Wednesday, June 27, 2012

Will Walgreens bypass Cardinal Health?

On Monday, a Cleveland Research report publicized something that many of us already know: "Walgreen's (NYSE:WAG) may be looking to bypass Cardinal Health (NYSE:CAH) in order to source branded drugs directly and that the Boots acquisition may help support the initiative." (Sorry, the complete report is not available.)

Obviously, this would be a material change for Cardinal as well as the brand-name manufacturers selling through wholesalers. By my estimates, Walgreens accounts for about 25% of Cardinal Health’s drug distribution revenues, but only about 6% of Cardinal’s drug distribution operating profit.

Walgreen’s potential move highlights an apparent drug channel puzzle: Why do the biggest pharmacies (listed here) almost always purchase brand-name drugs—but not generics—via drug wholesalers rather than buying directly from a manufacturer?

Below, I take a brief detour into the arcane world of pharmaceutical pricing to explain the hidden economics that sustain these warehouse sales for wholesalers. At a minimum, Walgreens must convince manufacturers to alter long-standing discount structures, or the math just doesn't work. And as Cleveland notes, "manufacturer support is mixed."

Two important points:
  • Because the information about Walgreen’s intentions had not previously been disclosed, I have not commented on the topic in any public forum, including on Drug Channels. But Cleveland’s report, along with at least one other sell-side report published yesterday, puts the topic into the public domain.
  • To maintain confidentiality and avoid conflicts of interest, my work with pharmaceutical manufacturers precludes me from any business consulting assignments with pharmacies or drug wholesalers. So, my point-of-view is 100% neutral when it comes to the channel intermediaries.
Here's a brief primer on the odd economics of the brand-name channel, taken verbatim from pages 62-64 of the 2011-12 Economic Report on Retail and Specialty Pharmacies:

"The largest self-warehousing chain drugstores and mail-order pharmacies have the size and scale to perform the functions of drug wholesale distribution. Surprisingly, these companies continue to purchase brand-name drugs—but not generics—via a drug wholesaler rather than buying directly from a manufacturer.

In theory, large pharmacy buyers with sophisticated in-house supply chain capabilities could also bypass drug wholesalers to purchase brand-name drugs. However, large pharmacies can buy brand-name drugs from a wholesaler less expensively than when buying directly from the manufacturer. A self-warehousing chain pays a lower price when purchasing via a wholesaler for delivery to the retailer’s warehouse than it would when purchasing directly from the manufacturer for delivery to the retailer’s warehouse.

As a result, the pharmaceutical purchasing strategy of a large pharmacy differs from that of a smaller pharmacy for both brand-name and generic drugs:
  • Brand-Name Drugs—A self-warehousing pharmacy chain or a large mail-order pharmacy will purchase brand-name drugs via a wholesaler but have the product delivered to a chain warehouse instead of directly to the store. The wholesaler acts either as a transactional intermediary with the manufacturer or as a redistributor of bulk product from the manufacturer.
  • Generic Drugs—Unlike smaller pharmacies, the largest chain and mail-order pharmacies use their negotiating power and in-house warehousing capabilities to bypass wholesaler intermediaries. They buy drugs directly from generic manufacturers.
This results from the unique pricing structure and market dynamics for brand-name drugs. In the U.S. pharmaceutical industry, manufacturers can offer different levels and types of price concessions from the published Wholesale Acquisition Cost (WAC) list price to different Classes of Trade (COT). A COT is a group of entities that share unique service requirements, dispensing methods, patient populations, professional capabilities, or other factors. Representative COTs include long-term care, physician, wholesaler, specialty pharmacy, or retail pharmacy.

Different types of purchasers face different net acquisition costs for brand-name pharmaceuticals. These variations occur because different price concessions are available to different COTs. Some of the factors that could influence the pricing concessions include:
  • The total volume of product purchased
  • The purchaser’s ability to influence the selection of one drug from a set of therapeutically similar products
  • The benefits provided by the purchaser to patients or others stakeholders
  • Timely payment
A purchaser must take advantage of (or meet) the criteria for offered price concessions. For example, retail pharmacies typically pay more for single-source, brand-name drugs than do other classes of trade, such as hospital buyers. Thus, large retail pharmacy chains may pay more for brand-name drugs than do non-retail classes of trade that purchase in smaller volumes.

The situation is very different, however, for a large chain customer of a drug wholesaler. These volume buyers can demand deep discounts from wholesalers by threatening to substitute in-house supply chain capabilities. They can then negotiate with drug wholesalers to capture discounts or fees that brand manufacturers offer to the wholesale class of trade. These wholesale discounts are not available to the retail class of trade. Estimates of these buy-side discounts are provided in the 'Components of Buy-Side Gross Margin' section of the 2011-12 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors.

In addition to the acquisition cost advantage, large chain and mail-order pharmacies benefit from the wholesalers’ higher service levels vs. direct distribution from a manufacturer. Large customers can also use a single vendor for both direct-store and warehouse deliveries.

Large customers would bypass wholesalers if manufacturers change their policies, although we do not expect any significant changes in these relationships during the next few years. The advantage of buying from wholesalers would be eliminated if pharmaceutical manufacturers erased the class-of-trade pricing distinctions between wholesale and retail.

Alternatively, manufacturers could pay for other services to enable a chain to buy directly without an acquisition cost disadvantage. These services could include inventory or shipment data about a large chain’s individual retail locations. Today, large customers prevent wholesalers from sharing this detailed data with manufacturers. Manufacturers could gain access to these data by selling directly to the self-warehousing chains and paying data access fees.

Rather than bypass wholesalers, some large pharmacies are shifting to direct-store deliveries from their primary wholesaler. This allows the pharmacy to retain the acquisition cost advantage of indirect purchasing via wholesalers. For example, Walmart now uses McKesson to deliver product directly to its stores rather than receive deliveries to a Walmart warehouse for redistribution."

WHAT’S NEXT?

Given my exposure to non-public information from my manufacturer clients, I can’t comment publicly on Walgreen’s plans. My clients know where I stand on the matter.

I note that Walgreens has built a large internal team that includes ex-executives from both wholesalers and manufacturers. For background, see Walgreens sets Rx purchasing leadership team or A conversation with Jeffrey Berkowitz. Walgreens can also leverage Alliance Boots’ wholesale know-how to accelerate its buy-direct strategy.

In the meantime, stay tuned for any other public disclosures or statements.

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