McKesson 2005 Annual Report Download - page 29

McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
The decrease in our Pharmaceutical Solutions segment gross profit margin in 2004 primarily reflects:
Our Pharmaceutical Solutions segment uses the LIFO method of accounting for the majority of its inventories, which results in cost of sales
that more closely reflects replacement cost than do other accounting methods, thereby mitigating the effects of inflation and deflation on
operating profit. The practice in the Pharmaceutical Solutions distribution businesses is to pass on to customers published price changes from
suppliers. Manufacturers generally
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somewhat in the second half of the year,
– partially offsetting the above decreases, is increased compensation from pharmaceutical manufacturers under certain new fee-based
arrangements. Throughout 2005, we have been actively working with pharmaceutical manufacturers to restructure our distribution
agreements towards a fee-based model whereby we are appropriately and predictably compensated for the services we provide. Under
these fee-based agreements, all or a significant portion of our compensation from pharmaceutical manufacturers is fixed and is no longer
dependent upon pharmaceutical price increases. We have made progress towards this objective and expect to be complete by mid 2006,
– the benefit of sales volume growth for U.S. and Canadian pharmaceutical distribution and services,
– a lower proportion of revenues attributed to sales to customers’ warehouses within our U.S. pharmaceutical distribution business. Sales to
customers’ warehouses represent bulk shipments, which we purchase and bring into our central distribution center and subsequently ship
out in bulk to our customers’ warehouses. These revenues differ from our traditional direct store business in that we do not break the
merchandise down; the merchandise comes in and goes out in the original bulk containers and we ship only to warehouse locations. We
have significantly lower gross margin on these sales as we pass much of the efficiencies of this low cost-to-serve model on to the
customer. These sales do, however, contribute to our gross profit dollars in that the volume allows us to earn incremental product sourcing
profits. In addition, our cash flows benefit from these sales due to favorable timing between the customer payment to us and our payment
to the supplier,
– higher supplier cash discounts from a change in customer mix,
– the benefit of increased sales of generic drugs with higher margins,
– a last-in, first-out (“LIFO”) inventory credit of $59.2 million, reflecting a number of generic product launches and the lower level of
branded pharmaceutical price increases. In 2004, gross profit was impacted by a LIFO charge of $27.9 million which was primarily
attributable to a small number of pharmaceutical drugs which did not move to the generic category (i.e., the price did not decrease) until
2005,
– the receipt of $41.2 million cash proceeds representing our share of a settlement of an antitrust class action lawsuit brought against a drug
manufacturer. In 2006, $51.2 million has been received for another settlement of an antitrust class action lawsuit. This additional
settlement will be recorded in the first quarter of 2006. A similar credit of $21.7 million was received in 2004, and
– improved performance in the segment’s pharmacy outsourcing business.
– lower selling margins within our U.S. Pharmaceutical distribution business which reflect competitive pricing pressure, as well as lower buy
side margin as the industry is evolving, including the ways in which distributors are being compensated by manufacturers. In addition, the
proportion of cash discounts to revenues increased reflecting a change in customer mix,
– a higher proportion of revenues attributed to sales to customers’ warehouses within our U.S. pharmaceutical distribution business,
– a LIFO charge of $27.9 million compared to a credit of $13.7 million in 2003,
– unfavorable adjustments from certain fixed-price contracts in this segmen
t
’s pharmacy outsourcing business,
– partially offsetting the above decreases, the benefit of increased sales of generic drugs with higher margins, and
– the receipt of $21.7 million cash proceeds representing our share of a settlement of an antitrust class action lawsuit brought against the
manufacturer of a cardiac drug.