Drug Pricing Will Moderate Independent Of Government Action: Stock Winners Will Be Driven By Increases In Unit Volume

by: Leonard Yaffe


After three years of above average drug price increases, pharmaceutical companies will revert back to historical norms. A full understanding of the pricing issue requires knowledge of rebating.

Mr. Trump's comments in a magazine interview served as a shot across the bow. It was appropriate, in my opinion, given recent trends.

The pharmaceutical companies likely anticipated a victory by Mrs. Clinton and attendant deleterious legislation. They, therefore, raised prices more than usual. A similar situation occurred in the 1990s.

The obscene price increases in a few select cases are not the drug industry norm, though they cannot be fully ignored. I do not expect this to recur.

From an investment standpoint, one must focus on those drugs either with expanding indications or serving a major unmet medical need.

As it relates to drug company profits, in my opinion, the only deleterious change would be to allow for direct Medicare price negotiations. This seems unlikely for the following reasons: First, this action was specifically precluded in the Medicare Modernization Act of 2003, and it was stated as a "non-interference clause". Additionally, Medicare Part D drug plans must give nearly full access to drugs in six therapeutic classes, namely anticonvulsants, antidepressants, antipsychotics, antineoplastics, antiretrovirals and immunosuppressants, effectively eliminating price negotiation. A Millman study found that these six protected classes represent 17-33% of Part D drug costs. Finally, Medicare plan formularies must include drug classes covering all disease states, with a minimum of two chemically distinct drugs in each class. This further limits formulary management from influencing market share, in turn reducing the pharmaceutical companies' incentive to offer discounts.

The Congressional Budget Office examined the effect of striking the noninterference provision and estimated that it would have a negligible effect on spending versus what private plans negotiate. It should also be noted that a repeal of this provision would require action by both Houses of Congress. Of greater plausibility is legislation concerning "dual eligible beneficiaries." These are individuals who are enrolled in both Medicare and Medicaid. The Medicare Prescription Drug Law last decade moved dual eligibles' (an estimated 10 million people, or 20% of Medicare enrollment) prescription drug coverage from Medicaid to Medicare. Medicare drug discounts, obtained by insurers and pharmacy benefit managers, are less than the discounts and rebates obtained by Medicaid. Therefore, requiring drug manufacturers to provide the same pricing to dual eligibles as it does to Medicaid would result in cost savings of about $12 billion annually, or 3% of the total US pharmaceutical spend. My expectation is that this will represent an acceptable compromise. As for drug re-importation, it will be inconsequential for cost savings. Most Americans have pharmaceutical benefit plans with co-pays and deductibles. For generic drugs, which represent 90% of prescriptions but only about 25% of the dollar spend, re-importation will not offer a significant pricing advantage. As for the high-priced specialty drugs, many of them are biologics, and therefore have complex handling and processing requirements, and are usually injected or infused. These drugs account for 1% of prescriptions, but 37% of the dollars, due to their high cost. There is a group of oral, branded medications that may prove to be cheaper than a co-pay by reimporting, but this segment is unlikely to be sufficiently large to result in noticeable overall savings.

Pharmaceutical companies have raised prices at an above average rate over the past two years, with a concomitant increase in rebating. This had the effects of reducing the relative growth in actual net pricing and transferring a greater percent of the payment to the individual from the employer. I maintain that price increases will moderate to historical norms, driven in part by adverse publicity. We saw similar action by the drug companies in the 1990s. At the same time, we are on the threshold of a new era in drug discovery that will improve both the quality and quantity of life. Those companies that succeed in bringing transformative medicines to the market will continue to command a premium price. However, we are about to experience the initial wave of biosimilars that will dramatically reduce cost in several of the expensive specialty pharmaceutical categories, notably TNF inhibitors. Therefore, independent of any action by the government, the growth in US drug spending is going to moderate. In fact, when combined with the multitude of important new therapeutics in advanced clinical trials, the "health value per new dollar spent" on drugs may be at one of its highest levels in the industry's history.

In conclusion, I have long believed that focusing on the pharmaceutical industry to control healthcare costs, while acknowledging recent excessive price increases, is unlikely to be very beneficial. Drug costs amount to 12% of the $3 trillion annual total. Furthermore, US healthcare spending will grow at a 6% average yearly rate for the next 15 years, at which time it will exceed $7 trillion, or 25% of GDP. Bending the healthcare cost curve will require other means, as I discuss in my article "Solving America's Health Care Crisis."

The investment implications of this outlook are that, as we have seen in 2016, the rising tide will not lift all boats. There will be winners across the market capitalization spectrum, and it will be based to a greater degree on volume gains due to expanded indications or new drug introductions that serve a significant unmet medical need. My focus remains primarily on oncology, hepatology, nephrology and metabolic disease. My "buy list" includes (not a full representation) MRK, CELG, BLUE, ONCE, KITE, DRRX, ARDX. Please note that the market capitalization of DRRX and ARDX is small.

Disclosure: I am/we are long MRK, CELG, ONCE, KITE, BLUE, DRRX, ARDX.

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.