McKesson 2006 Annual Report Download - page 32

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McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Gross profit increased 12% to $3.9 billion in 2006 and 7% to $3.5 billion in 2005. As a percentage of revenues, gross profit increased 8 bp
in 2006 and declined 36 bp in 2005. Increases in our gross profit dollars were mainly due to our Pharmaceutical Solutions segment and
additionally, to a lesser extent for 2006, due to our Provider Technologies segment. In 2005, our gross profit margin was negatively impacted
by our higher proportion of revenues attributable to our Pharmaceutical Solutions segment, which has lower margins relative to other segments.
In addition, our Pharmaceutical Solutions segment gross profit margin improved in 2006 compared to 2005 and declined in 2005 compared
with 2004. Changes in our Pharmaceutical Solutions segment’s gross profit margin were due to:
28
– higher buy side margins in 2006 compared with 2005, and lower buy side margins in 2005 compared with 2004. Our buy side margins
reflect changes in our distribution arrangements with the U.S. pharmaceutical manufacturers (“manufacturers”):
Historically, a significant portion of compensation from the manufacturers was inflation-based. We purchased and held pharmaceutical
inventory in anticipation of manufacturers increasing their prices. We benefited when the manufacturers increased their price as we sold the
inventory being held at the new higher price. Beginning in 2003, branded pharmaceutical manufacturers began to assert control over the
amount of pharmaceutical product available in the supply chain by restricting the volume of product available for purchase by
pharmaceutical wholesalers. Manufacturers also increasingly sought more data concerning product sales and distribution patterns. We
believe that the manufacturers sought these changes to provide them with greater control over product supply and movement in the market
and to increase product safety and integrity by reducing the risks associated with product being available to, and distributed in, the
secondary market. These changes limited our ability to purchase inventory in advance of price increases. In 2005, manufacturers also
reduced the number and average magnitude of price increases. As a result, gross profit margin for our U.S. pharmaceutical distribution
business decreased in 2005 as compared to 2004.
Commencing in the second half of 2005, we started revising some of our distribution arrangements with the manufacturers. Under these new
arrangements, a significant portion of our compensation from the manufacturers is generated based on a percentage of purchases and, as a
result, we are no longer as dependent upon pharmaceutical price increases. These distribution arrangements are, however, subject to
compliance with various customary performance requirements.
By the end of 2005, our U.S. pharmaceutical distribution business had transitioned or was in the process of transitioning to these new
distribution arrangements with almost all of the manufacturers. This process was essentially completed in early 2006 and as a result, our buy
side margins increased in 2006. We continue to have certain distribution arrangements with manufacturers that still include an inflation-
based compensation component while other arrangements remain structured under the historical inflation-based compensation model. For
these manufacturers, a reduction in the frequency and magnitude of price increases as well as restrictions in the amount of inventory
available to us could adversely impact segment gross profit margin.
In addition, with the transition to these new arrangements, purchases from certain of the manufacturers are better aligned with customer
demand and as a result, net financial inventory (inventory, net of accounts payable) has decreased. This decrease has had a positive impact
on our cash flow from operations. These new arrangements also have somewhat diminished the seasonality of gross profit margin which has
historically reflected the pattern of manufacturers’ price increases.
– the benefit of greater amounts of antitrust settlements. Results for 2006, 2005 and 2004 included $95 million, $41 million and $22 million of
cash proceeds representing our share of settlements of various antitrust class action lawsuits,
– the benefit of increased sales of generic drugs with higher margins,