McKesson/Rite Aid: The Early Bid Catches the Contract

On Wednesday, Rite Aid (NYSE: RAD) unexpectedly announced an early renewal of its supply agreement with McKesson (NYSE: MCK). The agreement, which wasn’t due to expire until April 2013, will now run until March 31, 2016. See Rite Aid’s 8-K filing.

Investors must have been relieved, because McKesson's stock price jumped 3% yesterday. 2012 has already seen multiple large contract renewals with terms of three years or more. Examples include Cardinal’s agreements with Kmart and Kroger or AmerisourceBergen’s discount deal with Express Scripts. Given uncertainty about the supply intentions of large chains, I expect we’ll continue to see wholesalers offering incentives for early contract renewal.

Below, I quantify the McKesson/Rite Aid relationship and explain a bit about the deal’s economics, which are probably not as unfavorable to McKesson as you might expect.

THE RELATIONSHIP

In 2012, purchases from CVS Caremark’s mail pharmacy and Rite Aid accounted for about 30% of McKesson’s U.S. drug distribution business. In some years, growth of these two pharmacy chain customers accounted for a disproportionate share of total drug distribution revenue growth.

Rite Aid accounts for 10% of McKesson’s total account receivables, so Rite Aid’s precarious financial position could potentially hurt McKesson. However, Rite Aid continues to refinance and restructure its debt, pushing its obligations further into the future. In February 2012, Rite Aid refinanced an additional $481.0 million in principal due in 2015 into bonds due 2020. (See Rite Aid: Smart or Lucky?)

Despite Rite Aid’s more than $6 billion in net debt, the likelihood of a Rite Aid bankruptcy filing seems low to me. Essentially, the company is perpetually refinancing its mortgage, without ever making a big dent in the underlying principal. Courtesy of the 2008's global financial economic collapse, Rite Aid has been able to borrow money at unusually low interest rates. Thank you, subprime mortgage-backed securities!

THE AGREEMENT

Rite Aid will be buying primarily brand drugs via McKesson. Here’s some text from Rite Aid’s 8-K filing:

“The Agreement generally requires the Company to purchase from McKesson all of the Company’s requirements for brand name prescription drugs, as well as some generic prescription drugs, for Company purchases for warehouse delivery. The Agreement also generally requires the Company to purchase from McKesson all of the Company’s requirements for prescription drugs for Company purchases for direct store delivery (i.e., that are not supplied to the Company’s stores from the Company’s warehouses).”

Like Cardinal Health, McKesson provides both warehouse and direct-store delivery to its chain customers. See Cardinal Health's Big Customers: Mo Money, Mo Problems.

THE ECONOMICS

Rite Aid’s 8-K also highlights the oft-misunderstood wholesaler pricing model:

“Pricing of prescription drugs under the Agreement, as amended by the Sixth Amendment, continues to be generally based on published wholesale acquisition cost, less certain discounts, rebates and other adjustments that vary with the type of products being purchased and services provided.”

As I describe in Chapter 3 of the 2012-13 Economic Report on Pharmaceutical Wholesalers, such negative sell-side margins for brand-name drugs are sometimes called cost-minus pricing, because the wholesaler sells a product at a discount from the manufacturer’s list price (or a different measure of cost).

However, cost-minus pricing does not mean that a wholesaler sells the product below its own acquisition cost. On average, gross margin percentages remain positive for wholesale sales of brand-name drugs to all customer groups and product types. See Exhibit 16 (page 34) of the wholesale economic report for my estimates of average negative sell-side margins.

Fee-for-service (FFS) agreements provide wholesalers with compensation from brand-name manufacturers for achieving performance goals established in negotiation with a manufacturer. (These agreements are also called “distribution service agreements” or “distribution performance agreements.”)

Since these agreements are generally computed using pharmaceutical list prices, the dollar value of a wholesaler’s quarterly fee payment from the manufacturer rises whenever a manufacturer increases a drug’s list price—the Wholesale Acquisition Cost (WAC). See Exhibit 17, on page 38.

Thus, large customers periodically renegotiate their wholesaler contracts to recapture the wholesaler's incremental profits associated with pharmaceutical price inflation. While a wholesaler's sell-side gross margin discount from WAC tends to get bigger over time, a wholesaler's absolute gross profit dollars do not shrink as quickly.

This Rube Goldberg channel model is opaque and confusing, but it sorta makes sense, in a messed-up U.S. healthcare system kind of way. Or perhaps I've been eating too many worms. Tweet.