Thursday, September 21, 2006

Wal-Mart's Generic Pricing Will Trigger Big Changes

Big news from Bentonville: Wal-Mart will sell generic drugs for $4 per 30-day prescription supply. (Summary from today’s online WSJ: Wal-Mart Cut's Prices for Many Generics to $4.)

Yes, you heard right - less than a triple grande non-fat caramel machiatto at Starbuck’s! (So now, dear reader, you’ll know what to order when you meet me in person.) Check out Wal-Mart’s full announcement, which has some additional details.

Folks, we are witnessing a triggering event in real-time. I think Wal-Mart’s move will create massive change in the U.S. pharmaceutical distribution system because it threatens our current system of cross-subsidization.

In May, I pointed out that profits on generic drugs now subsidize the distribution of much more expensive branded pharmaceuticals. (Click here to read my original post.) All the major players in drug channels – PBMs, wholesalers, and retailers – generate higher profit margins and more profit dollars per script from generics. Wal-Mart has been anticipating this unbundling for some time, as indicated by the December 2004 testimony of Frank Segrave, then-VP of Wal-Mart’s Pharmacy division, which was titled “Medicaid Prescription Drug Reimbursement: Why The Government Pays Too Much.” (Subtle, huh?)

Wal-Mart began repositioning its pharmacy department with consumers this summer through the “Pharmacy at Wal-Mart” campaign. They need to convince consumers that a mass merchant pharmacy is just as good as the category killer chains (CVS and Walgreens), but more convenient for the one-stop shopping. By adding the price angle, Wal-Mart provides another benefit for consumers while simultaneously unbundling and attacking the profit streams of competitors and suppliers.

Some initial predictions:

Chain margins will shrink. Wal-Mart is really aiming at the big 3 pharmacy chains, essentially forcing them to blink and lower their margins on generics, too. CVS and Walgreens have less room to maneuver because pharmacy is the biggest chunk of revenues at the chains (70% at CVS, 65% at Walgreens) versus less than 10% at Wal-Mart. PBMs could also get caught in a margin squeeze if payers question their generic margins versus Wal-Mart. And some consumers may prefer to pay cash rather than processing through their benefit manager and paying a co-pay.

The consolidation of retail pharmacy will accelerate. Just look at what has happened to the retail grocery industry. Wal-Mart has used its proprietary distribution system to grab a nearly 20% share of U.S. retail grocery sales in only 10 years, triggering an intense shakeout among regional chains and independents grocers.

Wholesalers will suffer as independents fight for survival. Large chains purchase generics directly from manufacturers, while small chains and independent pharmacies purchase primarily through wholesalers. (Wal-Mart’s largest wholesaler for branded products did not mention any large chains when raving about its generic growth opportunities in June.) Wal-Mart’s move will shift generic market share away from independents, particularly in rural counties that have low chain pharmacy penetration. Recall that wholesalers and their customers will be splitting a maximum generic profit pie (AMP+250%) after Jan. 1. (See my June post on AMP.)

Manufacturers face tough fee-for-service negotiations in 2007. Large branded pharma manufacturers have been able to negotiate very good fee-for-service deals, due in part to wholesalers’ willingness to cross-subsidize services with higher margins from smaller branded companies and generics. I predict that the next round of fee-for-service negotiations will be much more contentious as wholesalers ask manufacturers to plug the gaps.

Check back in 18 months and I'll let you know whether my predictions came true.

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