You probably saw the news earlier this year that pharmaceutical companies raised the prices of over 250 drugs. As someone with a website that offers the investor’s perspective on all of this, I get to wondering: If you see the news items that a drug company is raising the prices of prescription drugs in its portfolio by an average rate of 8-10%, and the typical unit sales growth for a drug company is 8%, shouldn’t these companies be delivering close to 20% annual returns to shareholders each year?
Historically, drug makers outperform the S&P 500 by a percentage point or two each year, which is a difference that becomes significant over time, but the degree of investment performance does not seem to match the degree to which the list prices for prescription drugs increases every year.
The answer is that there is a huge difference between “list prices” for pharmaceutical drugs and “net prices” that are actually paid to the manufacturer. Pharmacy benefit managers (PBMs) into rebate agreements with drug manufacturers in which negotiate rebates from drug manufacturers in exchange for the prescription drug being given “preferred status” on its drug listings.
Notably, these rebates are not fixed dollar amounts, but rather, are calculated as a function of a drug’s list price. This creates a perverse incentive in which drug makers benefit from increasing the list price, give a higher rebate, and then maintain the spot on the preferred list. A rise in list price, with a commensurate rise in the rebate, is an annual tradition that is necessary for a drug to remain on the pharmacy benefit managers’ preferred list. In 2012, these rebates to PBMs were a little over $70 billion. Entering 2019, that figure has climbed to $170 billion.
For those who study investments, the key is to identify the relationship between list prices and net prices. A company like Bristol Myers Squibb has increased the list price of its U.S. drugs by 137% since 2008. Yet, its gross margins on drugs, after rebates, decreased from 34% to 20% over the same time frame because the company is a rebate machine. Allergan’s U.S. portfolio has moved in the opposite direction over the same time frame, with its profit margins increasing from 21% to 47% over the past decade as it has raised list prices by 178% over the same time frame while offering more limited rebates than Bristol Myers Squibb.
I find it much easier to study a company like Novartis, which is based out of Switzerland. It had 29% gross margins a decade ago, it has 29% gross margins now. It is only playing the rebate/artificial pricing game with about a tenth of its overall portfolio. More than most, what you see is what you get.
I suppose the upshot is that many large drug makers are likely to be mispriced because it is more difficult to accurately identify such a firm’s true earnings power. A weekend spent studying distribution channels, the differences between net prices and list prices (and the current rebate relationships), as well as the other competitors seeking a spot in the same spot on a PBM’s formulary for preferred status, is the likely path to investment outperformance. It will take a few minutes, but you will find three drug companies that are stopping at no cost to game the system, and three others, with one including Eli Lilly, that are just now really getting into adding substantial rebates and list price increases to the repertoire, which will result in higher sales that is nevertheless built on the shaky foundation of its manipulated preferred list status with PBMs.