Drug Distributors Say Ouch

The middlemen of the drug industry have found themselves squeezed into a very tight spot.

The big drug distributors can no longer rely on manufacturers for a historically lucrative source of profits. Nor can they count on their customers to help out by suddenly paying for services they have come to expect for free.

As a result, companies such as AmerisourceBergen (ABC Quote) continue to issue profit warnings.

"This is the third straight quarter the company has lowered earnings expectations prior to reporting the quarter," noted Merrill Lynch analyst Thomas Gallucci, who has a neutral rating on the stock. The "shortfall highlights uncertainty of [the] business ... warranting our historically cautious stance toward the group."

AmerisourceBergen and its two larger peers, Cardinal Health (CAH Quote) and McKesson (MCK Quote), tumbled this week on news of yet another shortfall.

Anatomy Lesson

The latest warning came just as Pembroke Consulting -- a firm that specializes in distribution issues -- polished off an innovative report dissecting the industry's problems and suggesting possible cures.

In that study, Pembroke founding President Adam Fein traces back troubling symptoms that began to surface some 20 years ago. Over the past two decades, Fein notes, drug buyers have evolved into huge groups -- representing multiple hospitals, pharmacies and supermarkets -- with the power to demand increasingly deep discounts from the distributors who supply their drugs. Indeed, he says, some major buyers now routinely negotiate "cost-minus" agreements that leave distributors with negative gross margins.

As a result, Fein says, distributors rely on compensation from manufacturers to achieve their profitability. They have long cashed in on discounts and rebates, the report says, but they have seen their ability to capitalize on speculative drug-buying -- once a lucrative exercise -- diminish in recent years.

Before, distributors would routinely buy more inventory than necessary on the speculation that drug prices would rise and make the supplies worth more in the future. They tended to win that bet, because of the steady inflation of drug prices, and even helped out manufacturers in the process. Specifically, Fein notes, distributors accepted indirect compensation -- such as the investment buying opportunities -- that enabled manufacturers to "avoid reporting the true distribution expenses for their products."