Court ruling designed to protect independents, hospitals, not chains

Drug Store News, August 24, 1998 by Allene Symons

WASHINGTON -- After reviewing 2,000 exhibits and listening to the opinions of more than 60 experts, a federal court judge enjoined the industry's four largest wholesalers from proceeding with two proposed mergers: McKesson Corp. with AmeriSource and Cardinal Health with Bergen Brunswig. U.S. District Court Judge Stanley Sporkin granted the Federal Trade Commission's motion for an injunction to block the mergers because of concerns that post mergers, the two surviving wholesalers would combine to hold close to 80 percent of the pharmaceutical wholesaler market.

Also a concern: the lack of drug wholesaler competition in several regions, including the Northwest, and the potential impact on hospitals and independent pharmacies--more than by the potential impact on chain drug stores. Among the factors swaying Judge Sporkin was the finding that of the three segments served by drug wholesalers, two are largely dependent on this source of supply: hospitals depend on wholesalers for 85.3 percent of their pharmaceutical purchases; independent pharmacies depend on them for 95.4 percent of purchases. In contrast, chain pharmacies use them for 24.3 percent of drug purchases. Unlike the other segments, drug chains self-warehouse almost 74 percent of their pharmaceutical product. While the judge conceded that large drug chains and large hospitals have considerable leverage when negotiating with these wholesalers, this does not outweigh the damaging effects of the merger on independent pharmacies and smaller hospitals, he wrote. Most of these customers "could not replicate the wholesalers' services nor obtain them from any other source or supplier," he wrote. Wholesaler case shot down Despite the wholesalers' arguments that the proposed mergers are a necessary reaction to industry trends such as the emergence of powerful buyers and pressures to reduce costs, increase efficiency and lower prices, a key factor in the final decision was the wholesalers' inability to convince the court that their combined business should be calculated not as 80 percent of the pharmaceutical market, but instead as a 57 percent share. Wholesalers claimed that their business should be considered as part of the whole pharmaceutical market, which encompasses wholesalers, manufacturers, retail drug chains that self-distribute and other alternative forms of distribution, such as mail order distribution. Viewed this way, they claimed their business represented only 57 percent of a $94 billion market. The FTC contended that the relevant market is limited to the $54 billion drug wholesaler market, of which the four wholesalers in the suit control 80 percent, according to a market analysis adopted by the judge. Other market-share factors contributing to the decision included a potential duopoly in certain regions of the U.S., including Los Angeles, Seattle and San Francisco. The court found that the FTC presented three "compelling examples" of the way in which significant anti-competitive effects would likely occur if the mergers were to be approved. One way was by showing, through the evidence of the defendants' internal documents, that excess capacity currently in the marketplace was the primary factor fueling so-called "irrational pricing"-and suggesting that by removing excess capacity through mergers, competition could be less stiff for the merged companies. A second persuasive point, according to the ruling, was that "continued competition in the industry ... led to a significant reduction in prices benefitting the American customer"-which was shown in the fact that wholesalers' upcharges have dropped, in a competitive marketplace, in recent years from 400 basis points in 1988 to 35 basis points today. On the third point, Sporkin noted in the ruling that "even without the mergers, [the wholesalers now] have the ability to engage in collusive pricing practices." Evidence presented showed that three of the four defendants engaged in a subtle form of "price stabilization" or "some form of anti-competitive pricing." The ruling cited testimony and evidence that in 1994-95 three of the defendants (Cardinal, AmeriSource and Bergen Brunswig) negotiated contracts with the VHA, one of the largest hospital purchasers, "which set a floor on the price the defendants would offer to other hospitals..." Among other twists and turns cited in the ruling was that the four wholesalers guaranteed if the mergers were allowed, they would not raise prices and would return 50 percent of any merger cost savings to their customers. This turned out to be a negative point, or as Judge Sporkin ruled, "While such undertakings would go a long way toward addressing the public's legitimate concerns, the mere fact that such representations had to be made strongly supports the fears of impermissible monopolization." Industry reactions The four wholesalers, in their statements following the announcement of the decision, expressed disappointment. "We are extremely disappointed with this decision, since we continue to believe strongly that this transaction would be highly beneficial for our customers," stated Robert D. Walter, chairman and chief executive officer of Cardinal. In a joint statement, Mark Pulido, president and chief executive of McKesson, and David Yost, president and chief executive of AmeriSource, said they were "surprised and disappointed with the court's ruling." The FTC was understandably pleased with the outcome: "Competition in the market for drug wholesaling is protected as a result of this decision," stated Richard Parker, deputy director of the FTC, plaintiff in the case to halt the mergers. No further elaboration was available from the FTC at press time, as the agency was awaiting the wholesalers' decisions about a possible appeal. Although before the trial some chain drug leaders were opposed to the mergers--most outspokenly Martin Grass, chief executive of Rite Aid--at trial, some industry executives were optimistic about the possible mergers. Among those testifying on behalf of the wholesalers, specifically for Cardinal Health, was Gordon Barker, former chief executive of Thrifty PayLess, which is now owned by Rite Aid. Barker told Drug Store News, "I think it could have been good for the drug wholesalers and could have been good for chain drug retailers. I see little difference between this and the mega mergers in the drug store industry--it was my belief that customers would benefit by the mergers of these companies." Gordon added that in his view, "when (the judge) weighed the entire case, he was persuaded that chain drug stores would not be impacted and perhaps would benefit. It was the independents and hospitals that would suffer." Many Wall Street analysts expressed disappointment, such as Michael Krensavage of Oppenheimer & Co. in New York, who told Drug Store News, "I have no vested interest in [the mergers] going through, but I see where it makes sense to the health care system." Added Krensavage, "Yes, these companies would have benefited financially, but the health care system would have benefited more." Krensavage also noted that--like Barker--in his view the issue of regional market share pales when compared to the dominance of giant retailers. "We see Wal-Mart rolling into town after town ... no one can tell me there are five [major] retail chains competing against them. Maybe two or three, counting Kmart, Target and Sears. A lot of towns only have one major retailer: Wal-Mart."