Marsh and Kroger and O'Malia's and Retail and Real Estate & Retail

Marsh sues to exit pharmacy vendor agreement, could face up to $61M fine

March 16, 2009
Marsh Supermarkets Inc.'s attempt to switch to a cheaper supplier of prescription drugs has touched off a legal battle with the current supplier — which suggests it could fine the grocery chain as much as $61 million for reneging on its deal.

At issue is a five-year vendor agreement that former CEO Don Marsh signed in 2005 with Skokie, Ill.-based Topco Associates LLC and Chesterbrook, Pa.-based AmerisourceBergen Corp.

Marsh sued the companies last month after it became clear they will fight the Indianapolis grocery chain's plan to switch to San Francisco-based McKesson Corp.

Topco and AmerisourceBergen want to hold Marsh to its original terms.

"If Marsh withdraws... [AmerisourceBergen] will lose the many millions of dollars of revenues to which it is entitled over the remainder of Marsh's five-year purchase commitment," wrote AmerisourceBergen counsel Craig D. Mills in a September 2008 letter to Marsh's attorney.

"Should this occur, [AmerisourceBergen] will seek to recover its damages from Marsh, together with all other applicable legal remedies."

Neither Marsh nor the drug suppliers would comment. In the lawsuit, which is pending in U.S. District Court in Indianapolis, Marsh argues the contract has an escape clause. It says it has the right to walk away because it gave at least 60 days' notice of its intent to withdraw.

The legal tussle throws the spotlight on one of the most challenging parts of the grocery business. Grocers feel compelled to offer in-store pharmacies to draw in shoppers, but running them profitably is difficult, said Danny O'Malia, who formerly ran the O'Malia chain and also is a former Marsh executive.

Marsh, which was purchased by Florida-based Sun Capital Partners a year after Don Marsh signed the Topco-AmerisourceBergen deal, operates 101 groceries in Indiana and Ohio. Forty-one of them have pharmacies.

The Indianapolis company had signed that deal in an effort to get the buying power enjoyed by larger firms, such as its top rival, Cincinnati-based Kroger Co., the nation's largest pure grocery chain. Topco is a private purchasing cooperative whose 60 member-owners include Marsh, Meijer, Schnucks, IGA, Piggly Wiggly and Winn-Dixie.

AmerisourceBergen is the smallest of three drug-distribution companies that dominate the U.S. pharmacy market. The others are McKesson and Dublin, Ohiobased Cardinal Health Inc.

Court papers show the Topco-AmerisourceBergen deal requires Marsh to purchase 98 percent of its prescription drugs from them. To get discounted pricing, the deal requires Marsh to make annual purchases of at least $35 million or 5 percent of "total cost of goods sold" — whichever is less. Documents filed in court don't make clear what's included in cost of goods.

If Marsh breaks its contract, Topco and AmerisourceBergen threaten to charge the company a penalty of 12 times 175 percent of its monthly average drug purchases. Based on annual purchases of $35 million, the fine works out to $61 million.

Tough business

Supermarkets long have been small players in the pharmacy game, which is dominated by such chains as CVS and Walgreens. Nationally, just 10 percent to 15 percent of drugs are sold to consumers through supermarket pharmacies, said Craig Svensson, dean of Purdue University's College of Pharmacy, Nursing and Health Sciences

It's a business with ever-escalating costs in which volume dictates price. And it's driven by the need to protect the integrity of drugs, Svensson said, which is why only a handful of companies are trusted to move most of them from point A to point B.

Grocers like Marsh end up squeezed. To offer pharmacy services, they must pay expensive fully qualified pharmacists to work their counters. Shopping for bulk deals among the drug distribution giants is their only realistic opportunity to trim expense.

The alternative is removing pharmacies from supermarkets entirely. But that strategy has its drawbacks. Many grocery stores began introducing drug windows in the 1970s. Now customers have come to expect them.

"Obviously, it is always a tricky thing once you've put one in to take it out, because you never really know the impact on your business until you close it," Svensson said.

"You don't know the impact on [overall customer] traffic until you do the experiment. And that's got to be a hard part of the decision-making process."

Danny O'Malia said his nine-store O'Malia chain stayed out of the pharmacy business before Marsh acquired the family-owned company in 2001. Instead, he said, his family preferred to make sure a drugstore operated near its stores.

"We didn't want to be in a business we didn't understand," said O'Malia, now a public speaker with Spotlight Speakers and Entertainment.

While having in-store pharmacies is a huge convenience for shoppers, he said, the units crowd out shelf space that otherwise would be allocated for food, groceries' core business.

Making trade-offs

Supermarkets always are weighing such trade-offs. Every grocery store offers loss leaders — a few products on which it makes little or no profit, such as Miracle Whip, Velveeta cheese or StarKist tuna — to lure customers through the doors Meanwhile, shoppers don't notice the markup on dozens of other items that generate profits.

But in recent years, stand-alone drugstores have begun playing the same game, offering discounts on the same kinds of products, as well as milk and eggs. Now, supermarkets can't escape the vicious cycle of competition without ceding more ground.

At the same time, additional players have crowded into the pharmacy business, such as Costco and Sam's Club.

"At some point, it was great profit [for groceries], but I'm guessing competition and the economy have cut that quite a bit," O'Malia said. "It's not what the grocer hangs his hat on. It's something he has to have."

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