Tuesday, February 10, 2015

Why Blockbuster Hepatitis C Drugs Are Squeezing McKesson’s Profits

Last week, McKesson reported big revenue gains for its distribution business segment—increases that have been driven partly by booming sales of new hepatitis C drugs. Read the press release.

However, McKesson’s disclosures suggest that the company barely broke even—and may have even lost money—by selling such drugs as Gilead Science’s Sovaldi and Johnson & Johnson’s Olysio.

Three key factors—outlined below—are driving this profit squeeze. More broadly, the hepatitis C situation highlights wholesalers’ growing risks for pharmacy-dispensed specialty drugs.

Read on and see if you agree with my slap and tickle math.


McKesson sold $1.3 billion more hepatitis C drugs in 2014’s fourth calendar quarter, compared to 2013’s fourth calendar quarter. These drugs accounted for 4 percentage points of McKesson’s 17% year-over-year North American pharma distribution revenue growth.

Unfortunately for McKesson, it looks as if the profit margin on these drugs was below that of other products. Here’s what Chairman and CEO John Hammergren said last week:
The segment-adjusted operating margin rate for the quarter was 226 basis points, a decline of 8 basis points versus the prior year. This decline was driven by a higher mix of branded drug sales and an adjusted operating profit contribution from Celesio that was lower than we expected. Excluding the impact of Celesio and the hepatitis C drugs, the segment-adjusted operating margin was 248 basis points, an increase of 14 basis points over the prior year. (source)
In other words: Excluding the sales and costs of Celesio and hepatitis C drugs, McKesson’s operating margin would have been higher by 22 basis points (=2.48% minus 2.26%). His explanation is presumably intended to provide Wall Street with a comparable sales growth figure.

These results echo a pattern disclosed in McKesson’s third calendar quarter results, which contain a much more specific disclosure. Here’s what Hammergren disclosed during McKesson’s October 2014 earnings call:
The segment-adjusted operating margin rate for the quarter was 242 basis points…Excluding the impact of both hepatitis C drugs, segment-adjusted operating margin was approximately 250 basis points for the current quarter. (source)
Here, Hammergren is saying that hepatitis C drugs (but not Celesio) reduced operating margins by 8 basis points (=2.50% minus 2.42%). His comments imply that McKesson barely broke even—and possibly even lost money—selling the hepatitis C drugs. Here’s my math based on its reported financials:
  • In McKesson’s second 2015 fiscal quarter (2014’s third calendar quarter), its Distribution Solutions segment revenues were $43.998 billion. Operating profit was $1.063 billion, or 2.42% of revenues.
  • To break even, McKesson would have had to sell at least $1.5 billion of hepatitis C products in last year’s third calendar quarter. If they had, Hammergren’s statement implies that non–hepatitis C revenues were $42.520 billion and operating profits were $1.063 billion (=2.50% * $42.520 billion).
 Total third quarter 2014 U.S. sales of Sovaldi and Olysio were about $2.9 billion. Did McKesson account for more than half of those sales? If not, then it lost money selling its hepatitis C product sales. That would not be cool for cats.


Wholesaler profits are being squeezed in three ways:
  • Higher-than-expected sales of the new drugs. Consider Gilead Sciences’ Sovaldi, the hepatitis C drug approved in December 2013. This product had 2014 global sales of $10.3 billion, exceeding pre-launch consensus forecasts by $8.9 billion, or more than 600%! (source)
  • Greater-than-expected concentration of dispensing share. The hepatitis C drugs are open distribution products and can therefore be dispensed by any licensed pharmacy. However, commercial payers required patients to use a much smaller set of specialty pharmacies—often the ones owned by a health plan or pharmacy benefit manager. As a result, product sales shifted into the wholesalers’ largest customers with the deepest discounts. For McKesson, these include CVS Health’s Caremark business, UnitedHealthcare’s Optum Rx, and the VA.
  • No offsetting generic margins. Wholesalers’ usual economic model relies on the blended margins from lower-profit brand-name drugs and higher-profit generic drugs. A pharmacy with a high specialty mix will buy very few generic drugs, so it’s another nail in the heart of the wholesale pricing model.
Due to these factors, wholesalers sold billions of dollars more hepatitis C drugs than they had planned—but to fewer, larger pharmacy customers that got the best deals. To understand wholesaler pricing models, see Chapter 4 of the 2014-15 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors.

For hepatitis C drugs, some wholesalers instituted “net pricing” terms, which reduce the discount available to smaller pharmacies. Larger pharmacies with negotiating power have been able to push back against these demands. Is that love?

You may be tempted to view specialty drugs as automatically good for wholesalers. But as this example indicates, they may not always be cool for cats.


  1. Great post. Enjoyed the math, music, and explanation of the profit squeeze

  2. It is a reverse Robin Hood in the DSA market. Wholesalers take 10% from emerging brands, while less than 1% from existing large pharma. Perverse system, should be based on the cost of managing the flow of the specific product and not on WAC. When wholesalers can demonstrate value other than giving away margin, they will thrive. PS, no one starving on Post Street.

  3. It reminds me of the novel Catch 22: we'll produce it for 5 cents, sell it for 3 cents and make it up on the volume.

  4. Insightful as always Adam. I am e-mailing this link to 5 or 6 friends, as it weighs heavily on debates/speculation we've been having.

  5. Adam, given the price of the Hep C drugs is it possible that "normal" FFS rates were drastically lowered by the manufacturer and that this contributed as well?

  6. Wowsa on McKesson. Slap and Tickle – is that like Fifty Shades of Math???

  7. Love the math, thanks for brining this intringing consequence of the wholesale pricing approach to light.

  8. I think some of the large Specialty pharmacies may have been price protected in 2014 when the wholesalers surprised all the specialty pharmacy's
    by changing the cost of goods to WAC - 1.0% stating changing market forces.
    Lesson learned when you negotiate with a wholesaler don't forget to discuss price protection. McKesson was likely unable to lower pricing on large SP
    and therefore did take a loss.