McKesson Snags US Oncology

This morning, McKesson (NYSE:MCK) announced the acquisition of U.S. Oncology. See McKesson to Purchase US Oncology in a Transaction Valued at $2.16 Billion.

This deal is a big win for McKesson. The company now solidifies its position as the #2 specialty products distributor. McKesson also picks up the services and Group Purchasing Organization (GPOs) businesses of US Oncology.

On the other hand, Cardinal Health (NYSE:CAH) now has an even bigger challenge in rebuilding its specialty business and diversifying away from its two mega-customers, CVS Caremark (NYSE:CVS) and Walgreen (NYSE:WAG). See Double Trouble for Cardinal Health. Time to go shopping?

Manufacturers of specialty oncology products should be paying close attention. Two drug wholesalers—McKesson and AmerisourceBergen (NYSE:ABC)—are simultaneously the largest distributors of specialty drugs as well as the owners of the largest community oncology Group Purchasing Organizations (GPOs). Today's acquisition signals even tighter vertical integration between oncology care and the distribution channel. Combined distributor-GPO entities gain leverage as the channel to the physician gets narrower, requiring a more strategic view of the customer and improved account management.

ANOTHER WIN FOR MCKESSON

McKesson ended the third calendar quarter of 2010 with $3.1 billion in cash but only $2.3 billion in long-term debt, so it can easily swing the deal despite US Oncology’s big debt load. McKesson has previously tried to minimize expectations about a mega-acquisition, but its big pile o’ money said otherwise. Larry Marsh of Barclays estimates that McKesson will be using $400 million from cash and borrowing $1.7 billion to finance the transaction.

After the US oncology acquisition, McKesson and AmerisourceBergen (NYSE:ABC) will now represent almost 80% of all specialty pharmaceutical distribution, which is the primary channel to market for office or clinic-based physicians. These smaller, high service customers prefer to work with distributors for high-cost oncology drugs. See The 2010-11 Economic Report on Pharmaceutical Wholesalers for more detail. Check out this chart from McKesson's June 2010 Analyst Day presentation (available on this page):

This transaction will also further concentrate ownership of community oncology Group Purchasing Organizations (GPOs). These GPO relationships allow wholesalers to create preferred supply relationships for product distribution. For example, ION, the largest community oncology GPO, has a prime vendor distribution arrangement with Oncology Supply. Both organizations are part of AmerisourceBergen’s Specialty Group.

McKesson dramatically expanded its specialty distribution business when it acquired OTN/Onmark in October 2007. See Fresh Consolidation in the Oncology Channel. McKesson had previously acquired National Oncology Alliance, a small GPO, in April 2006. Onmark is the second-largest community oncology GPO, with about 2,800 practices. US Oncology brings about 490 more practices to the GPO.

Preferred vendor agreements create barriers to direct sales by a manufacturer, because the distributor and the GPO customer are the same company. By forward-integrating into contracting services, a drug wholesaler gains business stability. A manufacturer cannot easily bypass the channel and sell directly to the provider/customer.

DOUBLE FAULT FOR CARDINAL HEALTH

Poor ol’ Cardinal Health can’t catch a break.

Cardinal has been building out its own specialty distribution physical infrastructure to complement the pricey acquisition of Healthcare Solutions Holding and its P4 subsidiaries. McKesson’s acquisition makes it harder for Cardinal to catch up in specialty.

It’s not the first time that McKesson’s dealmaking has hurt Cardinal. Cardinal Health sold their oncology distribution business to OTN in 2006 and became a minority owner in OTN’s parent company Oncology Holdings, Inc. McKesson’s 2007 subsequent acquisition of OTN/Onmark led to a $1.7 billion revenue loss for Cardinal (per page 34 of CAH’s FY2007 10-K). Ouch.

There may have been some people speculating that Cardinal would win US Oncology. The website Zero Hedge highlighted unusual activity in Cardinal’s Credit Default Swaps, which led to some weird stock trading activity last Tuesday. Cardinal Health took the unusual step of officially dismissing rumors of a Leveraged Buyout (LBO) in Cardinal Health Statement on Market Speculation.

But as I told The Columbus Dispatch last week in Cardinal Denies It's Target Of Takeover, another explanation for a surge in the price of insuring cardinal’s debt is the possible acquisition by Cardinal of a company with a lot of debt—such as US Oncology.

Sure looks like they let the Golden Snitch get away.