McKesson's core distribution agreements with small manufacturers will set the stage for discussions with its large pharma partners, CEO John Hammergren said.

In transitioning away from the inventory management agreements large manufacturers have instituted with wholesalers, McKesson plans to use core distribution agreements to control inventory and offer additional channel services.

"CDAs cover the core services of pick, pack, and ship data, administrative services, and efficient inventory management." Fee-for-service options are "single-point delivery programs and redistribution programs, returns management, new product launches, strategic solutions and customized data reporting," Hammergren said during an April 29 earnings call.

"It's more than just an inventory management agreement."

McKesson has started sending letters to its "tier four" manufacturers - companies with products that reach a limited number of patients - informing them of the transition to CDAs.

"Two weeks ago we sent a letter to the lower tier of companies saying we would implement CDAs on June 1, at which point we will begin charging a core distribution fee that reflects the value of access to our distribution capabilities," Hammergren stated.

The reaction of the smaller companies will prepare McKesson for upcoming discussions about core distribution agreements with larger manufacturing partners, the CEO said.

The transition to the core distribution agreement model "began by segmenting our hundreds of manufacturing partners into four tiers according to size, product differentiation, markets served, costs to distribute, strategic position, and the current economics of our relationships."

"As you might expect, companies whose growth and innovation create more opportunities for profit are in the upper tiers. Companies whose products reach fewer patients yet still enjoy access to our sophisticated and far-reaching distribution system are in the lower tiers," Hammergren said.

Cardinal is also negotiating fee-for-service distribution contracts based on an internal analysis of each company; it has divided manufacturers into eight tiers (¹ Also see "Cardinal Bases Fee-For-Service Deals On Customer Profitability Analysis" - Pink Sheet, 23 February, 2004., p. 12).

So far, the transition for tier four companies to core distribution agreements has gone smoothly for McKesson. "We probably have double-digit numbers" of core distribution fees "that have already come back in, just basically signed without any discussion," Hammergren said.

"Certainly, there'll be people who want to have a discussion with us about it, and we'll have to go through...the specifics around how we deliver value."

McKesson will use a recently compiled survey by the Healthcare Distribution Management Association to describe the "value distributors provide to the marketplace and how it's a better alternative than third-party logistic companies, or FedEx or UPS kinds of companies, or internally developed distribution programs," Hammergren said (² Also see "HDMA Study To Show “Value” Of Wholesalers As Pricing Model Shifts" - Pink Sheet, 9 February, 2004., p. 15).

"I'm very bullish about our progress on many of these fronts."

More than 100 manufacturers fall into the tier four category, representing between 5% and 25% of McKesson's overall revenue.

"There's a lot of opportunity in those tier four suppliers, but the big money really relies on us getting through the more lengthy discussions we're having with our larger manufacturing partners, some of which we've already obviously signed and we've got implemented, like the Merck fee-for-service agreement, and others that are still being delayed because we're educating our customers on the value that we deliver," Hammergren stated.

"Some of the stuff is going to take some time to roll in, but in my mind it's not a question of if, it's a question of when we get these agreements signed with our manufacturing partners."

The earnings call also provided McKesson with an opportunity to discuss its impending assumption of prime vendor status for the Department of Veterans Affairs.

The contract switch from AmerisourceBergen was initially slated for April 1, but was postponed by the Court of Federal Claims during ABC's protest of the VA's decision (³ 'The Pink Sheet' Feb. 16, 2004, In Brief).

ABC's contract extension granted McKesson ample time to prepare for the additional $3 bil. in annual volume the VA contract adds, Hammergren stated.

"We...have been afforded an opportunity during this phase to understand the implementation and actually begin the implementation in a very complete way."

"I believe we're well on track to making this a very smooth transition for the VA. I know in talking to the folks over there they're very pleased with the work they've seen so far and they believe that they've made the right decision in selecting McKesson," Hammergren said.

VA could realize up to $1.2 bil. in savings over eight years with the McKesson contract (⁴ Also see "McKesson Bid Offers VA $1.2 Bil. In Savings, Court Says In ABC Challenge" - Pink Sheet, 12 April, 2004., p. 43).

From April 1 until the contract switch, ABC has serviced VA at McKesson's bid price of cost minus 5%.

"Certainly, we were happy to have the VA contract for a few more weeks," ABC CFO Michael DiCandilo said during an earnings call April 26.

However, "we would have been happier if we had it at our old price or our proposed price," he added. "I think the price differential has offset the majority of the benefits from the additional time that we've had the contract."

ABC noted one upside to losing the contract: a potential for $40 mil. in savings from reduced operating costs (⁵ Also see "AmerisourceBergen Expects Veterans Affairs Contract Loss To Save $40 Mil." - Pink Sheet, 2 February, 2004., p. 14).

These savings will be derived from headcount reductions and the consolidation of five distribution centers. "The first of these closures was completed during the March quarter, on time and on budget," ABC Chief Operating Officer Kurt Hilzinger said.

Each distribution center consolidation could result in from $3 mil. to $6 mil. savings, he said.

McKesson Begins Fee-For-Service Deals With Small Manufacturers June 1

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