US Generic Inflation Pauses in 2Q15, But is Very Likely to Resume

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Richard Evans / Scott Hinds / Ryan Baum


203.901.1631 /.1632 / .1627
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July 23, 2015

US Generic Inflation Pauses in 2Q15, But is Very Likely to Resume

  • The sales-weighted price at which US drug retailers acquire generics (NADAC*) has grown by more than 40 percent in just over two years. This unprecedented run of inflation is wholly explained by price increases on products with very low (pre-inflation) total national sales
  • In the wake of wholesaler / retailer tie-ups, US drug wholesalers control or directly influence roughly 3/4ths of US generic spending. Because the prices at which wholesalers sell price-inflated generics have grown more rapidly (~76%) than the prices wholesalers pay to generic manufacturers for these same products (~49%), wholesalers have captured the lion’s share of gains from generic inflation
  • Given wholesalers’ dominant role in US generic purchasing, and the extent to which wholesalers benefit from the current inflationary pattern, in all likelihood inflation should continue as long as there’s still room – i.e. as long as there remain products with very low national sales whose prices have not yet inflated
  • For every generic drug product with very low national sales whose price has inflated, there remain about 1.5 similar products whose prices have not meaningfully changed – meaning the available ‘substrate’ for the current inflationary pattern is only about 40% consumed

*National Average Drug Acquisition Cost

Where we’re BULLISH: Biopharma companies with undervalued pipelines (e.g. AMGN, BMY, CELG, GILD, SNY, VRTX); Biopharma companies with pending major product approvals (e.g. ABBV, ALIOF, AMGN, AZN, BDSI, BIIB, CLVS, ENDP, GNMSF, HLUYY, HSP, ICPT, JAZZ, LLY, MACK, MRK, NVS, PTCT, RLYP, RPRX, SHPG, SNY, SRPT, TSRO, UCBJY, ZSPH); SNY on undervalued basal insulin franchise and sales potential for Praluent (alirocumab), in addition to its undervalued pipeline; ABBV and ENTA on sales prospects in Hep C; RAD as an acquisition target as WBA and CVS seek to defend against narrowing retail networks; CFN, BCR, CNMD and TFX on rising hospital patient volumes; XRAY and PDCO on rising dental patient volumes and rising average dollar values of dental products and services consumed per visit; CNC, MOH and WCG on bullish prospects for Medicaid HMOs; and, DVA and FMS for the likely gross margin effects of generic forms of Epogen

Where we’re BEARISH: PBMs facing loss of generic dispensing margin as the AWP pricing benchmark is replaced (e.g. ESRX); Drug Retail as dispensing margins are pressured by narrowing retail networks and replacement of AWP (e.g. WBA, CVS); Research Tools & Services companies as growth expectations and valuations are too high in an environment of falling biopharma R&D spend (e.g. CRL, Q, ICLR); and, suppliers of capital equipment to hospitals on the likelihood hospitals over-invested in capital equipment before the roll-out of the Affordable Care Act (e.g. ISRG, EKTAY, HAE)

US generic drug inflation has been quite rapid since at least early 2013 (Exhibit 1); however inflation paused in 2Q15 (Exhibit 2). Despite this pause, we expect rapid generic inflation to resume

As we’ve previously shown[1], generic inflation during this period has been entirely explained by products with relatively low overall sales, either because of very low unit prices (3/4ths of inflation), or because of products with relatively normal pre-inflation prices simply having very low unit volumes (1/4th of total inflation). In this same work, we showed that conventional explanations (e.g. product shortages and/or limited numbers of manufacturers on inflating products) are inconsistent with the evidence

Largely as a result of tie-ups[2] between US drug wholesalers and US retailers, US drug wholesalers now control – or are at least closely involved in – the purchasing of roughly 3/4ths of all generics dispensed at retail in the US

Wholesalers generally sell generics to retailers at some derivative of generic products’ wholesale acquisition cost, or ‘WAC’. Despite the name, wholesalers purchase from generic manufacturers at negotiated prices that are below the WAC or ‘list’ price. As such at a given WAC-multiple selling price[3] changes to wholesale gross margins are a function of changes in the gap between WAC and negotiated acquisition costs

Wholesalers benefit if WAC – which defines their selling price – rises more rapidly than their negotiated or ‘actual’ acquisition costs. To get a sense of how the recent wave of generic inflation has impacted wholesale margins, we compared the pre- and post-inflation spreads between average manufacturer price (AMP) and national average drug acquisition cost (NADAC). AMP is a fair indication of the price manufacturers are receiving for a given drug (and dosage), and NADAC is a fair indication of the price that retailers are paying to acquire that same drug and dosage – thus the trend line of AMP / NADAC spreads[4] is a reasonable indication of the trend in wholesalers’ gross profits from selling generics at retail

For products with total inflation ≥ 10% from March 2013 – April 2015[5] where we could find both AMP and NADAC values (433 of 963 such products), AMP grew an average of 48.5%, and NADAC grew an average of 76.1% – meaning the price at which wholesalers sell price-inflating generics is growing faster than wholesalers’ cost of acquiring these same generics (Exhibit 3; further detail in Appendix 1). It’s clear that wholesale gross margins have benefited from the recent trend of generic inflation, and it’s similarly clear that wholesalers are capturing the lion’s share of the inflationary gains. Given wholesalers’ degree of control over US generic sourcing, the positive gross margin effects of generic inflation, and the fact that wholesalers appear to be capturing a majority of the inflationary gains, it’s more than reasonable to believe that generic inflation will continue – assuming there are enough products left to inflate, which there are

As we mentioned at the outset, the generic inflation trend since 2013 has been driven by products with very low overall sales, in most cases because these same products had (before inflation) very low prices. To get a sense of what proportion of such products have or have not yet experienced price inflation, we identified all generic retail products whose total sales or unit prices were below the average sales or prices of products whose prices ultimately inflated. Of the 2,192 products with sales below the threshold, only 807 (37%) have inflated. Similarly, of the 1,683 products with prices below the threshold, only 653 (38%) have inflated (Exhibit 4; further detail in Appendix 2)

Pulling everything together – the recent generic inflation trend can be wholly explained by price increases on products that have very low per-product sales, usually because of very low prices. Wholesalers benefit from generic inflation if and when their selling prices grow more than their acquisition costs, which is presently the case. Because wholesalers now influence a substantial majority of total US generic sourcing, and because they benefit from the current inflationary trend, wholesalers are unlikely to do anything to disrupt the pattern. Thus as long as there are products with very low sales that fit the pre-inflation profiles of products whose prices have inflated, the trend is likely to continue. By our estimates, just less than 40% of such products have experienced price inflation, meaning there is substantial fuel remaining for the generic inflation trend

©2015, SSR, LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein. The views and other information provided are subject to change without notice. This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. Through a wholly-owned subsidiary, SSR Health provides paid advisory services to Pfizer Inc (PFE) on both securities-related and non-securities-related topics. One or more of SSR Health’s analysts holds a long position in ENTA

  1. “Motive & Opportunity: The Convoluted Tale of Generic Price Inflation”, SSR Health LLC, February 9, 2015; “ABC/CAH/MCK: US Generic Inflation Continues in 1Q15”, SSR Health LLC, April 21, 2015
  2. ABC gained control of WBA’s generic sourcing in 2013 (Walgreens Boots Alliance Development, or ‘WBAD’); since then MCK gained control of RAD’s generic sourcing (February 2014), and CAH gained control of CVS’ generic sourcing (Red Oak Sourcing, established July of 2014)
  3. Wholesalers might sell to very large customers (e.g. the Veterans Administration) at prices below WAC, but might also sell the same product to smaller customers (e.g. independent retail pharmacists) at prices above WAC. As WAC rises or falls, the selling price remains a constant multiple of WAC, thus the selling price rises or falls in proportion
  4. Manufacturers have every reason to report the lowest possible AMP’s, as this lowers the base on which federal rebates are calculated. Conversely retailers have every reason to report the highest possible NADAC’s, as this increases their reimbursement. Thus despite our belief that AMP and NADAC are very reasonable indices, we recognize that if anything AMP will be under-reported and NADAC over-reported, and that this of course has to be kept in mind when working with the AMP / NADAC spread
  5. These products explained more than 100% of aggregate generic inflation over this period
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