McKesson will be providing wholesale distribution services to the Department of Veterans Affairs at cost minus 5%.

According to pricing info released by the VA, McKesson will provide "negative distribution fees" that vary depending on site and payment method. However, McKesson anticipates that all VA hospital and mail order facilities will opt for the "fast pay" method, which calls for a distribution fee of -5%.

McKesson was selected as the new prime vendor for the VA system on Dec. 31. The wholesaler will take over from AmerisourceBergen effective April 1 (¹ Also see "McKesson Takes VA Contract From Amerisource, Cites Technology As Reason" - Pink Sheet, 5 January, 2004., p. 14).

The service fee on the VA contract represents a new low point for wholesaler pricing and reinforces the agency's reputation as one of the shrewdest purchasers of pharmaceuticals in the U.S.

The price negotiated with McKesson is significantly lower than the fee paid to ABC: cost minus 2.8%.

VA estimates that it will save $1.23 bil. over the life of the contract as a result of the switch. The term of the agreement is two years, with three two-year options at the VA's discretion. McKesson's service fee would decrease by .05% in each of the option periods if the VA renews.

So-called "negative upcharges" have been standard practice in the wholesaling sector since the 1990s.

However, the size of the rebate offered by McKesson raised eyebrows, both because all three wholesalers have been publicly discussing the "stability" of the marketplace, and because of the perception that changes in buying practices mean that wholesalers have less flexibility in pricing to end customers.

Each of the "big three" wholesalers has talked publicly about how it no longer pays to make aggressive bids to win clients from each other because of the high cost of transferring large clients.

As a result, they have been telling investors that their focus will be productivity enhancements that will flow through to the bottom line (² Also see "Cardinal Tightens Customer Pricing Due To Manufacturer Inventory Policies" - Pink Sheet, 18 August, 2003., p. 19).

The wholesaling sector is also in a period of transition as more manufacturers push for inventory management agreements that would shift the distributor profit model away from investment buying and towards "fee for service" (³ Also see "Cardinal “Fee-For-Service” Model Includes Rx Product Integrity Payments" - Pink Sheet, 27 October, 2003., p. 25).

ABC reacted to the VA contract decision by declaring McKesson's pricing to be "irresponsible."

"We think that McKesson made a mistake in the very low bid they submitted, a bid that was not in the best interest of their shareholders nor in the industry's long term," CEO David Yost said during an analyst call to discuss the impact of the VA contract loss Jan. 5.

"We think what has been done is irresponsible," Chief Operating Officer Kurt Hilzinger stated.

Amerisource believed that the VA was satisfied with its service. "We knew we would get high marks for service based on the VA's most recent internal customer service survey where we received a 99%-plus rating," Yost said.

"In technology, we knew we were doing some unique things for the VA," Yost continued. "We literally spent over a decade developing the program and interfaces we have with them. We also knew there were switching costs and challenges associated with moving 1,000 VA delivery points."

So, "we were surprised we did not get the business, until we saw the price," Yost declared.

Amerisource maintains that it will not retaliate by lowering its prices. "ABC will not launch a price war," Yost said. "We will remain disciplined and focused on our core mission of meeting the needs of our manufacturer and provider customers to our myriad of value-added services while seeking to be compensated adequately for the value we create in the channel."

"I do not believe this account represents a lack of pricing discipline on the part of the entire drug distribution industry," Yost said. "We understand our industry and its changing dynamics. Cardinal does as well. McKesson clearly does not," Yost declared.

Amerisource has "had some feedback with a handful of manufacturers," Hilzinger added. "I think they're doing a little bit of a head-scratch on this contract award. They don't understand how this industry can continue to reduce prices to the degree that we just witnessed with the VA contract."

"It does make our discussions with our manufacturer partners more difficult," Hilzinger added. "We have a lot of service and value to offer to our manufacturers. We're trying to do the right thing here by communicating our expectations about how we ought to be working in the marketplace."

Amerisource predicted that McKesson will have difficulty living with the low price.

"McKesson is going to have its hands full absorbing this large and complex customer in less than 90 days. In addition, McKesson will be spending a lot of time explaining to their other accounts why they should not get the same pricing as VA," Yost said.

ABC "spent a lot of time talking to other accounts [about] why they should not get the same price" it gave to VA under the prior contract, Yost noted.

He maintained that ABC would not change its bid in hindsight. "I'm not sure we would have done it any differently. The spread was so big. It is not like we missed it here by a couple of basis points."

ABC will be ready to take advantage of any missteps by McKesson in implementing the contract, Hilzinger indicated. "Our very best customers...are folks that have gone to another provider on price, have been dissatisfied, and have come back," he said. "That happens quite frequently with our accounts."

"Obviously we've got our fingers crossed here. This is an eight-year contract. Maybe we'll get another bite at the apple in the interim."

"There's a big transition that's going to take place for the VA and we'll stand ready to support the VA through the transition," Hilzinger said. "We'll stand ready to support the VA down the road if necessary, if they find their service isn't up to the level they're used to. I'm sure that's going to be the case."

Yost acknowledged that it is unusual for a wholesaler to speak so explicitly in response to a lost contract. "This kind of critical commentary has not been the pattern at ABC, but we believe it is a necessary step today," he said. ABC also hopes that McKesson heeds the reaction from Wall Street. "The market's reaction may serve as a strong wake-up call to" McKesson, Yost declared.

After gaining about 3% on Dec. 31, McKesson lost 10% during the first days of trading in the New Year as investors digested the news of the contract.

[Editor's Note: A full analysis of the performance of drug manufacturers, wholesalers and chains in 2003 will appear in "The Pink Sheet" Year-In-Review issue. Look for it in January.]

After losing the VA contract, Amerisource is predicting approximately 5% earnings growth in 2004, down from its prior estimate of 15% growth.

However, ABC maintains that the loss of the VA contract will not affect its long term growth rates. "ABC will free up significant financial and other resources to deploy in replacing the earnings contribution of the VA," Yost said.

"We expect to deploy that capital in a disciplined and rational matter. We have a number of options, from debt reductions to acquisitions to new distribution business," Yost said. "What we will not do is invest in new market contracts that do not earn an adequate return for our shareholders."

"We will also continue our optimized program to build the lowest cost, most efficient distribution network in the industry. While we may examine the program for some quicker cost saving opportunities, we remain committed to this effort."

"There is a fair amount of human capital in this business and that's where a lot of our costs are today. So that's obviously something that we'll need to take a close look at," Hilzinger said.

ABC had been planning to expand its capacity in anticipation of increased business created by the new Medicare drug benefit. The company estimates that the new benefit could mean $3 bil. in new revenues in 2006 - almost exactly the size of the lost VA contract (⁴ Also see "Medicare Bill Means $10 Bil. Plus In New Rx Spending In 2006, ABC Says" - Pink Sheet, 8 December, 2003., p. 15).

Amerisource is facing another potentially significant customer loss. The company is the supplier to AdvancePCS, which is in the process of being acquired by Caremark. The impact on that account "remains to be seen," Yost said. Amerisource had previously expressed optimism in renewing the agreement with the PBM (⁵ Also see "Anti-Counterfeit Measures Benefit Major Wholesalers, Amerisource Says" - Pink Sheet, 10 November, 2003., p. 31).

McKesson/VA Contract Is Cost-5%; “Irresponsible,” Amerisource Says

More from Archive

More from Pink Sheet