PBM Gross Margins – This Looks Like the End of the Cycle

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Richard Evans

212.531.6101

richard@sector-sovereign.com

March 10, 2010

PBM Gross Margins – This Looks Like the End of the Cycle

  • Since 2001, PBM gross profit per claim has grown three times faster than average drug prices, and 1.25 times faster than drug retail mark-ups
  • As with drug retail, during this period PBMs benefitted from drug price inflation and an increasingly generic product mix. Unlike drug retail, PBMs shared in increasingly generous manufacturer rebates; and, PBMs gained at drug retail’s expense by driving retail mark-ups and dispensing fees downward
  • PBMs’ gross margin (GM) gains came predominantly after 2005; since this point the 3 major PBMs’ GMs have been of roughly similar magnitudes and have grown at roughly similar rates, characteristic of a cooperative oligopoly. Industry structure also is consistent with oligopoly; the 3 majors have roughly 50 percent share of US Rx’s; the next full-service / non-captive PBM has roughly 3 percent
  • MHS and CVS saw slight declines in GM – and attendant shifting of clients – in 2009. It is reasonably clear that the PBM competitive dynamic since 2005 has been one of (implicitly, not explicitly) cooperative oligopoly; the question of whether MHS v. CVS action in ’09 signals a near-term shift to price competition is a coin-toss. Looking out to the mid-term, we see a return to price competition as highly likely, as we expect business conditions to deteriorate for PBMs
  • The traditional (and current) PBM model relies on large volumes of highly interchangeable products, written by large numbers of prescribers and consumed by large numbers of patients. Share shifting in this context is a clinically sterile (drug choice matters little), brute force process of converting very large volumes of moderately priced prescriptions at a very rapid pace – something PBMs do better than their plan sponsors (HMOs and employers)
  • As the market shifts from these traditional, highly interchangeable products to more specialized products, whether to use a product and which product to use becomes a slower moving, more clinically complex and higher dollar per-decision game – something health insurers do better than PBMs
  • We suspect that PBMs cannot shift from traditional products to specialty products quickly enough to preserve GMs (75 percent of sales attributable to highly interchangeable products will lose patent by 2014) nor do we believe PBMs offer the same value proposition in specialty care (particularly to HMOs) that they have with more traditional products. Add to this the likelihood that the cooperative pricing dynamic crumbles, and we see considerable odds of considerable mid-term GM pressure
  • In the very near term, PBMs may benefit from deeper manufacturer rebates if Congress chooses to expand Medicaid – either as part of large scale reforms, or as a separate initiative
  • We believe that large scale reforms will not pass, but whether the Speaker holds a vote on large scale reforms is potentially meaningful to informed trading of PBMs in the near-term. If the Speaker holds a vote that fails, Congress is unlikely to attempt a smaller reform package, meaning no Medicaid expansion and no attendant benefit to PBM GMs. Conversely, if the Speaker declines to vote on large scale reforms, we see reasonable odds that Congress passes a modest reform package that expands Medicaid, with a one-time near-term benefit to PBM GMs
  • Beyond the near-term matter of Medicaid expansion, we see more downside than upside in the PBM business model, as both fundamentals and competition conspire to narrow margins. Drug retailers are more levered to the GM benefits of an increasingly generic product mix; and, being free of PBM’s risks, strike us as a far better way to play this trend

Generics, Product Mix, and Gross Margin

In a recent report[1] we noted that sub-sector estimates fail to add to a logical whole; and, that a particular dis- connect exists in the relationship between PBM and drug retail estimates on the one hand, and manufacturer (brand, generic, biotech) and wholesaler estimates on the other. Manufacturer and wholesaler sales estimates reflect falling sales due to brand patent losses; PBM and drug retail estimates do not. Further, PBM and drug retail earnings estimates appear to reflect an assumption of productivity gains through classic operating synergies as sales grow, whereas to our minds sales are likely to be more modest, and the effect of increasing generic mix on gross margin is likely to be the dominant productivity variable – for both businesses.

We showed that because drug retailers appear to be more beneficially levered to rising generic mix than PBMs, that drug retailers were more likely than PBMs to meet earnings expectations – despite lower than expected sales. At best, PBMs see around 32% more per-prescription profit from generics than brands (Exhibit 1); drug retailers see nearly twice this amount (Exhibit 2). Even after accounting for the fact that only 65-68% of drug retailers’ sales are from the prescription counter, we concluded that drug retailers had more to gain from pending generic approvals than PBMs.

Looking Back, It’s Much More Complicated …

Plainly this begged the question of how drug retailer and PBM gross-margins have behaved relative to one another in recent history, since the last decade has seen a considerable mix-shift from brands to generics – 42 percent of US retail prescriptions were generic in 2000, that figure is now roughly 60 percent.

We compared PBM gross margin to drug retailers’ prescription gross margin. Specifically, we compared gross profit dollars per claim[2] (PBM) or prescription (retail). The PBM figures are readily found in company reports. Drug retailers’ prescription gross profits are reported on a whole-store basis, making it impossible to see prescription-counter gross profit. We found that as part of its broader suite of pricing indices the Bureau of Labor Statistics tracks dollar mark-ups at retail pharmacy[3]; and, with the much-appreciated benefit of advice from BLS staff we were able to create an apples-to-apples comparison of PBM and drug retail mark-ups. The bottom-line is that despite substantial gains in generic mix, and retailers’ greater leverage to generics, PBM’s per-prescription mark-ups have grown more quickly than drug retailers’ (Exhibit 3).

Either we’re wrong about relative leverage to generics, there’s more to the mark-up equation than generics, or some combination of these. The simple answer is that there’s much more going on than shifts in product mix; and, that on net these other historic moving factors tended to benefit PBMs more than retailers. Two of the dominant ’01 – ’09 themes benefitted both PBMs and drug retailers – namely drug price inflation, and the shift in product mix toward generics. Exhibits 4 and 5 show the relationship between $/Rx growth, drug inflation and generic mix shift for both PBMs and drug retailers, respectively. Plainly inflation and mix shift have large positive influences on mark-ups, but just as plainly there is more to the picture for both of these sub-sectors.

Where generic mix and drug price inflation tend to benefit both businesses, there are three additional – and large – channel effects that tend to benefit PBMs far more than retailers, and/or penalize retailers but not PBMs. These effects are contract terms between PBMs and drug retailers, payor mix at retail, and drug rebates. During the last decade third-party payors – particularly PBMs – have gained leverage over drug retailers, as reflected in the mark-ups that retailers are allowed to charge PBMs’ clients (the spread between AWP and sales price to PBMs’ clients), and the dispensing fees PBMs pay retailers for filling clients’ prescriptions (Exhibit 6). Clearly this shifts the gross margin / prescription balance in PBMs’ favor. This is particularly true as third-parties – particularly PBMs – have become a larger proportion of drug retailers’ payor mix; since 2000, third parties’ share of drug payments at retail has grown by roughly 15 percent (Exhibit 7). This not only gives PBMs more negotiating leverage over retail – as reflected in falling mark-ups and dispensing fees – this also serves to immediately reduce retailers’ gross profits, since cash paying customers pay roughly 80% higher mark-ups for brands, and 12% higher mark-ups for generics, as compared to customers covered by a third-party[4].

Finally – and we believe most importantly going forward – PBMs participate in manufacturers’ rebates, and drug retailers do not. Recall that the general level of manufacturer rebates is heavily influenced by Medicaid best price effects. Up until 2006, Medicaid represented a very large (hi-teens) share of total retail purchases, and was entitled to the lower of a 15.1 percent discount or the lowest price in the market. This had the effect of limiting drug rebates; note in Exhibit 8 that once the underlying laws went into full effect (early 90’s), manufacturers’ discounts fell from the mid-30’s to roughly 15.1 percent – i.e. to the best-price threshold

(diamond-marked line). Exhibit 8 also shows the actual rebate manufacturers pay to Medicaid (square-marked line); this tends to be higher than the 15.1 best price threshold, after various additional rebates (particularly for pricing faster than CPI) are added to manufacturers’ deepest commercial rebates. From Congressional Budget Office (CBO) testimony, we know that the average total rebate paid in 2007 was much larger than it was before 2006 (Exhibit 8, again) – which effectively proves that manufacturers offered larger rebates in 2007 than in prior years. The reason is fairly simple – when the Medicare drug benefit (Part-D) went into effect in 2006, a little more than half of Medicaid drug retail purchases shifted to Part-D. Discounts to Part-D are not included in best price calculations – so manufacturers can discount as steeply as they chose to Part-D plans without affecting their Medicaid rebates; and, because Medicaid was now a much smaller (about 7 percent) share of retail purchases, manufacturers were somewhat less concerned with setting new Medicaid best price levels even in their non-Part-D commercial contracts. Very simply, because of Part-D, average drug rebates immediately became more generous. Glance back at Exhibit 4, and note that PBMs gross margin growth is tightly correlated with underlying generic trends (primarily) and pricing trends (secondarily) with the exception of a single year – 2006. PBM gross margins saw their single biggest gain that year, despite relatively more modest mix and pricing effects. We’re convinced this is because of more generous manufacturer rebates in 2006 – which PBMs participate in, but drug retailers do not.

Thus looking back, PBM’s had better gross margin dynamics than drug retailers, arguably because of growing manufacturer rebate levels, winning the zero-sum game of what margins and fees are or are not shared with retail; and, the shift in retail payor mix toward less generous payors.

Looking Forward –Fundamentals and Politics in the Near- to Mid-Term

Looking forward, whether PBMs or drug retailers have better gross margin performance is simultaneously a narrow question of relevant fundamentals, and a broader question of competitive and value-proposition dynamics within the PBM industry. In the near- to mid-term the fundamentals of both businesses will continue to be fed by real gains in drug pricing and an increasingly generic product mix. Our expectation is for brand manufacturers to continue with relatively rapid pricing, both as a response to general weakness elsewhere in their businesses, and as a reaction to the specific concerns that political actions may soon restrict pricing freedoms. Nominal gains are at roughly 7 percent (Exhibit 9); we expect list pricing actions to be driven by two rules that will serve to keep the industry at or near this nominal pace: 1) take pricing actions as close to double digits as possible without going over; 2) don’t be the most aggressive pricer among your industry peers. And, to our original point, pending mix shifts to generics are large, inevitable, and appear to benefit retailers more than PBMs.

This leaves the fundamental questions of whether PBMs will continue to lower retailers’ compensation, whether retailers’ payor mix will continue to deteriorate, and whether manufacturers will increase rebates further. We suspect that retail mark-ups and dispensing fees have gone nearly as low as they can, and clearly see that payor mix has stabilized – and so conclude that these two effects, which advantaged PBMs relative to retailers over the past decade, are unlikely to be major effects as we look forward.

Whether manufacturer rebates increase further is to our minds a question of whether Congress passes an expansion of Medicaid – either as part of the current attempt to pass large-scale reforms, or as a subsequent attempt to pass more modest reforms. We believe large scale reforms are unlikely to pass; however we note the possibility of Congress passing a more modest reform package, and believe that any modest reform package almost certainly includes an expansion of Medicaid. In turn, Medicaid expansion almost certainly raises manufacturers’ mandatory Medicaid rebate from 15.1 to 23.1 percent. As we’ve seen (Exhibit 8, again) drug manufacturers’ discounting behavior is heavily influenced by Medicaid best price considerations. As such, if the mandatory Medicaid rebate falls, we would expect commercial discounts from manufacturers to become more generous – which benefits PBM gross margins, as we saw in 2006. At the risk of diverting into politics – if Speaker Pelosi forces a vote on the present large-scale reform package and fails, as we believe she would if she called the vote, then to our minds this fully exhausts Congress’ legislative capacity on health reform for the duration of this Congress – and perhaps for several Congresses afterward. On the other hand if – as happened in 1994 – the Speaker chooses not to force a vote on the comprehensive package, Congress retains the capacity to pass a more modest package of reforms before November. Thus all in, if the speaker forces and loses the large votes, we see stable Medicaid rebates, stable commercial rebates, and no contribution of expanding rebates to PBM gross margin. Conversely, if the Speaker chooses not to force a vote on the comprehensive package, we see high odds of much more modest reforms passing – including Medicaid expansion – and with this a deepening of commercial rebates, with attendant benefits to PBM gross margin.

Looking Further Forward – PBM Competition and Value Proposition in the Mid- to Longer-Term

If we stopped here, we might conclude that historic PBM v. drug retail gross margin trends were heavily affected by influences that may (larger drug rebates) or may not (tighter retail re-imbursement, erosion of retail payor mix) be present in the near- to mid-term. In turn, this might lead us to conclude that drug retailers’ gross margin is likely to do better than PBMs’ because of greater leverage to (large, certain) generic mix shifts, aside from the risk of PBMs seeing a one-time gross margin gain on the heels of a Medicaid expansion.

All of this would presume that the PBM business model — and its margin structure – is stable. For two reasons, we’re not sure this is the case: 1) PBM margins reflect a cooperative oligopoly; and 2) PBMs’ value-proposition may erode as a larger proportion of products go generic.

The three largest (MHS, CVS, ESRX) PBMs control roughly half of US retail prescriptions. The next largest full-service (including mail) non-captive (i.e. not operated by a health insurer to manage its own plans’ drug benefits) PBM that serves public clients (HealthTrans) has roughly 3 percent share of US retail prescriptions. Thus if an employer chooses to carve out its drug benefit from its overall health coverage, for practical purposes that employer needs to choose one of the three largest PBMs. This creates the opportunity for a cooperative oligopoly, wherein price competition is at least somewhat limited.

Exhibit 10 compares PBM gross margin per prescription to IMS figures for retail sales dollars per prescription, with both values being indexed to 2001 = 100. Since 2001 – and particularly since 2005 – PBM mark-ups have risen substantially faster than average prescription costs. The three large PBMs’ gross margins as a percent of revenues have followed similar paths since 2006 (Exhibit 11); and, gross profits per prescription have all reached roughly the same value as of 2009 (Exhibit 12). Price competition among PBMs appears to have been very limited at least since 2005; whether recent drops in MHS and CVS per-prescription mark-ups – and associated account gains and losses – play out in further price competition is as yet unclear, though we note the tendency of PBM negotiations to be relatively slow moving in light of the industry’s tradition of multi-year contracts. In short, PBMs appear to have been a cooperative oligopoly with weak price competition through 2008, and may or may not have entered an era of intensifying price competition.

Regardless of whether price competition breaks out among PBMs, we believe that the major firms must rapidly shift their value proposition in order to retain reasonable gross margins after 2012 / 2013. Presumably, plan sponsors come to PBMs for either of two reasons – slower growing and/or lower costs per beneficiary. Interestingly, costs per beneficiary don’t grow any more slowly for PBM beneficiaries than for private-sector (essentially employer-sponsored) beneficiaries as a whole (Exhibit 13). We compared MHS and ESRX reported trend data to private-payor prescription spending in the national health accounts, dividing total national private-payor spending by the employed population. The trends are not terribly distinct; if anything, PBM beneficiaries’ (at least MHS and especially ESRX) spending may have grown slightly faster than the total market trend. Presumably this leaves costs per beneficiary as the only reason to use a PBM. Costs might be lower for either or both of two reasons – less (or more cost-effective) utilization, or lower costs per drug. The utilization case is very hard to make – for example Nexium, the second largest selling drug in the US, is clinically indistinguishable from its parent drug omeprazole (Prilosec), which is available over-the-counter as a generic. This leaves price per drug – and clearly drug costs are lower for managed versus non-managed benefits. By virtue of formularies, PBMs have negotiating leverage over manufacturers, and so can gather rebates that lower per-drug costs to plan sponsors. Crudely speaking, PBMs function as buying clubs.

PBMs’ ability to extract discounts from drug manufacturers – and thus their appeal as buying clubs — is directly proportional to the dollar value of products that have readily available substitutes. By and large, patients with high cholesterol can just as well take Crestor or Lipitor, patients with ulcer or gastro-esophageal reflux can just as well take Nexium or Aciphex or Protonix (or generic omeprazole); and patients with ADHD can just as well take Concerta or Adderall XR. Less substitutable products offer PBMs less opportunity to compel rebates. For example patients with schizophrenia respond to drug therapy with great variation, so it’s relatively impractical to create a formulary that either excludes certain agents, or places agents in a preferred order. The problem PBMs face is that the pending patent wave eliminates many of the products that are more readily interchangeable.

As a rough estimate, we categorized 2008 US retail sales of the top 200 products (83.5% of total market sales) into either of three categories: highly interchangeable, limited interchangeability, and not interchangeable. In the current market we classify 35% of sales as highly interchangeable, and 19% of sales as having limited interchangeability. By 2013, products representing 75% of today’s highly interchangeable sales, and 77% of limited interchangeability sales, will have lost patent protection (Exhibit 14). Once these brands are gone, unless they are replaced by comparably large and comparably interchangeable brands, the buying-club dynamic of the current PBM model becomes far less value-producing.

We have no definitive means of saying whether sufficient dollar values of new (and highly interchangeable) products will enter the market over the next five years to preserve some critical mass of PBMs’ rebate negotiating leverage – but we think it’s relatively unlikely. Plainly, interchangeable products are being lost to patents at a very rapid rate. For scale, consider that until the late ‘90’s, the relative rates of new product flow and patent expiry meant that roughly 3.5 percent of a given year’s total-market sales would be generically available in the following year. In the last decade, this average has pushed well above 5 percent. For the record, steady-state (a balance between sales gains from innovation and sales losses from patent expiry) calls for a patent-expiry rate[5] of about 5.25 percent. With 15 percent of today’s interchangeable sales losing patent in an average year between 2009 and 2014, interchangeable dollars are leaving the market dramatically faster than we should expect them to be replaced.

Thus we’re reasonably sure that the market will consist of fewer high-dollar and highly-interchangeable products over the next five years than it has for the last 20[6]. And, we’re very sure that PBMs’ gross profits have historically relied on a very small number of very highly interchangeable products. For example, the FTC found that in 2003, more than seventy percent of PBMs’ total rebate dollars were accounted for by only 25 products[7].

We recognize that PBMs’ are collectively shifting in the direction of specialty pharmacy benefit services – with good reason. The question becomes whether PBMs can offer the same kind of value proposition for specialty products that they have for traditional products, and whether such a value proposition can be in place before the narrow base of rebate-generating traditional products lose patent. Our suspicion is that they can neither create a comparable value proposition nor — if they could — have one in place in time, and that PBM’s gross margins ultimately will compress as a result.

PBMs made their bones on highly interchangeable chronic use brands prescribed by a broad base of prescribers for large populations of patients. The clinical relevance of distinctions between alternative products tended to be narrow, setting the stage for competition on price. And, the interventions required to shift patients from non-preferred to preferred were clinically sterile (little need to match a specific patient to a specific drug) and highly standardized (picture Medco call centers) economically-driven events that occurred very quickly (a patient at the drug counter), in large numbers, and with comparatively small dollar values per intervention. Not what plan sponsors – i.e. HMO’s or employers – do, but perfectly suited to the model PBMs evolved – particularly those with mail-order facilities.

By comparison, specialty pharmaceutical management tends to deal with larger dollar, lower volume, slower moving and more clinically complex cases. Which is exactly what health insurers do. Thus not only do we doubt that there are as many dollars in specialty pharmacy benefit management as there are in traditional pharmacy benefit management, we further doubt that PBMs are necessarily better-geared to capture these dollars than are health insurers – who will also want these dollars. If prescription product mix in fact does shift heavily toward specialty pharmaceuticals and away from traditional, highly interchangeable pharmaceuticals, it stands to reason that this would also tend to re-integrate management of the prescription drug benefit with the broader health benefit. Arguably insurers’ capacity for more clinically detailed intervention plays to their advantage; and, the elements of infrastructure that were so essential to PBMs’ historic success (e.g. mail order facilities) become less of an advantage. This suggests that PBMs’ HMO clients will be better able to do more of what needs to be done – which argues that HMOs will give PBMs less of the pharmacy management dollar in the future than they have in the past[8], and further argues that employers may find PBMs’ argument to segregate prescription and health benefits less compelling than in the past. We note that with the exception of WLP, the major insurers all operate captive PBMs.

Returning to where we started – whose gross margins look better going forward, PBMs or drug retailers – the answer is far more complex than our original framing of who (drug retailers) is more levered to the gross margin benefits of patent expiries. Generic effects remain important, but are less important than the three fundamental questions facing the PBM business model: whether renewed price competition will erode (arguably generous) gross margins in the near- to mid-term, whether a Medicaid expansion may lead to larger rebates in the near-term; and, whether PBMs can create value in specialty benefit management more quickly than value is lost in traditional benefit management. We conclude that while it’s fairly easy to see the end of the PBM gross margin cycle from here (loss of highly interchangeable products’ sales volume, coupled with an inevitable intensifying of PBM v. PBM competition as the business gets tougher), it’s hard to tell whether we’re at the peak. We clearly see more downside than upside over the mid-term; and, our best argument for sticking with PBMs over the near-term has a picking up nickels ahead of the steamroller feel. Here it is: over the near-term, we would consider using PBMs as a means of benefitting from deepening branded drug rebates if it appears likely that a Medicaid expansion will pass. We continue to doubt that large scale reforms pass, and believe that if a vote is taken and fails, that this Congress is unlikely to act further on health reform – meaning no Medicaid expansion, no attendant gross margin effect for PBMs, and no clear reason to take the near-term risk of renewed price competition. Conversely, if Congress does not vote on large scale reforms, we see relatively hi odds of a smaller package – including Medicaid expansion – passing before November, which ultimately would benefit PBM margins, and perhaps even lower the immediate risk of renewed price competition. Despite PBMs’ favorable leverage to the gross margin effects of generics, we would tend to avoid the sub-sector after taking any gross margin benefit from deeper drug rebates, since drug retailers are both more levered to the gross margin effects of generics, and less susceptible to either intra-sector price competition[9] or dis-intermediation.

  1. “Mopping Up Residual Reform Risks; Why Consensus Expectations at the Sub-Sector Level Don’t Add Up” Sector & Sovereign, LLC, February 1, 2010
  2. PBMs report claims rather than prescriptions; some unknown number of claims will be for prescriptions that are not filled and accordingly are not re-imbursed. Assuming the filled / not-filled ratios are constant, claims are a reasonable proxy for prescriptions across time. For simplicity the call uses ‘prescription’ and ‘claim’ interchangeably when referring to measures of PBM unit volume. In all cases, PBM data are adjusted for the balance between mail and retail prescription sizes.
  3. Series Id: PCU4461104461104
  4. See Table IV-6, “Pharmacy Benefit Managers: Ownership of Mail-Order Pharmacies” Federal Trade Commission, August 2005
  5. Defined as the percent of this year’s sales subject to generic competition next year
  6. PBMs were essentially born from the 90’s era brand wars – Zantac v. Tagamet, Claritin v. Zyrtec v. Allegra, various ACE-inhibitors, angiotensin-II receptor antagonists, statins, arthritis drugs and more.
  7. It’s not so much a matter of whether the PBMs keep large shares of these rebates or not – increasingly they’re not. Rather, the point is that if rebates aren’t available, PBMs are less able to offer lower per-unit pricing than before, which provides their clients with less incentive to join the buying club.
  8. We recognize that if our logic is correct, either WLP should have held onto NextRx; or, the combination of being able to both sell the NextRx equity at the PBM peak (?) and lock in access to the broader PBM at favorable rates was sufficient compensation.
  9. We recognize the pressure of $4 Wal-Mart generics on drug retailers; however we believe this has more of a pull on the falling population of cash-paying patients than on the very large population of insured patients that drug retailers rely on.
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