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Making a Fortune by Wagering That Drug Prices Tend to Rise By Stephanie Saul
But as he becomes
increasingly visible as one of New York's wealthiest men, Mr. Rahr,
a 58-year-old law school dropout, is girding himself Over the last 20 years, the packing and shipping of drugs evolved into a game of arbitrage, called speculative buying, with distributors like Mr. Rahr wagering on drug price increases. This common industry practice seems more fitting to a casino than a distribution warehouse. And in the 1990's and the early years of this decade, with prices far outstripping inflation, it was a sure bet. Knowing that drug manufacturers typically increased prices at the same time, often in January, drug middlemen like Mr. Rahr, the sole owner of Kinray, which is based in Queens, made millions by overstocking their warehouses before manufacturers announced price increases. By acquiring extra inventory at the lower price, distributors made quick profits once they sold the drugs at higher prices a short time later to retail pharmacies. Prescription drug prices are a combustible political issue, and manufacturers feel intense pressure to restrain them. With their historically large profits threatened, and with regulators questioning aspects of the speculative buying system, the manufacturers have taken steps to shut it by limiting distributors to just one month's worth of inventory. Drug manufacturers have also begun using special software to help detect speculative buying. Mr. Rahr would not disclose exactly how much he made through speculative buying. Goldman Sachs estimated that the distribution industry, which is dominated by three large public companies, made 60 percent of its profit, or $980 million, from speculative buying in 2001, when the practice was at its peak. More recently, Goldman Sachs estimated speculative buying's contribution at 40 percent of profits. Mr. Rahr, who honed the practice with the help of a computer program, said that his profit from the practice never reached 40 percent. Mr. Rahr also said that his and other distributors' fees accounted for a tiny portion of the cost of drugs to consumers, with manufacturers taking the major share of profits. "We're talking an infinitesimal impact on the consumer, based on the total cost of the health care industry," Mr. Rahr said. "Whether there is spec buying or not is not the greatest factor in the high cost of pharmaceuticals." In some ways, the practice helped drug manufacturers, who relied on speculative buying in lieu of paying distributors to get drugs to pharmacies. In effect, it was a form of hidden compensation that never showed up as a cost to manufacturers. But speculative buying fostered many problems, industry analysts and economists said. Some say it played a role in drug cost inflation by adding an incentive for manufacturers to raise prices repeatedly. It also sometimes gave drug makers false signals that products were in demand, prompting them to turn out excess product. By encouraging distributor stockpiling, the system also led to shortages in some regions of the country, a situation known as a "stock out" and one that the industry does not like to discuss. Last year, Bristol-Myers Squibb paid $150 million to settle allegations, without admitting or denying guilt, that it misled investors by aggressively encouraging wholesalers to flood their warehouses, thus artificially inflating its sales. The case, brought by the Securities and Exchange Commission, was the beginning of the end of speculative buying, as other manufacturers worried that they, too, might run afoul of securities laws. "It was a dysfunctional model," said Ken Abramowitz, an analyst and managing general partner at NGN Capital, a health care venture capital company in New York. Exactly how much retail drug prices have been affected by speculative buying is an open question. Adam J. Fein, a Philadelphia business economist, says that the end of speculative buying can reduce the rate of drug price inflation by one or two percentage points a year. Based on the 5.3 percent increase in retail drug prices in 2003, as calculated by IMS Health, a pharmaceutical-market research company, consumers could save $2.2 billion to $4.4 billion annually. Others agree that speculative buying created inflationary pressures, but are more concerned that ending the practice will drive up retail prices if distributors, who operate on slim profit margins, are forced to pass any costs to retail pharmacies. "They'll have to make up their margins somewhere that they aren't getting from the manufacturer," said Steven W. Schondelmeyer, a University of Minnesota professor who studies the economics of the pharmaceutical industry. "They'll raise the prices to the pharmacies. The pharmacies have very thin margins to begin with, and all they can do is pass it on to consumers." Experts agree, however, that consumers will benefit in at least one way. Speculative buying helped foster a secondary pharmaceutical market, with some distributors reselling extra drugs they did not need to other distributors. "It invited the risk of the type of counterfeit and adulterated market that we saw with some of the biotech drugs and Lipitor," said Christopher McFadden, an analyst with Goldman Sachs. The shift away from speculative buying has put pharmaceutical distribution at a critical point, according to Mr. Fein, whose company, Pembroke Consulting, advises both manufacturers and distributors. "Of course it's affected our business," said Mr. Rahr, who said he had no plans to raise prices to compensate for the loss of profit from speculative buying. Instead, he said that his company was working harder to control costs and expand its territory. "Volume, volume, volume," he said. The transformation has also affected bottom lines at the three large public pharmaceutical distribution companies - AmerisourceBergen, Cardinal Health and McKesson. Today, they deliver 90 percent of the $220 billion in drugs sold in the United States. As distributors try to recoup, they have become engaged in what Mr. Fein said were tough negotiations with manufacturers, asking that they pay fees for distributing drugs to pharmacies. "The question is, How much more value or how much more fees is the manufacturing community going to be willing to pay?" Mr. McFadden said. "It's kind of whatever you can negotiate." In one of the first of these "fee for service" deals, Eli Lilly recently announced it had struck an agreement with Cardinal Health, but neither side disclosed terms. Last week, Eisai, a Japanese pharmaceutical company, announced that it had broken off negotiations with Cardinal Health and warned patients of potential disruptions in the supply of drugs to treat Alzheimer's, epilepsy and gastrointestinal problems. Three days later, the companies announced that they had reached a deal, after all. Pfizer, the giant pharmaceutical manufacturer, said last week that it would not negotiate fee agreements with distributors. "Someone like Pfizer says, 'the fact that you lost money is not my problem,' " said Mr. Abramowitz, the health care analyst. As his profit margin narrows - Mr. Rahr describes it as "razor thin" - Mr. Rahr is expressing confidence that Kinray will prosper even without speculative buying, based on its efficiency, low costs and the fact that he has no debt. His company has established a national telemarketing office that makes cold calls to pharmacies across the country. Mr. Rahr, whose company employs about 1,000 people, is expanding his business in home health equipment like walkers and bedpans, as well as generic drugs, both areas with higher profit margins than brand-name drugs, where he makes less than 2 cents on the dollar. "We do all this work for pennies," Mr. Rahr said. "But like my father said, 'pennies do add up to dollars.' " Last year, the pennies added up to $3.1 billion in sales. Mr. Rahr's business, he said, is dependent on a large computer-operated picking system that fills orders from among 34,000 items in the company's 400,000-foot warehouse. The items, he said, include anything a drugstore would sell. "I'd be out of business without this technology," he said. Despite his wealth, Mr. Rahr still exudes Queens from every pore. He is gregarious and down to earth, perpetually tanned, and seems both proud of his success and slightly apologetic about it, emphasizing that he still wears a $19.95 watch and drives himself to work in a 10-year-old Jeep Cherokee. He loves to tell stories about how a headwaiter or a security guard stopped him because he was wearing his usual attire, a baseball cap and jeans. "My wife's used to it," he said. "I identify with the underdog." He specializes in sales to 3,000 independent drugstores in seven Northeastern states. Mr. Rahr says he controls 75 percent of that market. Among the druggists, Kinray is known for its easy-to-use Web site. It has been 36 years since Mr. Rahr dropped out of New York Law School and persuaded his father, Joseph Rahr, not to sell the family's retail pharmacy in Brooklyn, which also supplied a few other drugstores. Mr. Rahr recently described the rejection he felt at first, when he tried to expand the wholesale business. "I used to call the pharmacies and I would call and say, 'Kinray,' and they'd say, 'Nothing for you today.' And after about three or four in a row, I would get, 'Here's three aspirin for you and two Colgate toothpaste and one Mennen Speed Stick, if I were lucky,' " Mr. Rahr recalled. "And the sound of them hanging up on me, the 'nothing for you today,' just started to make me feel like I had to do something to get to become the primary jobber in these stores." In 1973, Mr. Rahr and his wife, now a partner in a Manhattan jewelry design firm, Beach to Ballroom, bought their first home on one acre in suburban Dix Hills, N.Y. The Hamptons estate is considerably more grand, and Mr. Rahr sees it as his crowning achievement. It sits on 25 acres. The main house is 18,000 square feet, with 8 bedrooms and 14 baths, a private 2,000-foot beach with its own dock and boathouse, a waterside heated pool with waterfall and whirlpool, a tennis court and viewing pavilion, and a greenhouse. Mr. Rahr said that buying the property was an emotional experience for him. "Here we were, 32 years later, walking on a much larger estate and feeling blessed that we were able to be in this position," he said. Mr. Rahr says he has never borrowed a penny, so in a few days, when the deal closes on the oceanfront mansion, called Burnt Point, he will pay cash.
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Stewart
Rahr's new $45 million East Hampton estate, the most expensive house
ever purchased in New York State, is just across the pond from
Steven Spielberg's. Mr. Rahr plays golf with Donald Trump and
practices putting on an indoor green in the basement of his
warehouse in Queens. He and his wife, Carol, last drew attention in
2003 when they bought four works of art, including a Renoir and a
Picasso, in one sitting at
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A Feast
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