While Gulliver Slept: The Rapid Pace and Fragile Pre-Conditions of VRX’s US Pricing Power

gcopley
Print Friendly
Share on LinkedIn0Tweet about this on Twitter0Share on Facebook0

Richard Evans / Scott Hinds / Ryan Baum

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

203.901.1631 /.1632 / .1627

https://twitter.com/images/resources/twitter-bird-blue-on-white.png richard@ / hinds@ / baum@ssrllc.com

@SSRHealth

October 14, 2015

While Gulliver Slept: The Rapid Pace and Fragile Pre-Conditions of VRX’s US Pricing Power

  • We estimate that US prescription brands account for just over half of VRX’s global sales. Since 1Q07, we estimate that average selling prices for VRX’s US Rx products have grown at an average annual rate of 48%, offsetting unit volume declines of -18% to produce net sales growth of 32%. Over the past year the situation is even more dramatic; we estimate net pricing gains of 93% for US Rx products, offsetting volume declines of -39% to yield net sales growth of 55%
  • Congress lacks any realistic near-term options that would limit VRX’s pricing power, and VRX cannot afford to meaningfully decelerate – so Congressional pressure is very nearly meaningless to the VRX pricing trend. Commercial formulary managers (e.g. PBMs, HMOs) are another matter
  • Market pressure on prices typically comes in the form of cheaper (often generic) and/or clinically superior alternatives, spurred along by formulary controls that force substitution of one product or another. Because the vast majority of VRX’s US Rx sales consist of very small products, most of the VRX product line fails to draw the interest of either competitors or formulary managers
  • Such an under-the-radar approach has merits, but also limits. VRX has grown to a size, and inflated US Rx prices at such a pace, that it has for the last six quarters been one of the five largest contributors to overall US Rx market inflation
  • Formulary managers’ traditional approach of forcing substitution of one brand for another is too unwieldy to be applied to VRX’s portfolio on a product-by-product basis. So the formulary managers must either passively accept VRX as an ever-larger inflator of drug benefit costs, or they must adapt
  • Adaptation is the likely response. Company-wide and/or large multi-product deals are unlikely in the brand space (but common in the generic space); however they’re not unprecedented. We believe formulary managers are likely to soon consider tactics such as ransoming VRX’s US Rx darlings (e.g. Xifaxan, Jublia) in exchange for price-escalation constraints on the broader portfolio, and we believe such tactics are likely to work, the result being a slowdown of VRX’s rate of US Rx net pricing gains

 

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, ACAD, ADMA, ALIOF, AZN, BDSI, BIIB, BMY, CHMA, CLVS, CPRX, ENDP, GNMSF, ICPT, JAZZ, LLY, LPCN, MACK, MRK, NVS, PTCT, RLYP, RPRX, SHPG, SRPT, TEVA, UCBJY, ZSPH); SNY on undervalued basal insulin franchise and sales potential for Praluent (alirocumab), in addition to its undervalued pipeline; 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)

Summary and Conclusion

VRX is perhaps the purest sizable example of US prescription pricing opportunism. Recent Congressional saber-rattling has forced consideration of whether VRX’s rate of US prescription net pricing gains can continue, and what might happen to VRX if they cannot

VRX reliance on US net pricing gains is extreme; since 2007 the average selling price of US prescription products owned by VRX has grown by a CAGR of 48%; offsetting unit volume declines of CAGR -18% to produce a net US prescription sales gain of 32%. If VRX US prescription net pricing gains were to end the company would only survive if volume declines also ceased

Politics are unlikely to slow VRX’s pricing. Congress has too few means of restricting VRX, and VRX has far too much to lose by restricting itself

This leaves only the question of whether VRX has the commercial footing to continue realizing US net pricing gains. Typically rate-limits on US net pricing come in the form of either generic competition, or forced substitution of alternatives by third-party payors. VRX’s products generally have been too small to attract either form of attention – at least historically. VRX has only one US prescription product (Xifaxan) with annual gross sales in excess of $1B; excluding Xifaxan average US gross sales per product are less than $60M

The relevant pricing policy question is not what Congress might do, but what formulary managers might do. Within the framework of normal business practices (product-level interventions) it’s difficult for formulary managers to push back against VRX’s US net pricing gains (individual products are too small to make each intervention worthwhile); however as a company VRX has for the last 6 quarters been one of the five largest contributors to US brand inflation (Exhibit 1)

It logically follows that the VRX bull case relies on an implicit assumption which should be obvious, but perhaps is not: that US formulary managers, whose pricing power traditionally has been limited to product-level interventions, will not adapt to VRX as a source of drug price inflation by developing and deploying company-level interventions

It’s crucial to realize that US formulary managers are literally compelled to make the attempt. Because VRX is such a large contributor to brand price inflation (and by extension, to the cost of drug benefits), if one formulary manager successfully shields her clients from VRX inflation but her competitor does not, she takes her competitors’ clients – and vice versa. Gulliver awakens

It doesn’t take a great deal of imagination to realize that formulary managers have viable options – linking coverage of larger (e.g. Xifaxan) and/or newer and faster growing products (e.g. Jublia) to portfolio-wide (rather than product-specific) pricing constraints is just one example

We conclude that VRX’s US prescription pricing power is more likely to face emerging constraints than it is to continue running free, but that these constraints are likely to come from commercial formulary managers, rather than from Congress

An estimate of VRX’s reliance on US Rx pricing gains

VRX reports US net sales not at the product, but at the category level, using category definitions that include both prescription and non-prescription products. This complicates efforts to track all of the moving parts (volume, price, mix) of VRX’s US prescription revenue growth

However by using VRX’s legacy (circa 2007) disclosures as a starting point, and adding in US prescription products on an acquisition-by-acquisition basis, it’s possible to: 1) extract reasonable estimates of net US prescription sales from VRX disclosures; and 2) back acquisition-driven growth out of reported net sales growth

The result is a pro forma breakdown of changes to volume (estimated using third-party prescription data) and average net selling price (pro forma US net Rx sales / Rx’s) for all US prescription products during the periods that VRX has owned these products

N.B.: Our usual definition of product mix captures changes in the relative volumes of higher and lower-priced products over time, net of price inflation that occurred during the period of comparison. E.g. if products that were more expensive than average in 1Q increased their unit share of products sold by the company in 2Q, the company would have had a positive contribution to product mix[1]. Because VRX does not report product-level net pricing, in this instance we’ve limited the calculation of mix effects to those caused by products entering or exiting the portfolio

We estimate that US prescription products currently account for roughly 52% of VRX’s global sales (Exhibit 2). Net sales growth for US prescription products is a balance between substantial volume declines, and substantial gains in average net selling price (Exhibit 3). Unsurprisingly, VRX’s rates of volume declines and average net sales price gains are extreme relative to peers (Exhibits 4, 5)

Bear in mind that the comparison in Exhibit 5 is not perfectly apples-to-apples in the following way. For VRX, changes to average net selling price include changes to product mix (except for launches and discontinuations). For the comparison groups (spec pharma, industry) changes to net selling price exclude changes to product mix. Nevertheless, because change to net selling price (green line, Exhibit 6) is largely explained by list (aka wholesale acquisition cost or ‘WAC’) price inflation (dotted line, Exhibit 6), we believe the effect of product mix on our net pricing estimate is modest. In particular, we’re confident that net price inflation, not changes to product mix, are primarily responsible for the differences between VRX and the broader industry indicated by Exhibit 5

On average since 1Q07, we estimate 32% annualized net sales growth for VRX’s US prescription products, consisting of 48% annualized net price inflation, offset by 18% annualized volume declines (Exhibit 7). As we move to more recent periods, the rate of volume decline has accelerated to nearly 40% over the past year, with net pricing gains accelerating to over 90%, to produce net sales gains for US prescription products of 55% (Exhibit 7, again)

Can the pace continue?

VRX’s reliance on US net pricing gains is extreme. Absent net pricing gains sales would fall, the COGS ratio presumably would rise sharply (despite large pricing gains the COGS ratio is largely static; declining volumes are almost certainly a major factor), and VRX would have no feasible prospect of covering its debt obligations. This raises the obvious question of whether net pricing gains can continue

We’ll approach this question from two perspectives – political, and mechanical

Congress’ available options (in the short- to mid-term) have limited effect

Politically, VRX is squarely in at least one US Congressional committee’s cross-hairs, but in all likelihood this hardly matters. The current (and presumably next) Congress almost certainly cannot pass broad, de novo restrictions on pharmaceutical manufacturers’ pricing freedoms. They can however install or adjust pricing restrictions in existing federal programs that purchase pharmaceutical products (Medicare, Medicaid, VA, DoD) and/or aid product development (Orphan Drug Act). As we’ve written elsewhere[2] the most accessible policy options for Congress are to: 1) install pricing boundaries into the Orphan Drug Act (ODA); and/or 2) make drugs purchased by low-income seniors under the Medicare Part D drug benefit subject to Medicaid pricing requirements

Amending the ODA would hardly affect VRX, as it is far less reliant on ODA provisions than most other companies. However, making low-income Part D beneficiaries subject to Medicaid pricing requirements would sting quite a bit. The provision would reduce net sales for a typical US prescription drug portfolio by around 5 percent[3], and would insulate about 16 percent of US drug spending from price inflation[4]

As painful as the Part D modifications might be, they’re nowhere near as painful as the cost to VRX – bankruptcy, presumably – of halting US net pricing gains. As such we seriously doubt that political pressure will meaningfully alter VRX’s pricing

Gulliver awakens: commercial payors are likely to adapt to VRX’s style of price inflation

This leaves the mechanical perspective – i.e. the matter of whether, politics aside, VRX has the commercial footing to keep realizing US net pricing gains at a rate on par with trailing gains. This is remarkably difficult to determine. Our first instinct was to assume that VRX was fully and optimally re-setting acquired companies’ prices soon after acquiring these companies, in a manner that ‘stacked’ net pricing gains in the immediate post-acquisition period. If such a pattern existed, it would imply that VRX took all (or most) feasible pricing gains right after acquisition, and that the company’s aggregate trend of US net pricing gains could only continue with further acquisitions. In fact this is not the pattern; the odds of large price increases appear to be independent of the amount of time that has passed since the product came to be controlled by VRX (Exhibit 8)

This leads to the question of whether VRX’s US Rx products have any remaining pricing power. Typically, constraints on pricing power come from either or a combination of two places – the launch of better-priced (often generic) and/or clinically superior alternatives; and/or, the forced substitution of alternatives by formulary managers. Because VRX’s average US brand is so small – only one (Xifaxan) has annual gross sales in excess of $1B, and average gross sales for the remaining products are less than $60M – the typical VRX brand is too small to attract either generic competition, or formulary managers’ attention

There’s very little immediate likelihood of generic competition for a broad cross-section of the company’s US brands, both because the brands are so small, and because of the traffic jam of ANDA applications at the FDA. This implies that if commercial pricing limits are to materialize for VRX, they’ll have to come from formulary managers

At first glance, formulary managers aren’t configured to deal with VRX’s pattern of drug price inflation. Formulary managers typically negotiate price on a product-by-product basis – in large part because formulary managers’ interventions (switching one brand for another) are by their very nature product-specific. If formulary managers approach VRX traditionally, they’ll have to engineer and manage an enormous number of product interventions in order to reign in the VRX price trend. And, because the fixed costs of individual product-level interventions aren’t trivial, they’re not worthwhile for products with very low sales – which are the majority of VRX products

But it’s hardly game over. When VRX was smaller, the company’s contribution to overall market inflation was minimal. Not anymore. For the last 6 quarters VRX has been one of the five largest contributors to US net pricing gains (Exhibit 1, again), which is to say VRX has been one of the five companies formulary managers most need to get in front of if they want to reduce the rate of drug price inflation on their clients’ behalf

From here, we think the likely outcome is easy to see, but difficult to time. Formulary managers can’t constrain VRX’s pricing using traditional tools, but because VRX’s pricing is such a potent contributor to the rising cost of drug benefits, formulary managers cannot afford to simply stand by. Thus the obvious conclusion is that if formulary managers can adapt, and put in place mechanisms to influence price at the company (rather than product-specific) level, that VRX’s rate of US net pricing gains will slow. The odds are plainly in the formulary managers’ favor

 

©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.

 

  1. More precisely, the contribution from mix would be the additional sales that would have been achieved if the 2Q volumes had gone out the door at 1Q prices
  2. “The US Congress and Prescription Drug Pricing” SSR Health LLC, September 30, 2015
  3. The average Part D rebate (negotiated plus mandatory donut-hole) is around 29.5%; if Medicare LIS beneficiaries are subject to Medicaid pricing requirements we estimate the average Part D rebate would increase to roughly 50.5%. Because Part D is about one-quarter of US drug spending, the effect is a roughly 5% reduction in net sales (1/4 * (50.5% – 29.5%))
  4. Medicaid pricing requirements force companies to rebate back any price inflation in excess of CPI. Part D accounts for roughly one-quarter of US drug demand, and about 55% of Part D beneficiaries meet the LIS requirement (and would thus fall under the Medicaid pricing requirements)
Print Friendly