Tuesday, February 06, 2018

A Lesson from McKesson: How Specialty Pharmacy Growth Is Hurting Wholesalers

Last week, McKesson released its quarterly earnings for the fourth calendar quarter of 2017. See the links below.

The profit outlook for its distribution business was lower than Wall Street’s expectations, due partly to what management termed “customer and product mix.” Below, I offer my take on the three interrelated mix changes that challenge wholesalers' profits from the growth of specialty pharmacy drugs.

Wholesalers have been trying to alter their conventional pricing and contracting approaches to address these pressures, though it’s not clear how successful these efforts have been. The specialty boom may prove to be a mixed blessing for wholesalers.

A BATCH OF THE LATEST NUMBERS

As always, I encourage you to read the original source material for yourself. Here are links to McKesson’s financial results for its third fiscal quarter of 2018, which was the fourth calendar quarter of 2017:
As usual, McKesson’s earnings were reported with an abundance of one-time adjustments. I suspect that the company would report EBE (Earnings Before Expenses) if it could.

SIR MIX-A-LOT

For the quarter, McKesson’s revenues were higher than Wall Street’s expectations. However, management reduced its guidance for operating margins in its distribution business. Here’s how McKesson CFO Britt Vitalone described the results:
“The third quarter segment adjusted operating margin rate was 185 basis points, an increase of 22 basis points. The adjusted margin rate was also impacted by our customer and product mix, including the growth of higher-priced specialty pharmaceuticals. Due to the mix shift, we now expect our full year Distribution Solutions adjusted operating margin rate to be slightly below our original guidance range of between 198 basis points and 208 basis points.” (emphasis added)
There were some follow-up questions about mix, though the company did not provide much additional detail.

So, what’s really going on?

MIXED EMOTIONS

Here’s why specialty drugs cause mix problems for wholesalers.

Pharmacy industry revenues are shifting from traditional brand-name drugs to specialty drugs. This growth will challenge wholesalers’ traditional pricing models and pressure their profits.

Per Section 6.3.3. of our 2017–18 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors, wholesalers face three interrelated but negative shifts in business mix as patient-administered specialty drugs grow:
  • Customer mix. For most recently launched specialty drugs, manufacturers limit and manage the specialty pharmacies eligible to dispense these expensive medications. PBMs and health plans often further limit the number of specialty pharmacies available to a beneficiary. In mnay cases, they require patients to use the specialty pharmacy that the plan or PBM owns.

    These network strategies have concentrated market share for dispensing specialty drugs into the largest specialty pharmacies—which are also wholesalers’ least profitable customers. Many of the largest U.S. pharmacies are now central-fill, mail pharmacies operated by large PBMs and health insurers. Fifteen companies in 2016 accounted for more than 80% of prescription revenues from pharmacy-dispensed specialty drugs. See The Top 15 Specialty Pharmacies of 2016. (The 2017 data are coming soon!)

    In some cases, larger specialty pharmacies purchase products directly from the manufacturer of a specialty drug, bypassing specialty distributors and full-line wholesalers. This further diminishes the wholesalers’ channel role.
  • Product mix. A wholesaler’s typical economic model relies on the blended margins from lower-profit brand-name drugs and higher-profit generic drugs. A pharmacy with a high specialty mix will buy very few generic drugs, undermining the traditional wholesale pricing model.
  • Manufacturer mix. For brand-name drugs, distribution service agreements with pharmaceutical manufacturers account for about half of a drug wholesaler’s buy-side gross margin. Large manufacturers pay a less-than-average fee rate, while smaller manufacturers pay much more. Specialty drugs are being launched by larger manufacturers, so the average buy-side margin is declining.
FIXING THE MIX

As I noted in Five Industry Trends for U.S. Drug Wholesalers in 2018, wholesalers are being forced to alter conventional pricing and contracting approaches to address the profit challenges of specialty pharmacy drugs.

For instance, wholesalers have attempted to counter the downward margin pressure by raising prices to some specialty pharmacy customers using “net pricing” terms. These reduce the cost-minus discount available to smaller pharmacies. Large pharmacies, however, have negotiating power against wholesalers and can often resist such demands. Note that a reduction in wholesalers’ sell-side discounts can be highly controversial, because it raises the acquisition cost—and lowers the profits—of a pharmacy.

Wholesalers also want to limit a manufacturer’s ability to add new specialty and biosimilar products to distribution service agreements with manufacturers. This creates opportunities for wholesalers to haggle with manufacturers before every new specialty product launch. When such a requirement is added to a typical full-line wholesale agreement, it reduces a manufacturer’s ability to control channel strategy for its products.

On the earnings call, McKesson highlighted its attempts to generate differential margins based on distinct product categories: brand pharmaceuticals, generics, specialty, biosimilars, and over-the-counter products.

McKesson CEO John Hammergren provided only a vague sense of the company’s success to date:
“I think our customers clearly understand that the mix changes going on in our industry is more and more as these specialty products are coming to the marketplace. And so I think in the short term, it has little impact on us or our customers, but as we reposition in advance of what we see is a cycle of a lot of specialty product, into the marketplace, we think these adjustments are appropriate for us.
And frankly provide better line of sight to our customers related to all these products flow through the supply chain. So we're making good progress, and we would expect to be complete with this, as you noted, these final contracts renew in the last section of this work.”
Translation: There's no quick fix.

On Thursday, I’ll examine some new data on the changing customer mix of wholesalers’ specialty distribution businesses for provider-administered drugs. In the meantime, I wonder whether pharmacies will nix any pricing tricks that fix the wholesalers' mix, but leave pharmacies taking the licks.

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