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 and overall healthcare spending has been on the rise. As the booming aggregate healthcare sector has been outpacing the S&P for several years, understanding this industry is instrumental to bolstering anyone’s portfolio returns.

Healthcare Intermediary

Key players in the overall healthcare space are the pharmacy benefit management (PBM) companies that collectively bring in almost $300 billion in revenues each year and engage more than 210 million Americans through their services. PBMs serve as the middlemen between insurance companies, pharmacies and manufacturers to secure lower drug costs for insurers and insurance companies. Since drug costs have been steadily increasing over the years (take for example Gilead Sciences' (GILD) Hepititis C pill, which costs $1,000 per pill), insurance companies have been relying 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 and then pass these discounts to insurance companies, but they slightly upcharge the drugs or retain a portion of the rebate in order to make a 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 a network of retail pharmacies for drug distribution. (See also, Investing In The Healthcare Sector.)

Source: The Wall Street Journal

PBM Marketspace

PBMs have 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 stock price, so it is no surprise that competition is fierce, with PBMs trying to optimally position themselves to enter contracts with insurance companies.

This competition has led to a large number of M&A deals in this space because consolidation allows PBMs to increase in size and thus negotiating power. The economies of scale explain the importance of consolidation and why the majority of market share is now currently occupied by only a few major players, namely Express Scripts Holding Company (ESRX), CVS Health (CVS), Catamaran Corp. (CTRX), 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

Due to the nature of the business, PBMs have been the target of several lawsuits and much 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 that would require them to act in the best interest of insurers and insurance plans, similar to how financial advisors have a legal obligation to act in the best interest of their clients. All of this serves to indicate possible regulation of the PBM industry that can affect future profitability.

The Bottom Line

While there is possible legal uncertainty regarding 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 the continually aging population, insurance companies increasingly rely on the pharmacy benefit managers to process and pay prescription drug claims at discount prices for insurers. The PBMs, acting as third party administrators and negotiators, are essential to facilitating transactions between the moving parts of the healthcare industry. 

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