Peter Bach recently published an article claiming that PBM rebates are only 4 percent of the total share of list price drug spending. The fact that he even acknowledges rebates and what Drug Channels calls the gross to net bubble is to be commended since for so long he and others ignore them.
Bach’s claim that PBMs only extract 4 percent while pharmacies and doctors pocket more — was bought hook, line and sinker by Politico’s Sarah Carlin-Smith. But his analysis is laughable for two reasons:
1. Bach uses PBM gross profit margins to estimate the industry’s share of the pie revenues. PBMs count the list price cost of drugs as expenses in calculating their gross profits. The 3 largest PBMs only had an operating-profit margin of 4% to 7%, which is 16% below average among S&P 500 companies, according to an article in Bloomberg. But PBMs never take title or own the drugs.. they make money on the pass-through income such as rebates, fees, etc. Had the PBMs calculated their revenue in the same way other companies do, their margins would dramatically increase, the article alleged. While this tactic may not attract new investors, it can, however, reduce criticism related to the companies’ practices. “It hides a lot. It’s as simple as that,” Ravi Mehrotra, a partner at the MTS Health Partners investment bank, told Bloomberg.
2. Moreover, unlike other parts of Bach’ supply chain, PBMs — unlike drug companies -invest litte in fixed assets or R and D. So the better benchmark is, as AllianceBernstein concluded EBITDA (earnings before interest, taxes, depreciation and amortization) and the rate at which gross profit converts to EBITDA. While drug distributors convert 45% of their gross profit to EBITDA, and insurers and pharmacies around 30%, PBMs convert 85%. And the reason for that is the relative lack of fixed assets, which in turn keeps depreciation and amortization low. PBMs, are middlemen without the warehouses or stores of pharmacies and wholesalers.
The release of the article coincides with growing skepticism of the PBM business model and the proposed merger of Cigna and Express Scripts(ESI). Both companies claim this is a merger to make health care more cost-effective and personalized. The share price Cigna paid to acquire ESI —$96 — reflects the huge impact the cash PBMs generate and which Bach’s article tries to hide. But as the PBM model is threatened, it behooves ESI and thepro-PBMM Bach to downplay margins.
Carl Icahn is publicly urging Cigna shareholders to reject the ESI acquisition because the PBM business model — built on the spread between list price and what PBMs pocket — is going to be dead:
“(We believe that Express Scripts is a company with major problems whose business could well fall off a cliff. Given the significant worsening of several major risks since the deal announcement, we are confident in saying that Express Scripts on a standalone basis would likely be worth less than $60. Though there is a not another standalone PBM to compare Express Scripts to, we note that drug distributors McKesson and Amerisource Bergen are down 17% and 16% respectively since the announcement of the Cigna/Express Scripts deal and that the risks are likely greater in the case of Express Scripts. Applying the 9x P/E multiple that pharmacies and drug distributors currently trade at to Express Scripts’ 2019E ex-Anthem earnings of $6.50 would result in a $58.50 standalone stock price. We find it unconscionable to pay over $90 for a company that today would likely be worth less than $60.”
If you had to take investment advice from Bach or Carl, who would you choose?
