Monday, October 31, 2016

What McKesson’s Profit Warning Means for Manufacturers and Pharmacies

On Friday, McKesson sharply lowered its outlook for future profits. Its stock closed down 23%, erasing more than $8 billion of market capitalization. Ouch.

The wholesale industry’s problems have been building for some time. From McKesson’s earnings call, I have interpreted some of its most revealing statements, which illuminate the key challenges facing wholesalers:
  • Why wholesalers want brand-name drug prices to go up—and the negative impact of slowing inflation
  • A sell-side price war started by...AmerisourceBergen?
  • The factors pressuring wholesalers' profits from specialty pharmacies
McKesson has a plan to recapture its lost profits from customers and manufacturers. Don’t say you weren’t warned when McKesson and its peers come asking for more money.


Here are direct links to the information about McKesson’s second fiscal quarter of 2017. As always, I encourage you to read the original source material for yourself.
BTW, I strongly encourage you to read the entire transcript. It provides one of the most complete public statements by a CEO about how wholesalers make money—and how that might change in the future.


Given the politics of drug pricing, no manufacturer wants to be hauled in front of Congress to explain a price increase. We are also in the midst of an unsustainable gross-to-net bubble.

John Hammergren, the chairman, president, and CEO of McKesson (and the owner of a phenomenal home), described the changed outlook:
“What we have seen this year to-date, our fewer products with price increases, and those price increases are at lower rates than both prior year results and our expectations for the current fiscal year. Given our second quarter performance specific to branded price inflation, we now expect full-year branded pharmaceutical pricing trends to be meaningfully below those experienced in Fiscal 2016.”
This slowdown in brand-name inflation will lead to a corresponding slowdown in wholesalers’ profits. That’s because fees from distribution service agreements 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 rise faster than gross margins.

Note that manufacturers and wholesalers usually have 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 WAC-based fees. I analyze these dynamics in Sections 4.6.1. and 4.6.2. of our The 2016–17 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors.

During the call, Hammergren articulated this profit model very clearly and then added: “So the takeaway here is that branded inflation still plays a meaningful role, and in some cases, it can be an important part of our overall compensation with specific manufacturers, and we can be impacted by their decisions, relative to price increases.”

McKesson therefore expects “to receive less compensation from branded price increases than we originally anticipated in fiscal 2017.” McKesson’s comments about drug pricing took down stock prices throughout the pharma and PBM sector. Here’s a chart from The Wall Street Journal article Backlash Against Drug Prices Hits Manufacturers and Middlemen.

[Click to Enlarge]


A drug wholesaler’s gross profit from distributing brand-name drugs can come from manufacturers (buy-side) and from customers (sell-side). The buy-side and sell-side terminology derives from a wholesaler’s buying products from a manufacturer and then selling products to a wholesaler’s customers, such as a pharmacy or hospital.

McKesson discussed sell-side margin pressures, particularly with independent pharmacies. When asked about the factors triggering this new price war, Hammergren coyly said:
“You'd have to really probably ask the companies involved in it as to why they would pursue price. I can tell you that McKesson doesn't believe you can build sustainable relationships with customers or value for shareholders with a price-oriented approach. And I know that at least one company in our sector has been pretty public about growing revenues above market and about regaining market share, particularly in the independent space. And so I think that certainly people have different motives perhaps to grow their business beyond the market.”
I presume he is referring to AmerisourceBergen. Its historically strong position with independent pharmacies has weakened, as evidenced by its declining market share with independent pharmacies. Smaller pharmacies maximize their buying power through pharmacy buying groups, which establish a relationship with one or more preferred wholesalers. ABC may be going after these groups to regain share quickly. See Exhibits 15 and 19 of our 2016-17 wholesaler economic report.

I also presume Hammergren is hoping that the CEOs of other wholesalers are listening to these not-so-subtle hints about pricing. In case there was any confusion, he ended the call by saying that “we believe the increased competitive pricing activity does not build sustainable customer relationships or long-term shareholder value.”

Everyone got that?


The growth of specialty drugs is fundamentally challenging wholesalers’ traditional pricing models. There are three separate but interrelated negative mix shifts:
  • Customer mix: Payer and manufacturer network strategies are shifting specialty product sales into the largest specialty pharmacies—which are also wholesalers’ least profitable customers. In some cases, specialty pharmacies purchase products directly from the manufacturer of a specialty drug, bypassing specialty distributors and full-line wholesalers.
  • Product mix: A wholesaler’s typical 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, undermining the traditional wholesale cost-minus pricing model.
  • Manufacturer mix: For brand-name drugs, distribution service agreements with pharmaceutical manufacturers account for about half of a drug wholesaler’s buy-side gross margin. Large manufacturers pay a less-than-average fee rate, while smaller manufacturers pay much more. Specialty drugs are being launched by larger manufacturers, which means that the average buy-side margin is declining.
Adding insult to injury: (1) the excess profits that wholesalers earned from the generic inflation bubble are vanishing. See AmerisourceBergen Charts the Profit Headwinds Facing Drug Wholesalers, and (2) pharmacy-dispensed biosimilars are unlikely to provide near-term profit relief for wholesalers, per Section 6.2.4 of our 2016-17 wholesale economic report.

In response, wholesalers are trying to institute new pricing terms that reset the typical discounts offered to customers. Early in the call, Hammergren painted this strategy in unusually positive tones, saying:
“We are making a fundamental change to the structure in terms of our relationship with both providers and manufacturers as it relates to hundreds of specialty products. We are charging separately for the supply chain value we add across a wide array of product categories and manufacturers. Our conversations with customers and suppliers around specialty pricing are proceeding as expected, and we are pleased with the responses we are receiving.”
But this sunny tone was later undercut by his chilling response to a question about renegotiating manufacturer agreements.
“[W]here a manufacturer's behavior has changed dramatically from its previous behavior and we had come to depend on those mechanisms as part of our funding source with that manufacturer,
I think we have every right to go back to those manufacturers and say, listen, we need to open the dialog again because by your unilateral decision, you have significantly impacted our profitability on your particular product lines and we don't think that's fair and we want to recover that lost margin. So I think that that certainly is something we plan to pursue.”
Here, "a manufacturer's behavior" means its list price increases. Hammergren's statement implies that McKesson will go after manufacturers that make a “unilateral decision” (!) not to increase WAC list prices. Shhh, nobody tell senators Warren and Sanders!

Cardinal Health and AmerisourceBergen will report earnings later this week and will likely echo the themes on McKesson’s call.

Strap yourself in. Wholesalers are trying to make the jump to a new profit model. This is where the fun begins.

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