The delay appears to be caused by alleged “improper buying” from McKesson (NYSE:MCK), the current sole PPV. See Veterans agency knew of improper buying under McKesson contract. The House Committee on Veterans' Affairs will hold a hearing on the PPV next Wednesday called Examining VA's Pharmaceutical Prime Vendor Contract.
Below, I take a totally unscientific guess at which wholesaler will win the $4 billion VA contract, given odd rumblings in the wholesale customer markets. And since McKesson provides a steep 5.15% discount to the VA, it’s a good opportunity to chat about the oft-misunderstood cost-minus pricing model.
BACKGROUND ON THE PPV
In 2009, the Congressional Budget Office (CBO) published an excellent overview of the PPV program. Read it here: The Department of Veterans Affairs’ Pharmaceutical Prime Vendor Program.
Here’s how the CBO memo describes the program:
“The PPV contract covers inpatient drugs, outpatient prescriptions, outpatient medical and surgical supplies, and prescriptions for patients discharged from VA medical centers. The vendor agrees to provide next-day delivery of drugs and additional services such as customer-service evaluations, paperless invoices, bar-coding of drugs and corresponding facility shelves, and installation and maintenance of equipment and software for automated ordering. All VA facilities must place orders through the PPV, which delivers pharmaceuticals to the facilities and receives payment directly.”Seven distributors bid on all or portions of the contract, but the entire award went exclusively to McKesson, with an effective date of April 1, 2004. The initial 2-year contract was then renewed for three times, i.e., through April 1, 2012.
Long-time industry observers may recall that AmerisourceBergen (NYSE:ABC) had the contract from 1999 to 2004. ABC’s stock price dropped by 10% on December 31, 2003, the day that its VA contract loss was announced. ABC’s legal protest over the awarding of the VA contract was denied by U.S. Court of Federal Claims.
COST MINUS: IT'S ALL IN THE REFLEXES
Here are the current discounts for the VA and DoD contracts. McKesson currently provides an astonishing 5.15% discount, a.k.a., the infamous cost-minus pricing.
So, does McKesson lose money on each sale? Nope.
Despite what you may have heard, cost-minus pricing does not mean that a wholesaler sells the product below its own acquisition cost. Instead, the wholesaler is selling a product for less than the manufacturer’s list price (or a different measure of cost). On average, gross margin percentages remain positive for wholesale sales of brand-name drugs to all customer groups and product types.
There are two primary ways that this apparently crazy “cost minus” math translates into positive wholesaler profits:
1. Buy-side margin allows the wholesaler to offer discounts from "cost" while still earning a positive gross margin.
Wholesalers earn buy-side gross margin from:
- Fee-for-service payments and discounts from brand-name manufacturers
- Purchasing discounts from generic manufacturers
- Payment terms from manufacturers
2. Payment terms can provide a wholesaler with negative working capital.
The cash conversion cycle (CCC) is a key element of wholesaler profits from the VA contract.
This balance sheet metric combines the inventory holding time (Days Inventory Outstanding, DIO); the time needed for a wholesaler to collect accounts receivables from a customer (Days Sales Outstanding, DSO); and the time in which a wholesaler needs to pay a manufacturer (Days Payables Outstanding, DPO). The average CCC (=DIO+DSO-DPO) for a large wholesaler is about 8 to 9 days, per Exhibit 20 (page 43) of my wholesaler economic report.
The 5.15% discount applies to all VA facilities using the Fast Pay system, which pays McKesson within 48 hours of receiving an invoice. With standard manufacturer payments terms and lean inventories, McKesson essentially gets free money to run its business.
This model also adds to the cash flow required for any over-the-top perks and compensation paid to McKesson’s CEO. Make sure you read page 2 of He’s One of the Nation’s Highest-Paid CEOs—and You’ve Never Heard of Him.
WHO WILL WIN?
I had been assuming that McKesson would retain all or most of the PPV. However, the alleged shenanigans have cast a shadow over their odds. McKesson will presumably respond to the allegations at next week’s House hearing.
Meanwhile, Cardinal Health (NYSE:CAH) and AmerisourceBergen each have their own reasons for bidding more aggressively, especially given the notable shifts in the wholesale customer environment.
- Big customers may be consolidating, e.g., Express Scripts and Medco Health Solutions, Omnicare and Pharmerica.
- At least one major pharmacy chain is exploring more direct purchasing from brand-name manufacturers.
- Some retail chains are reconsidering their usage of wholesaler generic programs
- Wholesale customers are feuding. The Express Scripts/Walgreens kerfuffle has already forced one wholesaler to choose sides.
- McKesson: 40%
- Cardinal Health: 20%
- AmerisourceBergen: 15%
- Multiple prime vendors (no sole-source): 25%