Thursday, October 14, 2010

Double Trouble for Cardinal Health

Tuesday’s post about CVS Caremark (NYSE:CVS) reminded me about Cardinal Health (NYSE:CAH), one of CVS' biggest suppliers.

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.


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.
Translation: Cardinal's sales were flat to slightly down last year to its non-Big Two customers. Ouch.

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.


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.


  1. I have heard of a Cardinal Specialty Wholesale Distribution business coming soon. I believe this would meet your recommendation of "smaller, higher profit" customers.

  2. Yes, that's exactly why CAH paid so much for P4. They need to play catch up in specialty with MCK and ABC.


  3. Merger ahead? Would SEC allow it?

  4. Adam, excellent overview. CAH has fast moved to the back of the Big 3 pack and as you astutely point out, they are highly leveraged into their large customers. There is a tremendous amount of criticism regarding CAH's lack of presence in specialty. The industry is laughing at the P4 acquisition as it is merely a play to help oncologists optimize product mix around payer profitability. Hardly a move that rivals them with either ABC's ABSG presence or even the strong moves that MCK has made with their specialty businesses. Given that there is no one left to buy in the SD market, it means CAH will have to grow organically, which has never been their strong suit.

  5. Excellent points, Bill. Cardinal just got $700 million for its carefusion shares, so I would not be surprised if they acquired one of the few remaining distribution assets with scale. Discretion (and fear of lawsuits) prevents me from naming these companies on Drug Channels, but not hard to figure out.



  7. Highly improbable, but thanks for playing!