Pharmacy Benefit Managers (PBMs) are essentially middlemen.
Their profit comes from the price difference between the volume discount they negotiate with drug manufacturers and the somewhat smaller discount they are giving their clients.
The clients are health maintenance organizations, insurance companies, employers, workers compensation plans, government health programs, and third-party administrators.
"Volume discount" obtained, as the name implies, can be bigger if the order is larger. The largest company in the industry presumably gets the biggest discount.
Express Scripts (NASDAQ:ESRX) is the largest pharmacy-benefit manager in the U.S., since it acquired Medco Health Solutions last year for $29.1 billion. Express Scripts now has 100 million members and manages more than a billion prescriptions per year.
The Express Scripts' 2012 Drug Trend Report is based on the company's claims data from 100 million Americans.
For the first time in more than 20 years, among the country's commercially insured population, total spending on traditional prescription drugs fell 1.5 percent in 2012. However, this decline was offset by an 18.4 percent increase in spending on specialty medications to treat more complex diseases such as rheumatoid arthritis, cancer, hepatitis C and HIV. Combined, total drug trend for the year was +2.7 percent.
The decrease in drug prices were mainly due to the rising use of generics and spread of home delivery services.
The patent for Pfizer's Lipitor, the cholesterol treatment that was once the world's best-selling drug, expired in November 2011. Cheaper generics hit the market almost immediately, which sharply reduced spending in the category. In commercial insurance plans, the average price of medicine for high cholesterol fell nearly 10 percent to $47.87 for a 30-day supply in 2012.
The growth in home delivery has also contributed. It is convenient, usually free to the customer, includes 90 days supply, and the dispensing accuracy is statistically better than buying it in-store. It also reduces waste in a sense that there is less of a chance that the patient is going to forget to refill.
But the downtrend on spending for pills was more than balanced by a rapid rise in new specialty drugs, which come with prices that are far less easy to control. And since Pharmacy Benefit Managers are contracted to control drug costs, specialty medicines are the next area to work on.
In 2012, the FDA approved 22 new specialty drugs, many of which will cost more than $10,000 per month of treatment.
Four of the country's 15 costliest diseases in drug spending are treated with specialty medications: inflammatory conditions, multiple sclerosis, cancer and HIV.
Inflammatory conditions such as rheumatoid arthritis, the costliest specialty category, saw spending increase of 23 percent. This increase is a combination of a 9 percent increase in utilization and a 14 percent rise in unit cost.
Spending on prescription drugs for diabetes medicines rose 11 percent, outpacing 2011's increase of 7 percent. About one-third of Americans are diagnosed as obese, which has led to an increase in the number of people diagnosed with diabetes.
At 33.7 percent, hepatitis C experienced a larger 2012 increase in drug spending than any other therapy class, traditional or specialty. The increase is due mainly to two new drugs introduced in 2011: Vertex Pharmaceuticals' (NASDAQ:VRTX) Incivek and Merck's (NYSE:MRK) Victrelis. Express Scripts projects total spending on hepatitis C medications will increase 32.3 percent in 2013 and another 56.3 percent in 2014.
Utilization and costs for cancer medications increased by 3.4 percent and 22.3 percent, respectively. Much of the increase in costs is driven by new drugs developed to treat unique genetic profiles, a trend that has increased recently.
In HIV rapid growth has also been experienced. HIV now ranks #4 among specialty therapy classes in total drug spending. After a 5 percent increase in 2011, total spending is expected to climb another 23 percent over the next three years.
An estimated 1.2 million Americans currently living with HIV, and 50,000 new cases diagnosed each year. As many as 20 percent of Americans currently living with HIV are unaware of their condition.
Great advances have been made in the treatment of HIV since it was first identified in the 1980s. Multi-drug, antiretroviral therapies have substantially reduced AIDS deaths from a peak of approximately 50,000 in 1995 to 17,774 in 2009 according to the Centers for Disease Control (CDC). With effective treatment, HIV antibodies can fall to undetectable levels. Still, nearly one in four HIV patients are nonadherent to their drug therapy, which severely reduces the benefit of the medications. A recent CDC study found that 41 percent of HIV patients are not under a physician's care, again reducing adherence.
Utilization of HIV medications is expected to increase however with expanded screening, increased diagnosis and longer life expectancy. Research by the Lewin Group found that specialty pharmacy services, such as those provided by CuraScript, a subsidiary of Express Scripts, increased overall adherence. Patients on average exhibited a 38 percent increase in CD4 cell count within six months, a sign of improved immune system function. The study also showed a $3,000 annual per patient savings in health care costs for those patients receiving their medications through a specialty pharmacy.
Specialty medications often require specialized handling, frequent dosing adjustments, intensive clinical monitoring and patient assistance. While affecting fewer than 2 percent of the general population, specialty conditions in 2012 accounted for 24.5 percent of the country's total drug spending within the pharmacy benefit segment, the highest percentage on record.
The "same principles of effective management solutions and increased drug competition that have been used to control traditional drug spending, are necessary to the country's effort to rein in specialty drug costs," says Glen Stettin, senior vice president at Express Scripts. "The plan sponsors who implement our specialty management programs are already seeing much lower growth in specialty drug costs than the national average. And increased drug competition, in the form of biosimilars, is necessary to offer more affordable medication for patients afflicted with these complex specialty conditions."
Those special programs include use of formulary design to favor the use of less expensive drugs as well as a host of restrictions, like prior authorization on expensive drugs or step therapy programs to require the initial use of less expensive treatments.
As payers flinch under the assault of specialty meds, those restrictive measures are likely to become standard industry wide.
Statistics show that physicians are more likely to prescribe generic medications to Medicare patients if the prescriber is younger, if they see a large number of Medicare patients, and if they practice in Midwestern states such as Ohio, Illinois and Michigan.
Despite a 46.9 percent increase in unit costs for hepatitis C medications, Medicare patients increased utilization of these medications by 63.5 percent in 2012. Infection rates for the virus are more prevalent among patients born between 1945 and 1965.
Utilization of cancer drugs increased 11.8 percent for Medicare patients in 2012, contributing to an overall spending increase of 32.8 percent for this population.
Medicaid spends more on asthma medication than any other single condition. Total asthma spending increased 6.2 percent, driven largely by increased utilization.
Due to the rise in the number of Americans seeking treatment for drug and alcohol abuse, the largest percentage increase in Medicaid drug spending is attributed to chemical dependence. With a spending increase of 24.3 percent in 2012, chemical dependence for the first time is among the top 10 Medicaid traditional therapy classes.
Super expensive drugs
Do ultrarare drugs need to be as expensive as for example Soliris, a specialty drug from Alexion (NASDAQ:ALXN), costing $440,000 per year per patient?
Peter Hillmen, a hematologist who played a key role in Soliris' development, says "We have to look at these things more carefully, because a lot of people have rare diseases. It's a lifelong treatment, and they're developing it for other indications, which can't be as expensive as the first indication. We do have to think about how these drugs are priced."
Another aspect is that the cost of personal care can be very expensive for seriously disabled people. The cost of that care should be considered when condemning the high price of these drugs.
Martin Shkreli, a New York hedge fund manager, for example, has founded a biotech company to develop a drug for the treatment of muscular dystrophy. Shkreli estimates that the annual cost of caring for a muscular dystrophy patient can reach $400,000 a year. A very expensive new drug, assuming it works, could probably eliminate some or all of this cost.
The National Institutes of Health estimates that about 6,000 diseases afflict less than 1 percent of the population. That's 30 million people; treating every one with a $30,000 drug would cost $1 trillion, the size of the global pharmaceutical market.
But if the medicines are effective, it's possible they could save almost as much as they cost, as in Shkreli's muscular dystrophy example.
Express Scripts processed 1.4 billion prescriptions in 2012, including Medicare orders for elderly people and Medicaid for the poor and disabled.
Full-year revenue for 2012 was $93.9 billion versus $46.1 billion in 2011.
Net income was $1.31 billion, or $1.76 per share. Adjusted earnings per share including Medco acquisition: $3.74.
Guidance for 2013 is very good: earnings per share is forecast at $4.20 to $4.30, up to 15 percent over 2012.
Claims are expected to increase approximately 5 to 7 percent over 2012. This increase in claims reflects the additional quarter of claims from Medco, new business wins, utilization increase of 0 to 1 percent, and these increases are partially offset by the loss of approximately half of the UnitedHealth (NYSE:UNH) claims during 2013.
Interest expense will be reduced by the planned redemption of the $1 billion of 6 1/4% senior notes in the first half of 2013. Cash flow from operations is expected to be $4.5 billion to $5 billion in the year.
One particular area of opportunity is Medicaid. Express Scripts' largest customer, WellPoint, Inc. (WLP), should benefit from expanding Medicaid enrollment which in turn benefits Express Scripts.
Another potential growth area are the newly developed Health Insurance Exchanges, as the members in these exchanges likely seek to lower drug costs.
Express Scripts had an outstanding 2012, closing the transaction with Medco, making considerable progress with integration, generating 26 percent earnings growth and setting up for 12 to 15 percent growth in 2013.
The Pharmacy Benefit Management industry stands to benefit from the changes in the health care at large. Express Scripts, with its operational scale and its pioneering ways to hold down costs, is well positioned to prosper.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.