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

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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

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