PBM Pricing Post-AWP – An Estimate of Sustainable Earnings Power

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Using Medco (MHS) as a proxy for large PBMs, we show that generic buying margins dominate PBM gross profits; PBMs appear to have sacrificed most (or even all) alternative sources of gross margin, levering the industry’s pricing structure almost completely to generic spreads

As the Average Wholesale Price (AWP) pricing benchmark is phased out, the arbitrage in generic margins closes, forcing PBMs to a wholly different pricing model, and raising the question of sustainable post-AWP earnings power. We define sustainable pricing – and thus sustainable gross margin – as a level at which clients’ next best alternative is a less efficient choice than the traditional PBM

As generic dispensing margins fall, PBM clients can recreate retail and mail networks using alternative service providers. Benchmarking to closed loop payment processing margins, we estimate that drug-benefit cards can be issued and a retail payment / claims processing network operated for roughly 2.7% of retail drug costs. For prescriptions filled at mail, we believe post-AWP dispensing margins of $11.04 or less are feasible (v. current retail of $14.10). All-in, this virtual / alternative network can operate on 16% less gross margin than MHS

At the very minimum, we see the large PBMs having to adjust current pricing – and thus current gross margin – by this amount, in order to maintain the total economic benefit (roughly rebates net of fees) that PBM clients presently receive

As available brand rebates fade and generics’ share of dispensing grows, the alternative network becomes increasingly efficient relative to the legacy PBM model, implying that gross margin pressures continue to build well after the shift to AWP

Present consensus calls for considerable earnings growth, implying margin expansion, share gains, or some combination of these, where we see both margin contraction and loss of market share. PBM share prices, at market parity on out-year (2013) consensus, belie the market’s general acceptance of reliable earnings growth

We accept that the relative timing of generic-wave gross profit gains and the negative margin effects we describe above is uncertain, and that we face the near-term risk of gross margins expanding before these pressures unfold, particularly if the market overestimates the synergies or price-stabilizing effects of an ESRX/MHS merger. Nevertheless with share prices reflecting considerable growth in earnings power when rather dramatic (≥ 30%) contraction is far more likely, PBMs remain the most compelling short story in healthcare

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