on renewed customer contracts” (primarily due to CVS).
Thus, the 10-K teaches us the Golden Rule of the Pharmacy Supply Chain: Whoever has the gold gets to make the rules.