Investment Buying: Not Dead Yet

Many inventory management agreements and fee-for-service agreements between manufacturers and wholesalers will be renegotiated over the next 24 months. So it’s interesting to note that investment buying remains an important source of drug wholesaler profits. (Click here for a little musical accompaniment to today's post.)

Peter Loftus from Dow Jones wrote a must-read article Wholesalers' Speculative Buying Still Unsettles Drug Sales to follow-up on the Pfizer (PFE) and Wyeth (WYE) inventory issues described in Harry Potter and the Wholesaler Inventory.

Here’s a key quote from the article:

Cardinal Health still practices what it calls "investment buying" with certain manufacturers, said spokeswoman Tara Schumacher. The company doesn't comment on specific customers or products. Also, it has "hybrid" relationships with some drug makers, engaging in speculative buying for some products and fee-for-service on others. "From the beginning, we knew we wouldn't have a 100% shift," Schumacher said. "That was never the intent. We wanted to ensure we were negotiating fair prices for each customer. We're comfortable with the economics of some of the contracts not being fee-based."

Translation: Investment buying is still around, just less prevalent and less visible. In some cases, investment buying appears to have shifted away from wholesalers to other points in the pharmacy supply chain.

I must give credit to Cardinal Health (CAH) for discussing this “open secret.” The adoption of inventory management and fee-for-service agreements has dramatically reduced (but not eliminated) drug wholesalers’ dependence on investment buying and price inflation. I estimate that inventory profits (investment buying + passive gains) are now less than one-third of wholesaler gross margins from large branded manufacturers.

If you don’t believe Cardinal, check out AmerisourceBergen’s (ABC) July 26 earnings announcement, in which they noted that “…operating income benefited from an above market sales increase in our proprietary generic drug program which offset in part the impact of fewer drug price increases in the June quarter.” (emphasis added)

The Wall Street Journal's Health Blog is more pejorative about these activities, writing Drug Wholesalers Back at Betting Window. That’s not really fair. Investment buying is nothing more than a means by which manufacturers can compensate wholesalers for the legitimate costs of distributing drugs. Unfortunately, there can be excesses in this system (summarized in the third paragraph of my 2005 article).

At least two senior wholesaler executives hate when I write about this topic. But facts don't cease to exist because they are ignored.

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P.S. Check out the new Health Wonk Review, edited by Julie Ferguson at Workers' Comp Insider.