Drug Distributors Say Ouch

Such arrangements have since fallen out of favor. Fein points to a past scandal involving Bristol-Myers Squibb (BMY Quote) as the reason. He says the company found itself accused of selling excess inventory to wholesalers just to meet financial targets in 2000 and 2001.

In the end, he notes, the company restated four years' worth of earnings and agreed to sell no more than one month's worth of inventory to drug distributors.

Since then, Fein says, drugmakers have begun favoring "inventory management agreements" instead. Under the so-called IMAs, he says, drugmakers essentially pay distributors not to speculate with inventory. Rather, he says, the manufacturers simply offer some kind of payment -- uncoupled from drug prices -- to compensate the wholesalers for their service.

"The elimination of investment buying using IMAs has led to short-term sales declines for manufacturers, as extra inventories are eliminated from the channel," he acknowledges. But "without IMAs, investment buying behavior by wholesalers may have allowed pharmaceutical manufacturers to perpetually pull sales forward in time as if on a never-ending treadmill."

Already, Fein has noticed a dramatic industry shift. In recent years, he says, manufacturers have seen their inventories expand by nearly $4 billion -- and their holding costs jump by $785 million -- because of the rise in IMAs. At the same time, he says, distributors have managed to avoid adding some $4.6 billion worth of inventory to their own balance sheets.

Ultimately, he says, manufacturers have found themselves bearing "substantial and generally unrecognized costs" as a result of the industry change. Even so, he notes, distributors take most of the heat in the market.

"IMAs have not provided wholesalers with the same amount of profit as the investment buying model," he explains. "As a result, the transition away from inventory profits has shrunk wholesaler profits and created substantial volatility in stock prices."

Need for a Cure

The change could also bring unwanted volatility to the drug supply chain.

So far, Fein says, manufacturers have essentially increased their own inventories enough to offset decreases one step down at the wholesaler level. But that arrangement, eliminating the buffer provided by the middlemen, could trigger drug shortages if it hasn't done so already. Currently, Fein says, only 6% of drugs are sold directly by manufacturers. Wholesalers continue to supply major users -- such as hospitals, nursing homes and pharmacies -- with their own stockpiles.