Thursday, January 26, 2017

McKesson’s Profit Shortfall: How Wholesalers Benefit From Rising Drug List Prices

Yesterday, McKesson reported another quarter of disappointing financial results. Click here to read the press release.

CEO John Hammergren complained that the company was “unfavorably impacted in the third quarter by weaker branded pharmaceutical pricing than anticipated.”

On last night’s earnings call, the company echoed its threat to renegotiate agreements with manufacturers that don’t increase drug list prices at a rate that's acceptable to McKesson.

In What McKesson’s Profit Warning Means for Manufacturers and Pharmacies, I explained that McKesson and other drug wholesalers want drug list prices to rise. To help you interpret what’s going on, below is a brief excerpt from our 2016-17 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors that outlines precisely how wholesalers benefit from drug price inflation—even when they have fee-based agreements with manufacturers. File this post under “warped channel incentives.”

The following text is adapted from Sections 4.6.1. and 4.6.2. of our 2016-17 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors.

THE PROFIT IMPACT OF BRAND-NAME DRUG PRICE INFLATION

Average year-over-year list prices for the brand-name drugs have been growing. Since 2010, weighted average price increases have ranged from about 10% to 14% annually. See this chart from Key Insights on Drug Prices and Manufacturer Rebates from the New 2015 IMS Report.

For brand-name drugs, wholesalers can profit from this drug price inflation. That’s because fees from distribution service agreements with manufacturers are generally computed as a percentage of a brand-name drug’s list price. Therefore, the dollar value of a wholesaler’s fee payment from the manufacturer rises whenever a manufacturer increases a drug’s list price—the Wholesale Acquisition Cost (WAC). Gross profits increase, because the wholesaler’s fees are computed based on the new, higher price.

The wholesaler could also benefit by selling inventory purchased at the older price at the new higher price. As we explain below, these inventory profits are typically eliminated by manufacturer-distributor agreements.

Consider a pharmaceutical product with a $275 WAC list price, which a manufacturer increases by 10% annually. We assume that price increases do not affect unit volume. The numerical example in the chart below illustrates that by the fourth year, the wholesaler’s total compensation per unit distributed grows by 33%.

[Click to Enlarge]

There are, however, important reasons that wholesalers do not retain all of the incremental buy-side operating profits from brand-name price increases:
  • Sell-side discounts. Manufacturer price inflation encourages customers to renegotiate their wholesaler contracts every few years. Since contracts are often linked to WAC, customers renegotiate sell-side discounts to recapture a portion of these incremental profits. Thus, the sell-side gross margins tend to fall as prices rise. Similarly, pharmaceutical manufacturers will renegotiate buy-side fees to re-index the fees back to an appropriate value.
  • Inflation in operating costs. Like other businesses, wholesalers face general inflation in the operating costs of distributing products. These costs are attributed to warehousing, transportation, technology, and other operating expenses. From 2011 to 2016, the price index for the wholesaling of non-durable goods (including pharmaceuticals) has increased at an average rate of 1.6% per year.
Price increases also have a corresponding effect on a wholesaler’s balance sheet. As a manufacturer increases the WAC price of its products, the wholesaler’s balance sheet assets and capital costs also increase. These assets are based on: (1) the drug’s purchase price from the manufacturer (inventories), and (2) the drug’s invoice selling price to the wholesaler’s customer (accounts receivables).

Inventory and accounts receivables are the two biggest current assets on a wholesaler’s balance sheet. Higher drug prices therefore increase a wholesaler’s cost for purchasing inventory and the value of credit extended to customers. However, these balance sheet costs are typically smaller than the extra fees illustrated above.

INVENTORY APPRECIATION AND REVALUATION

In recent years, manufacturers have negotiated agreements that recapture the value of price appreciation on inventory held in wholesalers’ warehouses and on order with the manufacturer. If a manufacturer recaptures the full inventory appreciation value, then a wholesaler earns only the buy-side fees. It does not benefit from buying inventory at the old price and then selling it at the new higher price. Distribution Services Agreements (DSAs) with large manufacturers almost always include recapture and revaluation clauses.

The chart below empirically illustrates the impact of inventory revaluation on a wholesaler’s profits. In this example, we assume that wholesalers purchase a drug from a manufacturer at a 4.5% buy-side margin and sell the drug to a pharmacy with a 3.5% sell-side margin. If the drug’s WAC is $250, then the wholesaler’s gross profit is $2.50 and its gross margin is 1.04%.

[Click to Enlarge]

If the manufacturer increases the WAC price by 10%, to $275, then the wholesaler earns substantial inventory appreciation profits on product purchased at the old price. This means that the wholesaler has purchased the product at the old price, but can sell it based on the new price. In this example, a product in inventory was purchased for $238.75, but could be sold for $265.38. The wholesaler’s gross profits are almost ten times larger. Gross margin is 10.03%.

However, the manufacturer and wholesaler can agree to “revalue” the wholesaler’s inventory based on the new WAC price. In the example, the wholesaler returns $23.88 (=$262.63 - $238.75) in revaluation amounts to the manufacturer. Consistent with the example in Exhibit 51, the wholesaler’s gross profit increases by 10%, but its gross margin remains the same as that of the pre-increase scenario.

CMS refers to these amounts as “price appreciation credits.” The manufacturer gains the value of price increase on product that has been purchased by wholesaler but not yet sold to wholesaler’s customer. As we discuss in Section 6.1.2. of our report, these sums therefore have important implications for government pricing and manufacturer’s channel compensation approaches. Revaluation amounts can be substantial, although manufacturers do not typically report the value of inventory revaluation received from wholesalers.

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Per The Weird and Wild Gross-to-Net Adventures of EpiPen and Its Alternatives, many drug channel participants profit from rising drug prices. McKesson’s latest earnings report highlights once again the odd economics of our current system.

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