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Generic dispensing (i.e. gross) margins are far higher than branded dispensing margins throughout the drug trades (wholesalers, retailers, and PBMs). In our view this is primarily due to the traditional use of average wholesale price (AWP) as a benchmark for calculating the trades’ reimbursement on each script. In brief, because AWP is largely unrelated to the trades’ true costs of acquiring generics, AWP-based reimbursement schemes create the potential for very disparate dispensing margins across generic products; and, because the trades can see through this disparity but their clients (e.g. plan sponsors) generally cannot, the trades take a disproportionate share of the potential gross profits on most generics dispensed. For more detail, please see: http://www.sector-sovereign.com/?p=3837
Thus if AWP is replaced by another index, and this new index bears a tighter relationship to the trades’ true generic acquisition costs, then generic dispensing margins should fall. Two candidate indices are emerging, namely a new index called the national average drug acquisition cost (NADAC) survey; and, a revised version of a long-standing (and equally long-hidden from public view) index called average manufacturer price, or AMP. NADAC estimates the trades’ acquisition costs by essentially taking a sample of wholesaler-to-retailer invoices. We fully believe NADAC is coming, and that NADAC ‘corrects’ the basic deficiency in AWP. More on NADAC and our related thinking here: (http://www.sector-sovereign.com/?p=4586; and http://www.sector-sovereign.com/?p=3654 ). We also believe that AMP is coming, and that it too corrects the basic deficiency in AWP. On Wednesday of last week CMS began to release AMP data publicly (please see here: http://www.cms.gov/Reimbursement/05_FederalUpperLimits.asp), which is an essential step toward making AMP available to commercial plan sponsors, and thus allowing the replacement of AWP by AMP. That step by CMS is the focus of this brief note
Bear in mind that CMS has ‘known’ AMP values on a per-drug basis since 1990 – but has only now disclosed these data publicly. The original statute (“OBRA ‘90”) that created AMP also established AMP as a proprietary value that CMS could not publicly disclose. Since 1990, various attempts have been made to remove this confidentiality requirement, the most recent being the Affordable Care Act (ACA). On Wednesday, CMS – under its new authorization as provided by ACA – made its first disclosure of AMP data. Manufacturer-specific AMP values are not provided; however average AMP values are given for all manufacturers selling a specific interchangeable (i.e. ‘A-rated’) drug (e.g. acyclovir), in a specific dosage form (e.g. tablet), and at a specific strength (e.g. 400 mg). The premise for disclosing AMP is to show the calculation of federal upper limits, or FULs[1] – but the relevance of the disclosure is that AMP is, for the first time, in plain view
The relevance of CMS’ action is that: 1) CMS intends to disclose AMP under its new authority provided by ACA; 2) we can see that the level of detail and frequency of disclosure will be sufficient for AMP to be a superior alternative to AWP; and, also importantly: 3) anyone that wants to stop CMS from disclosing AMP had better act quickly. This last bit shouldn’t be underestimated – CMS’ attempts to publish AMP have a long history of dying in Congress or the courts, typically at the behest of the drug trades. The ACA was written in full awareness of these prior efforts and their outcomes, and presumably offers CMS an avenue to full disclosure of AMP that circumvents the trades’ prior challenges. It remains to be seen whether the trades will mount a de novo challenge to CMS’ disclosure, and whether any such challenge might be successful
To summarize the potential path to lower generic dispensing margins and contextualize the relevance of Wednesday’s CMS action: For AMP (or NADAC) to result in lower generic dispensing margins a series of things have to be true:
1) our thesis linking AWP to ‘supernormal’ generic dispensing margins has to be at least roughly correct;
2) the trades must lack sufficient price-making power to retain margins at present levels after AWP-based support to generic margins are removed (please see here: http://www.sector-sovereign.com/?p=5147)
3) a superior alternative to AWP must be available; and,
4) commercial plan sponsors must insist on the AWP alternative
Obviously we’re comfortable with #1, though we recognize arguments to the contrary. And, while we believe that PBMs in particular have functioned as a cooperative oligopoly in the recent past, we believe the basis of cooperation is being and/or has been lost (even if ESRX/MHS goes through), and so also believe that the PBMs cannot maintain the benefits of AWP to gross margins after AWP has been lost[2]. The relevance of Wednesday’s events squarely hits #3 – we now know that despite a 20-year history of challenges to CMS’ publication of AMP, that CMS intends to publish AMP with sufficient clarity and frequency for it to serve as a viable (we believe superior) alternative to AWP. Importantly, we note that CMS has two options to replace AWP – namely NADAC and AMP – and, that the legislative / regulatory / judicial ‘fates’ of NADAC and AMP arguably are not linked. Accordingly we believe that CMS has two largely independent opportunities to replace AWP, and that both alternatives are being pursued aggressively. Developing two options plainly raises the odds that at least one will be successful. As regards #4, we believe that plan sponsors will insist on AWP alternatives as soon as one is reliably available. By ‘reliably’ we simply mean an index that has both survived judicial challenges to avoid being lost in litigation, and attracted enough end users to ensure its dissemination in common pharmacy information systems. For the record we commonly hear, but respectfully disagree with, the argument that payors will not see sufficient savings to total drug plan costs to warrant the necessary effort[3]; and to address another common counter, we believe PBMs no longer have sufficient seller power or intra-industry price cooperation to force plan sponsors to stick with an outdated index. CMS’ actions on Wednesday raise the odds of an alternative to AWP by ‘awakening’ AMP as a second challenger – i.e. we now have both NADAC and AMP as ‘pending’ AWP alternatives. Wednesday’s action also reduces the timing uncertainty around judicial challenges and/or regulatory process delays. On net, we expect the states to have, and broadly adopt, either or both of NADAC and AMP as alternatives to AWP in calendar 2012. We expect commercial payors to wait until it can be known whether either index is generally ‘clear’ of future judicial challenges, at which point we would expect commercial payors to switch from AWP to either alternative when their PBM contracts renew at the latest. Not knowing whether judicial challenges are coming, whether they will be credible and how long they might take, we don’t expect commercial payors to shift away from AWP before the 2013 contract year – but our best guess is that an alternative will be reliably available by then. We also expect commercial payors to switch quickly – regardless of whether their PBM contracts are due for renewal – because of the considerable potential savings. We note that common pharmacy information vendors are due to cease publishing AWP as soon as this fall, and that such an event could accelerate a shift to either or both alternative index(es) – though our expectation is that the information vendors’ treatment of AWP is not going to be a defining event. Also, we recognize the tendency of PBMs specifically and the drug trades generally to outperform as waves of new generics are approved; and, we recognize that many of these generics may appear before AWP is abandoned. Nevertheless, we believe PBM share prices reflect a (deteriorating) expectation of super-sized generic margins as a long-term structural feature of the industry, and so expect share prices to fall as it becomes clear that AWP will be lost, rather than remaining elevated until AWP is lost
For a broader consideration of PBM industry pressures, beyond the relevance of AWP, please see:
“ESRX, MHS, and the PBM Bear Case”, July 25, 2011 http://www.sector-sovereign.com/?p=4394
“Co-Pay Cards and the Stalling of Drug Rebate Growth”, January 5, 2011 http://www.sector-sovereign.com/?p=2939
“Uncertainty and Motive in Pharmacy Dispensing Mark-Ups”, November 10, 2010 http://www.sector-sovereign.com/?p=5150
“Why Generic Dispensing Margins (Eventually) Must Fall”, October 29, 2010 http://www.sector-sovereign.com/?p=2539
“PBM Gross Margins – This Looks Like the End of the Cycle”, March 10, 2010 http://www.sector-sovereign.com/?p=5147
[1]FULs are a value above which pharmacies cannot be reimbursed for give drug, dose, and strength. The ACA establishes FULs as no more than 175% of AMP; and, for the record, all of the FULs published in the Wednesday release are exactly (i.e. no more than, since they can’t be less than) 175% of AMP, which is also disclosed
[2] See our March 10, 2010 call “PBM Gross Margins – This Looks Like the End of the Cycle:” which addresses oligopoly
[3] See in particular our July 25, 2011 call “ESRX, MHS, and the PBM Bear Case”, page 7
