How CVS Health Drives McKesson’s Distribution Financials

McKesson recently released the annual report for its 2021 fiscal year, which ended on March 31.

The report provides fresh insights about the company’s business with CVS Health, its largest customer. As you will see, CVS purchased $50 billion in pharmaceuticals from McKesson—more than triple the figure from 10 years ago.

The report also reveals that CVS Health paid McKesson in about 24 days, providing the wholesaler with an often-overlooked cash flow benefit. In fact, McKesson’s overall business had a negative cash conversion cycle. That’s essential for a low margin distribution business.

Below, I delve into the financials behind these two elements of the McKesson-CVS relationship. You’ll understand why CVS is McKesson’s worst best friend.

Join me for DCI’s upcoming live video webinar, Drug Channels Update: 340B Controversies and Outlook , on June 25, 2021, from 12:00 p.m. to 1:30 p.m. ET. CLICK HERE TO LEARN MORE AND SIGN UP.

ACCURATE FACTS

Longtime readers know how much I truly enjoy Securities and Exchange Commission (SEC) corporate filings. Regulatory and legal requirements force companies to disclose important factual details about their businesses. These filings offer a fascinating—albeit opaque—source of competitive intelligence that surprisingly few people bother to read closely.

Click here to savor all 240 pages of McKesson’s 2021 10-K filing.

THE $50 BILLION CUSTOMER

McKesson primarily supplies CVS Health’s Caremark mail and specialty pharmacies. The Caremark-McKesson relationship began in 2001. In 2019, CVS and McKesson extended their agreement through June 2023.

The chart below shows the evolution of McKesson’s sales to CVS since 2011. We estimate that in McKesson’s 2021 fiscal year, its sales to CVS Health were about $50 billion—up by $3.8 billion (8%) from the previous year’s figure.

[Click to Enlarge]

Purchases by CVS Health account for 26% of McKesson’s U.S. drug distribution business.

CVS Health became McKesson’s largest customer through a combination of organic and acquisitive growth:

• CVS Health’s mail and specialty pharmacy businesses are among the largest in the industry. (See our list of the top 15 U.S. pharmacies of 2020 .) CVS’s revenues have benefited from organic growth in sales of specialty drugs as well as the company’s acquisitions of at least 10 smaller specialty pharmacies. (See Section 3.3.2. of our 2021 Economic Report on U.S. Pharmacies and Pharmacy Benefit Managers.)

• Over the past four years, significant incremental mail and specialty volume has transitioned from Anthem and Coventry to CVS Health’s Caremark business. (See Section 5.5.2. of our 2021 pharmacy/PBM report.)

• In 2015 and 2016, McKesson’s revenues from CVS Health were further concentrated after CVS Health acquired Target’s pharmacy business and Omnicare. Both of the acquired companies were existing McKesson customers, so their purchases were reclassified as sales to CVS Health. Following these transactions, McKesson remained the primary wholesale supplier of brand-name drugs to Omnicare and Target.

Note that CVS Health primarily sources generic drugs via Red Oak Sourcing, its joint venture with Cardinal Health.

FREE MONEY

Many people don’t realize that McKesson doesn’t need external financing to operate its business.

This becomes clear when we examine the cash conversion cycle, which measures how many days it takes a wholesaler to convert inventory purchases into cash from its customers. This cycle combines the following three elements:

• Days of sales in inventory (DSI): the inventory holding time

• Days sales outstanding (DSO): the time needed for a wholesaler to collect accounts receivables from a customer

• Days payable outstanding (DPO): the time in which a wholesaler pay a manufacturer (supplier)

The cash conversion cycle equals [DSI + DSO - DPO].

For its 2021 fiscal year, McKesson’s overall cash conversion cycle was an impressive -6 days.

Your eyes don't deceive you. That’s negative six days.

The negative cash conversion cycle means that, on average, McKesson got paid for the products that it sold before it had to pay for those products. This means that suppliers and customers essentially finance its operations. As McKesson’s sales grow, so do its cash balances.

McKesson doesn’t explicitly report the underlying cash conversion cycle for its relationship with CVS Health. However, we can deduce a few key things about this relationship:

• Using data disclosed in McKesson’s 10-K, we computed that on average, CVS Health paid McKesson in 24 days in the 12 months ending on March 31, 2021.

• Wholesalers typically agree to pay brand-name manufacturers in 30 to 40 days.

• Wholesalers’ inventory levels for brand-name drugs are typically about two to three weeks. Wholesalers can hold lower levels of inventory for products that sell quickly and can be readily replenished.

These figures suggest that McKesson needs very few days of working capital to service CVS Health with brand-name drugs. For example, if average brand-name manufacturer payment terms were 35 days, then McKesson would have a negative cash conversion cycle with CVS when brand-name product inventory levels are 11 days or less.

The cash cycle also shows why wholesalers emphasize payment terms and inventory levels when negotiating distribution agreements with brand-name manufacturers.

These patterns can vary by customer and product type. For example, McKesson sells generic drugs primarily to its smaller pharmacy customers. We estimate that compared with brand-name drugs, McKesson holds higher levels of generic inventory, pays generic suppliers more slowly, and collects from smaller customers sooner.

Wholesalers can also generate significant cash flow benefits from chargeback transactions, such as sales made under the 340B Drug Pricing Program. Some manufacturers process and pay chargebacks within days of a wholesaler's submission, so the wholesaler could receive the discounted portion of its payment before the customer has paid the wholesaler.

For more on the importance of the cash conversion cycle to wholesalers’ businesses, see Section 5.3. of our 2020-21 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors.

HOW TO WHOLESALE

Drug wholesalers make money from distribution in a straightforward manner: Buy low, sell high, collect early, and pay late.

CVS Health’s scale has allowed it to negotiate extremely favorable rates with its suppliers. DCI estimates that McKesson’s operating profit from CVS are below 0.5%. Hence, a favorable cash conversion cycle is essential for McKesson.

Distribution seems simple—but it’s certainly not easy.