Street Sleuth Drug Wholesalers Change Methods
Distributors Set Service Fees For Manufacturers in Shift From 'Arbitrage' Approach
By HEATHER WON TESORIERO
Staff Reporter of THE WALL STREET JOURNAL
November 12, 2004; Page C3
America's three big drug wholesalers are trying to kick the habit.
The habit, in this case, is the risky business of betting on drug-price increases. And the wholesalers are asking their suppliers -- the nation's pharmaceutical manufacturers -- for help.
AmerisourceBergen Corp., Cardinal Health Inc. and McKesson Corp. have made an estimated 15% to 25% of their profits by anticipating when manufacturers would raise prices, loading up on supply beforehand at the lower price and then selling it later at the new, higher price.
But it can backfire: Recently, these companies had to guide Wall Street's earnings expectations lower because anticipated summer price increases didn't materialize. In August, Bristol-Myers Squibb Co. agreed to pay $150 million to settle Securities and Exchange Commission charges of accounting fraud, largely stemming from "channel stuffing," or enticing wholesalers to buy excess inventory. The case marked a sea change in the long-standing practice, and many drug makers struck new deals to end speculative buying by wholesalers.
To reduce their reliance on this type of arbitrage profit, wholesalers are trying to reinvent their business model. They aim to charge brand-drug companies fees for services the wholesalers have long performed, such as packing, shipping, and billing for drugs, as well as for some extras, such as providing data. The fee-for-service system restrains arbitrage, because the agreements usually call for wholesalers to keep inventories at a specified level.
Should drug companies play ball, the new system could lead to more stable, predictable earnings for wholesalers. Last year, the Big Three wholesalers, which distribute 90% of the country's prescription drugs, had combined revenues of $187.7 billion, and net income of approximately $2.6 billion.
Drug giant Merck & Co. initiated its own fee-for-service program with wholesalers last summer, giving its wholesale customers discounts based on several performance-based options and incentives. For example, wholesalers get greater discounts for holding a smaller amount of supply, for prompt payment, and for adopting Merck's electronic billing and inventory system. There isn't an incentive for a wholesaler to hoard supply, since its payments now rely on adhering to supply specifications.
Merck says it wants wholesalers to stop price arbitrage because trying to fill huge wholesaler orders before price increases wreaked havoc on its manufacturing, and its financial reports. The fee-for-service agreements work out to be financially "net neutral to Merck in aggregate," compared with prior arrangements, says a Merck representative.
Not all manufacturers are eager to embrace the new system. "The manufacturers don't see the benefit yet," says Eric Coldwell, senior analyst with Robert W. Baird & Co.
Pfizer Inc., for one, shrugs off the notion that it needs to adhere to this new system. The drug maker said it doesn't pay wholesalers when prices go up, as some drug companies do to dissuade wholesalers from arbitrage. Instead, when the drug maker raises prices, it offers wholesalers one extra month of supply at the old price. Pfizer said it doesn't see any incentives to start paying fees for the services the wholesalers have already been providing over the years.
"We're committed to the current model and the way it exists," a Pfizer spokesman says.
Bernard Poussot, president of Wyeth's pharmaceutical operations, says the company is in discussions with the three major wholesalers, "looking at options that provide value for both sides. This being said, we cannot as an industry be expected to compensate for deficits in their downstream business."
Though San Francisco-based McKesson says it has signed fee-for-service agreements with 80% of its manufacturing partners, most of the companies are small. Just 25% of its large manufacturing partners have agreed to the fees.
AmerisourceBergen, Valley Forge, Pa., plans to charge for some new services. The company will offer to help manufacturers with new-drug launches by testing marketing and promotion programs prior to national rollouts. AmerisourceBergen says it can give the manufacturer quick visibility into how much product is sold immediately before and after promotion.
The company adds that its fee-for-service model is also performance-based and that it will be paid more when it reaches certain criteria, such as keeping agreed-upon amount of supply in the channel.
In August, Cardinal Health, of Dublin, Ohio, sent a letter to manufacturers reiterating its efforts to move them to fee-for-service. The company's goal is to convert most manufacturers to fee-for-service payments by April 1.
Some analysts say that drug companies are afraid the wholesalers will pass the discounts on to their customers, essentially charging manufacturers so they can remain competitive down the supply chain. "I cannot overemphasize how strongly that feeling is among manufacturers," says Richard Evans, of Sanford C. Bernstein & Co.
Write to Heather Won Tesoriero at heather.tesoriero@wsj.com
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