Hiking Downhill
Part Three of How Drug Pricing Works: The plight of wholesalers in the pharmaceutical economy
Last year, companies McKesson, Cardinal, and AmerisourceBergen (ABC) all saw steep drops in their stock prices as they reduced their earnings forecasts; on one occasion in late October, they lost nearly 20 percent of their value practically overnight. Similar drops happened for these stocks in mid-April, though they’ve since recovered. Here’s what happened . . .
McKesson, Cardinal, and ABC (stock prices in the above image) are the three largest drug wholesalers in the US, controlling around 85 percent of the wholesale market. They are also three of the largest companies in the US (numbers 5, 11, and 15 in the Fortune 500, respectively), with roughly a combined $500 billion in revenue in 2016.
Their job is to distribute drugs from manufacturers to retail pharmacies, who then dispense drugs to patients. Wholesalers are common in any industry, providing value by specializing in distribution and maximizing efficiency.
But why did the future look so bleak for these particular wholesalers? The answer lies in yet another example of how current players in our healthcare system benefit by driving up drug prices.
Check out the graphic linked here on Healthcare Value Hub. It shows the complexity of the drug supply chain in the US. My previous pieces in this series looked at the top portion of the flow chart: the manufacturer, the Pharmacy Benefits Manager (PBM), the health plan, and the patient. While that covers much of process of paying for the drug, the bottom portion of the figure shows the flow of the actual product.
Wholesalers buy the product and sell it to pharmacies, who then dispense it to patients. Notice that wholesalers also get discounts and fees and bonuses from manufacturers along the way. As with the PBMs, the essential question is how these payments come to be structured and justified.
McKesson’s CEO, John Hammergren, offered some insight on “branded inflation,” i.e. price increases for drugs:
What we have seen this year to-date, [are] fewer products with price increases, and those price increases are at lower rates than both prior year results and our expectations for the current fiscal year. Given our second-quarter performance specific to branded price inflation, we now expect full-year branded pharmaceutical pricing trends to be meaningfully below those experienced in Fiscal 2016.
He’s referring to a slowdown in drug price increases announced earlier this year. Drug-makers promised to limit their price increases to single digits, compared to double digit increases in past years. As a result, fewer drugs are seeing price increases, and the magnitude of those increases are lower.
So what sort of impact does that make? Hammergren (emphasis mine):
Today, all of our contracts with branded pharmaceutical manufacturers are individually negotiated, but generally, are constructed around charging for the service we provide. In almost all cases, the charge is derived as a percent of revenue managed and delivered by McKesson for that specific manufacturer. These charges vary not only by manufacturer, but also by the service requirement at the product level.
Clearly, revenue-based fees are all affected at some level by inflation. However, in some cases the benefit from inflation is greater, given the specifics and the characteristics of individual contracts . . . So the takeaway here is that branded inflation still plays a meaningful role, and in some cases, it can be an important part of our overall compensation with specific manufacturers, and we can be impacted by their decisions, relative to price increases.
What Hammergren is describing here is similar to what we previously saw with PBMs. For each drug, the wholesaler negotiates a chargeback (i.e. a discount or rebate) with a given manufacturer. This way, the more the wholesaler distributes, the bigger its cut. However, the structure of this chargeback is critical; it could be a raw dollar amount, resulting in revenue depending only on volume shipped, or it could be percentage-based and mean that more costly drugs result in more revenue.
Although the specifics of the chargebacks are confidential, Hammergren hints at the nature of their structure: some of McKesson’s contracts are tied to the list prices of drugs, which means that higher list prices get McKesson more money.
McKesson’s forecasts must have assumed ongoing increases in list prices, and did not account for the backlash against rising drug costs. Think about the public reaction to Martin Shkreli or the makers of the EpiPen, as well as the rhetoric Trump brought into the conversation. As more gradual price increases were announced, McKesson’s forecasts went down.
Hammergren had one more thing to say about the matter (emphases, again, mine):
I think we have every right to go back to those manufacturers and say, listen, we need to open the dialogue again because by your unilateral decision, you have significantly impacted our profitability on your particular product lines and we don’t think that’s fair and we want to recover that lost margin. So I think that that certainly is something we plan to pursue.
It’s clear that McKesson was counting (at least in part) on the rapid price increases of the past few years to drive its own profits, and they’ve suffered as the party winds down. That dependency was enough to drive massive drops in the stock prices of each major wholesaler this year.
Perhaps this kind of disruption will result in new negotiations and changes in the contracts so that list prices aren’t the basis of compensation.
On the other hand, maybe not. Stocks are generally back up and, as investors have noted, Trump’s rhetoric on drug pricing has been severely reigned in. Instead of trying to prevent what he described as “getting away with murder,” he’s been working with the industry to create legislation. Such legislation mostly focuses on FDA approvals and creating competition, which is all well and good, but is not nearly as drastic as suggestions of Medicare-pooled negotiation, drug importation, and other ideas Trump had previously “supported.” The result has been a much happier drug industry, and with that, happier wholesalers; notice how the NASDAQ biotech index spikes up alongside the wholesalers in mid-June below, as news emerged that Trump’s drug pricing proposals lacked teeth.
The question then is how this type of system emerged, where increasing drug prices create so much value for so many with seemingly limited downsides. That’s for part four . . .
David Chen is based in Boston.
