The modern-day healthcare system is notoriously complex, with many different components working together to meet health needs and provide goods and services to treat patients. 

In most developed nations, the healthcare industry is responsible for at least 10% of GDP with overall healthcare spending consistently on the rise. As the booming aggregate healthcare sector has outpaced the S&P for several years, understanding this industry is instrumental in bolstering portfolio returns.

Healthcare Intermediary

Key players in the overall healthcare space are pharmacy benefit management (PBM) companies, collectively bringing in almost $300 billion in revenues each year and engaging more than 210 million Americans through their services. PBMs serve as middlemen between insurance companies, pharmacies and manufacturers securing lower drug costs for insurers and insurance companies. Since drug costs have exploded over the years (for example, Gilead Sciences' (GILD) Hepatitis C pill, which costs $1,000 per pill), insurance companies have relied more on PBMs to control costs.

PBMs bring value through lower drug costs for insurers, but how do they do this? They negotiate with pharmacies and drug manufacturers to secure discounts on drug prices, then pass these discounts along to insurance companies, slightly up-charging the drugs or retaining portions of rebates in order to secure profit. 

Insurance companies rely on PBMs to manage costs, and PBMs leverage this backing to negotiate with drug manufacturers by demanding discounts on drugs in exchange for putting the manufacturer’s drugs in front of millions of customers. Furthermore, PBMs negotiate contracts with pharmacies to create networks of retail pharmacies for drug distribution. 

PBM Marketspace

PBMs exploit several revenue streams. They charge service fees for negotiating with pharmacies, insurance companies, and drug manufacturers, and for processing prescriptions and operating mail-order pharmacies. Contracts with the largest insurance companies can quickly change the prospects of a PBM, giving it huge power when negotiating with drug manufacturers and pharmacies. Thus, signing a new contract usually results in a double-digit boost to the stock price, so it is no surprise that competition is fierce, with PBMs working to optimally position themselves for contract negotiation with insurance companies.

Such competition has led to a large number of M&A deals in this space -- consolidation allows PBMs to increase in size, thus negotiation power. Economies of scale explain the importance of consolidation and why the majority of market share is currently occupied by only a few major players, namely Express Scripts Holding Company (ESRX), CVS Health (CVS), and OptumRx, UnitedHealth Group Inc.'s (UNH) pharmacy service. 

In addition to M&A deals among PBMs, there has also been consolidation between pharmacies and PBMs due to the inherent synergies between the two. Rite Aid Corp. (RAD) recently acquired EnvisionRX, and CVS Caremark has long had direct access to CVS’s retail pharmacy network of 7,800 stores.

Legal Troubles

As the sheer nature of the business likely implies, PBMs are common targets of lawsuits and government scrutiny. As third-party negotiators, many of their business practices are opaque, so PBMs haven’t always disclosed rebates, discounts, itemized billing statements or the percentage of savings passed on to insurers. 

State legislatures have been pushing for greater transparency and disclosure provisions to better regulate these companies. In addition, there has been pressure to force fiduciary duty onto PBMs which would require them to act in the best interest of insurers and insurance plans, similar to financial advisors' legal obligation to act in the best interest of their clients. All of this serves to indicate possible regulation of the PBM industry that could affect future profitability.

The Bottom Line

While legal uncertainty surrounds the PBM industry, there is no doubt that the scope of these companies is ever-growing. With Obamacare signing up millions of additional Americans to health insurance plans along with a continually-aging population, insurance companies increasingly rely on pharmacy benefit managers to process and pay prescription drug claims at discount prices for insurers.