Drug Wholesaler Forward Buying Continues; Supplier Behavior Is “Consistent”

Pharmaceutical wholesalers continue to find buy-side pricing opportunities despite the recent public scrutiny of manufacturer-reported trade inventory levels.

"We see the trends with our supply partners to be pretty consistent with what we've seen in the past," McKesson CEO John Hammergren said during a quarterly earnings call July 23.

All three national wholesalers noted that price increases are continuing at a 5%-6% rate annually, and that they continue to take advantage of the changes through forward buying.

"As for the buy side of the equation, we're seeing price increases still running in about the 5%-5.5% range depending on any given month," Cardinal Chief Operating Officer-Pharmaceutical Distribution & Medical Products James Millar told an Aug. 6 earnings call.

"Opportunities are still made the same way they've always been made," he continued. "We have to look at the deal [and] make sure it makes economic sense for us. In other words, we just don't make blind buys."

AmerisourceBergen also continues to rely on forward buying. The company "has invested more heavily in spec inventory this year than either of the combined companies did in the past because we have the financial resources to do such," Chief Financial Officer Michael DiCandilo said during an earnings call July 31. "We've done that at the time when price increases were very high."

AmerisourceBergen Chief Operating Officer Kurt Hilzinger added that the "buy-side margin contribution was again better than our expectations this quarter, which was due in part to the improved scale and now combined procurement expertise."

Bristol-Myers Squibb announced in April that it would be undertaking a substantial inventory work-down after purchasing incentives offered by the company in 2000 and 2001 left inventory levels very high (¹ (Also see "Bristol Inventory Issues Include High Supply Of Glucophage IR" - Pink Sheet, 6 May, 2002.), p. 17). The investor reaction to Bristol's announcement - and a follow-up inquiry from the Securities & Exchange Commission - has put forward buying in the spotlight.

Responding to questions about how manufacturers' behavior on sharing pricing information has changed since the Bristol announcement, Hammergren said, "We don't see much change in the behavior of our supplier partners."

"The opportunities from a price-increase perspective and from deals or opportunities kind of ebb and flow with various companies at various points and times depending on their needs and depending on what they're trying to accomplish in the market with their own products."

Hammergren said manufacturers recognize the role forward buying plays in keeping drug distribution profitable. "We have always made our margins from the manufacturers, because our customers don't pay us for our service. Our manufacturing partners realize that and continue to work with us," he said.

J&J recently said it has formed collaborative inventory management plans with two of the three national distributors designed to eliminate speculative buying (² (Also see "From The Quarterly Conference Calls" - Pink Sheet, 5 Aug, 2002.), p. 35).

The McKesson exec cited the pharmaceutical industry's appreciation of wholesalers' services as a major reason he does not expect manufacturer consolidation to affect distribution.

Asked about the impact of the Pfizer/Pharmacia merger, Hammergren said "it certainly makes it easier for us to deal operationally with fewer companies."

"They clearly do not have any interest in doing direct business...so we don't see any implications from these mergers."

"We take a very small slice of margin out for the service we deliver to the industry, and that margin largely comes from the pharmaceutical manufacturers, but those manufacturers want to keep healthy, viable distribution partners - all of us - in place, so we can meet the needs of our customers."

Cardinal CEO Robert Walter went farther in his assessment of manufacturer consolidation, claiming the trend will benefit to his company's Pharmaceutical Technologies & Services business. One reason Pfizer and Pharmacia want to merge is "to seek efficiencies," Walter said, and Cardinal is "a provider of efficiency. We're an outsource provider of services...so there's just more demand for what we do."

Walter also noted that drug chains are moving back to using wholesaler distribution services rather than receiving direct manufacturer shipments.

"The chains are doing less manufacturer-direct," Walter said. "We're doing more business with our chain customers through us rather than them buying directly into their warehouses."

Cardinal expects its pharmaceutical distribution business to grow faster than the overall prescription drug market because of its ties with the fast-growing chain drugstore segment. Walter cited Walgreens and CVS, for which Cardinal is the primary supplier, as "two examples of chains that are experiencing growth above the overall market growth rate."

However, as chains grow, they gain negotiating clout, putting pressure on wholesalers' sell-side margins. McKesson and Cardinal both noted that high buy-side margins are needed to offset a continued decline in sell-side margins.

"The benefits of our increased sales of generics with higher margins as well as increased product sourcing profits offset a decline in the sell margin to our customers," Hammergren said.

Cardinal's Walter said he foresees "some degradation of our selling margin" as Cardinal's largest chain drug and institutional customers grow. However, the impact "won't be very significant given some of the upward opportunities we have on the vendor side."

The decline in distribution gross margins is showing some signs of leveling off. Wholesalers continue to cite growing generic drugs sales as a key to expanding gross margins (³ (Also see "Wholesaler Interest: Rates Make Forward Buys Pay; Do Generics Pay Better?" - Pink Sheet, 6 May, 2002.), p. 15).

While AmerisourceBergen's gross margin was down 23 basis points for the quarter ended June 30, to 3.83% from a pro forma 4.06%, much of that was due to the LIFO appreciation charge it took because of aggressive forward buying early in the year. McKesson's gross margin was up one basis point over the year-ago quarter to 5.39%.

Cardinal's gross margin would have been up nine basis points for the quarter if not for a one-time charge related to closing distribution centers in its integration of Bindley Western. For fiscal 2002 (ended June 30), Cardinal's gross margin was down 8 basis points to 5.12%; excluding the merger-related inventory adjustment charge, gross margin was flat at 5.2%.