Obama's Budget and Wholesaler Inventories

President Obama submitted his fiscal year 2011 budget this week. The Wall Street Journal calls it “one of the greatest spend-while-you-can documents in American history.”

POTUS’ budget wish list once again included the repeal of the Last-In, First-Out (LIFO) inventory valuation method, an apparently obscure accounting change with major implications for the public pharmaceutical wholesalers—AmerisourceBergen (NYSE:ABC), Cardinal Health (NYSE:CAH), and McKesson (NYSE:MCK).

There is no legitimate business reason to repeal LIFO, so recognize that this proposal is nothing more than a $59 billion attempted cash grab by the government. Nevertheless, I suggest adding the topic to your list of low-probability/high-impact events that could alter the drug wholesaling industry and trigger a restructuring of fee-for-service agreements between pharmaceutical manufacturers and wholesalers.

LIFO: WTF

LIFO repeal has been bandied around Washington DC for a few years because the potential tax revenues are a tempting target for our elected officials.

The item “Repeal LIFO method of accounting for inventories” is buried in summary table S-8 of the FY2011 budget. See page 16 of the Summary Tables. This accounting change is projected to decrease the deficit by $22.9 billion from 2011-2015 and by $59.1 billion from 2011-2020.

Opposition from every company that holds inventory—manufacturers, wholesalers, and retailers—has halted previous attempts to repeal LIFO during the past 5 years. The anti-repeal effort is led by The LIFO Coalition, an ad hoc group of more than 120 trade associations managed by the National Association of Wholesaler-Distributors. The major pharmaceutical and healthcare products distribution trade associations are all members of NAW, including the Healthcare Distribution Management Association, the Health Industry Distributors Association, and the American Veterinary Distributors Association.

A mildly eye-glazing introduction to the accounting issues can be found in this article: LIFO vs. FIFO: A Return To The Basics. Savor more accounting thrills on the Save LIFO website.

Here is how McKesson described LIFO in its 2009 10-K filing (page 41):

“A LIFO expense is recognized when the net effect of price increases on branded pharmaceuticals and non-pharmaceutical products held in inventory exceeds the impact of price declines and shifts towards generic pharmaceutical products, including the effect of branded pharmaceutical products that have lost market exclusivity. A LIFO credit is recognized when the impact of price declines and shifts towards generic pharmaceutical products exceeds the impact of price increases on branded pharmaceuticals and non-pharmaceutical products held in inventory.”

LIFO AND DRUG WHOLESALERS

The HDMA is strongly opposed to LIFO repeal because it would disproportionately affect drug wholesalers, which primarily hold inventory of products increasing in value (branded pharmaceuticals). The HDMA’s Position Statement points out (correctly, IMO):

“Eliminating the ability to elect the LIFO method would have a grossly disproportionate impact upon pharmaceutical distributors with inventories of high-volume, high-value medications. Its repeal would unfairly reverse long-standing tax policy and result in an unprecedented tax increase for these companies.”

I’m not an accountant, but here’s what could happen to drug wholesalers if LIFO were repealed:

• Reported earnings up—LIFO is a more accurate and conservative method of accounting because it matches costs and revenues better than the alternative First-In, First-Out (FIFO) accounting method. A wholesaler using FIFO (versus LIFO) will report higher gross profits and higher operating earnings. However, these higher earnings merely reflect accounting gains, not improved business performance.
  
  
• Cash flow down—LIFO provides a cash flow advantage when inventory costs are rising by avoiding taxes on “inventory profits”—profits that arise merely from holding inventory. Cash flow at drug wholesalers would drop if they lose the annual tax deferral benefit of LIFO accounting.
  
  
• New tax liability—Drug wholesalers would also face a cash-flow hit because they would have to pay back the deferred tax liability that resulted from previous LIFO accounting.

I'm not going out on a limb by suggesting wholesalers would ask manufacturers for more money and/or better terms to cover any cash flow shortfalls.

More speculatively, a LIFO repeal could also trigger manufacturers and wholesalers to move toward completely non-inflation based, fee-for-service agreements. It could also open up new opportunities for third-party logistics companies to penetrate the market because taking title would become a more costly activity.

Again, I view LIFO repeal to be low-probability event, but one worth keeping tabs on.