ABC Wins Express Scripts Contract from Cardinal

Missy Franklin isn't the only one celebrating a first place finish today.

This morning, AmerisourceBergen (NYSE: ABC) announced it won the combined Express Scripts contract from Cardinal Health (NYSE: CAH). Here's the press release: AmerisourceBergen Signs Three Year Pharmaceutical Supply Agreement with Express Scripts.

The contract is worth $18.5 billion in revenues to ABC, although it will be minimally profitable. My first-pass, back-of-the-envelope computation suggests that ABC's operating profit from the contract will be 0.15% to  0.20%. That's one reason why the win has "no impact" on the company's financial expectations for fiscal 2013 (starting on October 1, 2012).

CEO Steve Collis has now proven that he can lead his team to victory in a good old fashioned, race-to-the-bottom bid business. Congratulations?

A BRIEF HISTORY

In 2001, Cardinal became the prime vendor for Express Scripts, which was just ramping up its mail pharmacy. In 2004 and 2005, Express Scripts acquired CuraScript and Priority Healthcare, both of which were supplied by ABC.

In 2006, Express Scripts transferred the Curascript and Priority business to Cardinal and subsequently renewed its contract through mid-2012. As an aside, ABC actually sued Express Scripts after the contract loss in AmerisourceBergen Drug Corporation v. CuraScript, Inc. and Priority Healthcare Corporation.

Wholesalers and PBMs have fascinating and complicated relationships. See ABC’s Steve Collis on the Tangled Web of PBM-Wholesaler Relations.

HOW LOW CAN YOU GO?

As I explain in Will Walgreens bypass Cardinal Health?, wholesalers use their strong balance sheets to serve self-warehousing chains and large mail-order pharmacies. These warehouse deliveries provide minimal operating profits for wholesalers. For example, Cardinal reported operating profits of 0.32% from its largest bulk customers in FY2011.

While revenues from warehouse deliveries appear only marginally profitable, wholesalers have at least four reasons for maintaining them:

• Channel Role—Drug wholesalers are able to retain a role in the pharmaceutical industry by participating in warehouse deliveries.
• Working Capital and Cash Flow—Revenues from warehouse deliveries are a source of working capital for wholesalers. Pharmacy customers pay wholesalers about two weeks before the wholesaler must pay its supplier.
• Buy-Side Payments From Manufacturers—Product volume from warehouse deliveries allows wholesalers to earn incremental buy-side fees, because the wholesaler takes title for pharmaceuticals delivered to customers’ warehouses.
• Positive Return on Invested Capital—Wholesalers can still profit from warehouse deliveries because of these customers’ reduced capital and service requirements.

With the latest agreement, Express Scripts is clearly leveraging its monopsony power from its merger with Medco. See my discussion of monopsony vs. monopoly in ESRX-MHS: Analysis of the FTC Decision.

McKesson had already demonstrated the power of a big buyer with its Veteran's Administration win. See McKesson Wins the VA…at Cost minus 8.65%! (although the VA contract is admittedly different than a private company deal).

WHAT ME, WORRY?

I wonder if Cardinal is secretly glad that it lost the business. Otherwise, Cardinal would have been at the mercy of three mega-customers—CVS Caremark's retail business, Walgreen, and Express Scripts.

On the other hand, Cardinal may now face some tough questions on Thursday's earnings call, especially given the recently-public news about Walgreen's intentions.