Thursday, January 26, 2012

Big Trouble in the VA Contract: Who will win?

Yesterday, Larry Marsh at Barclays Capital reported that the much-delayed Department of Veterans Affairs pharmaceutical prime vendor (PPV) contract has been pushed back again, at least until late March.

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.


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.


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
I conservatively estimate that 2011 buy-side margin for drug wholesalers averaged 5.6%, although a large wholesaler with a centralized distribution hub will have a larger buy-side margin. The negative sell-side discount eats up most, but not all, of the buy-side margin. See Exhibit 18 (page 39) of 2011-12 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors for the details.

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.


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.

My current odds:
  • McKesson: 40%
  • Cardinal Health: 20%
  • AmerisourceBergen: 15%
  • Multiple prime vendors (no sole-source): 25%
Note: Actual results may vary. May the wings of liberty never lose a feather!


  1. Dan SteiberJanuary 26, 2012

    As the majority of purchases both Brand and Generics are contracts based the wholesaler receives the cash discount on the full WAC in most cases yet pays the net amount after the cash discount is applied and any other buy side based discounts offered to the distributor/VA.

  2. Patrick_mcginnisJanuary 26, 2012

    It's unknown to what extent exemptions to cost minus prevail with the government, but exemptions to cost minus often apply to the private sector individual products or categories versus application across the board to all. These exemptions can make a significant difference in net acquisition cost of brand, specialty and generic products-minus from one wholesaler to another.    

  3. As with all things, YMMV.