Tuesday, November 05, 2019

CVS Health’s Specialty Gain Is McKesson’s Pain

Last week, McKesson released its earnings for the third calendar quarter of 2019. (See the links below.) The company revealed unexpectedly high revenue growth in its distribution business—but little incremental profit from these new revenues. Its stock dropped sharply on the news.

The thief that burgled the missing profits: CVS Health, McKesson’s largest customer. McKesson’s financial results reflected the challenges of an ultra-low profit customer that unexpectedly started growing much faster than the overall industry.

Consolidation and concentration in the pharmacy and pharmacy benefit management (PBM) industries continue to pressure wholesalers’ profits. Manufacturers and smaller customers should get ready for the fryer. Robble robble!


As always, I encourage you to read the original source material for yourself. Here are links to McKesson’s financial results for its second fiscal quarter of 2020, which was the third calendar quarter of 2019:

For the quarter, McKesson’s revenues for its U.S. Pharmaceutical and Specialty Solutions reporting segment were much higher than Wall Street’s expectations. Revenues for this segment, which includes wholesale distribution and related services for pharmaceutical products in the U.S., grew by 10% from compared with the third calendar quarter of 2018. However, operating profits for this segment grew by a mere 1%. Consequently, its operating profit margin (operating profits ÷ revenues) declined by 14 basis points, to 1.39%.

This quarter, McKesson’s management took a new approach with investors. They explained what happened.

Notably, the company called out its relationship with CVS Health’s Caremark business, the company’s largest customer. Here’s a key slide from McKesson’s earnings report slide deck. Note the comments in the bullet points.

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A brief look at the McKesson-CVS relationship highlights the unusual economics behind the companies’ relationship.

CVS Health remains McKesson’s largest customer. We estimate that in McKesson’s 2019 fiscal year, its sales to CVS Health were $41.6 billion. (See chart below.) Purchases by CVS Health account for an estimated 25% of McKesson’s U.S. drug distribution business. McKesson primarily supplies CVS Health’s Caremark mail and specialty pharmacies. In 2019, CVS and McKesson extended their agreement through June 2023.

[Click to Enlarge]

For more details on McKesson’s relationship with CVS Health, see Section 9.3.2. of our new 2019–20 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors.


As the chart above shows, growth in McKesson’s revenues from CVS Health in the 12 months ending March 31, 2019, was essentially unchanged compared with the previous year’s figure. CVS Health’s 2018 specialty revenues suffered because the specialty pharmacy benefit for the Federal Employee Program (FEP) switched from Caremark to Prime Therapeutics.

But earlier this year, CVS Health began adding claims volume from IngenioRx, the PBM that the health insurer Anthem formed in 2017. IngenioRx will provide Anthem with such PBM services as formulary management, clinical strategy, benefit design, retail network management, prior authorization, marketing, and managing the member experience. CVS Health’s Caremark PBM is providing claims processing and prescription fulfillment services for IngenioRx.

Anthem’s pharmacies are transitioning to CVS from Express Scripts, which is supplied by AmerisourceBergen. CVS’s specialty revenues are also benefiting from its acquisitions of smaller specialty pharmacies. See Specialty Pharmacy M&A: Our Look at 2018’s Deals.

McKesson’s revenues are therefore benefiting from the additional revenues at CVS Health’s mail and specialty pharmacies.

Alas, these revenues generate little incremental profit. We estimate that during McKesson’s 2019 fiscal year, the company earned an operating profit margin from CVS Health that was less than 0.5%. (See Exhibit 127 of our 2019–20 wholesaler report.) Its new contract with CVS began in mid-2019 and likely has even slimmer margins.


McKesson is not alone in facing these profit pressures. The top tier of dispensing pharmacies—CVS Health; Express Scripts (Cigna); OptumRx (UnitedHealth Group); Rite Aid; Walgreens Boots Alliance; and Walmart—accounts for almost half of the Big Three wholesalers’ combined U.S. drug distribution revenues.

These customers continue to extract ever-deeper sell-side discounts and more favorable payment terms from wholesalers. That’s why DCI has been predicting ongoing profit challenges for the U.S. drug distribution industry.

Consequently, wholesalers will pressure pharmaceutical manufacturers and their smaller customers for compensation to offset their structural profit challenges. Drugmakers and smaller pharmacies deserve a break today, because they did not play a role in negotiations between wholesalers and their mega-customers. However, wholesalers will still attempt to negotiate extra fees and discounts to offset lost profits. I doubt they’ll be lovin’ it.

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