Drug Distributors Say Ouch - TheStreet

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) - Get Report

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) - Get Report

and

McKesson

(MCK) - Get Report

, 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."

Such arrangements have since fallen out of favor. Fein points to a past scandal involving

Bristol-Myers Squibb

(BMY) - Get Report

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.

"If manufacturers can consistently maintain the same service levels with direct distribution as wholesalers, then this shift of inventory would have no apparent impact on patients, providers or pharmacies," Fein wrote. But "this assumption is highly questionable, given the current capabilities and distribution networks of most manufacturers."

Fein recommends a shift away from IMAs to the fee-for-service contracts that the industry is, in fact, rapidly adopting this year. Under the new contracts, manufacturers simply pay wholesalers a fair price for the services they offer.

Fein points to a recent deal between

Eli Lilly

(LLY) - Get Report

and Cardinal Health as a "step in the right direction."

"Fee-for-service payments by manufacturers to wholesalers should be designed to reward concrete actions that lower overall supply-chain costs," he says, "not merely encourage an inventory shell game."

Still, Fein does favor the return of some speculative drug-buying. He believes the abrupt shift away from speculative buying came as a radical change that may have unintentionally driven supply-chain costs higher and increased the risk of drug shortages. Thus, he suggests controlled investment buying -- with "tight limits and strict accountability" -- as a source of secondary, more modest, wholesaler profits.

At the same time, he feels that customers should start paying their share as well. He acknowledges that drug buyers will resist paying for that which they previously received for free. So he recommends that wholesalers further expand their offerings beyond drug distribution to those value-added services -- such as on-site inventory management, pharmacy automation and technology consulting -- that have already proven to be more profitable anyway.

Looking ahead, Fein clearly sees the need for a more balanced compensation system.

"Manufacturers should no longer bear sole responsibility for the majority of wholesaler compensation," he concludes.

Lingering Pain

In the meantime, many analysts remain understandably nervous about the group.

They have seen drug distributors repeatedly disappoint investors, and they fear more of the same for a while. To be fair, Thomas Weisel analyst Steven Halper believes that AmerisourceBergen's guidance -- previously dismissed as too aggressive -- may finally be achievable after this week's steep reduction. But he warns that others in the group will probably follow with reductions of their own.

Ultimately, he believes that the worst is yet to come and the transition will continue to be a "bumpy" one. David Veal, an analyst at Morgan Stanley, tends to agree.

The AmerisourceBergen warning "highlights the persistence of tough fundamentals for drug distributors," wrote Veal, who has an equal-weight rating on AmerisourceBergen shares. "We continue to believe that the transition to a fee-for-service business model will take longer and prove to be less profitable than is widely believed and expect that these stocks may struggle to perform as a result."