Summary and Investment Conclusions

First DataBank and Medi-Span are the dominant providers of point-of-sale pricing information to US pharmacies. In December First DataBank announced it would provide National Average Drug Acquisition Cost (NADAC) pricing data to its retail pharmacy clients; last Friday Medi-Span also announced inclusion of NADAC pricing in its data streams to retail pharmacies. As a result, NADAC pricing data is now routinely available to retail pharmacies nationwide

This means NADAC is now available to serve as a pricing benchmark in prescription drug agreements throughout the supply chain, from manufacturer to patient. CMS is pushing states to pay retail pharmacies for Medicaid prescriptions using NADAC-based calculations; we expect most states will do so by this July. Far more relevant to the drug trades (PBMs, retailers, wholesalers) is the likelihood that employer sponsors of drug benefits will insist on using NADAC as the pricing benchmark in commercial contracts. This will displace average wholesale price (AWP), which has served as the dominant pricing benchmark for nearly a quarter-century. AWP creates an information asymmetry that advantages the seller (e.g. PBM) and enables larger margins on generics. Replacement of AWP by NADAC substantially narrows the buyer : seller information asymmetry, and is likely to reduce generic margins

PBMs are most negatively affected; because of its greater exposure to mail (where generic margins are greatest), ESRX is most negatively affected among the PBMs. Retailers are less negatively affected than PBMs (CVS is the most negatively affected among retailers because of its large PBM operations). Wholesalers are least negatively affected in the short-term; however if falling margins put independent retail pharmacies out of business wholesalers could suffer in the mid- to longer-term, because independents are their most profitable customers. Among the wholesalers ABC is most at risk. By taking over WAG’s generic volumes ABC became more levered to generic margins than other wholesalers; and, unless ABC planned for generic margins to fall on the NADAC roll out they may have underpriced their relationship with WAG

Background and Recent Events

The Affordable Care Act (ACA) reconfigures how Medicaid reimburses pharmacies for generic drugs dispensed to Medicaid beneficiaries. Before the ACA, in all states pharmacy reimbursement relied largely if not wholly on average wholesale price (AWP), which is calculated by simply multiplying wholesale acquisition cost (WAC) by a factor of 1.2. WAC is the published list price at which manufacturers offer to sell to direct purchasers. In the case of single-source brands, WAC (almost always) is the actual price at which the manufacturer sells direct. Conversely in the case of generics, WAC is almost never the actual price at which goods are sold; actual transaction prices generally are substantially lower

Because WAC exceeds true generic acquisition costs, AWP (i.e., 1.2 WAC) also exceeds true generic acquisition costs. Accordingly AWP-based reimbursement formulas tend to overpay pharmacies for generics[1]

Among other changes, the ACA seeks to reduce overpayment for generics by shifting the Medicaid pharmacy reimbursement formula to average manufacturer price (AMP). AMP is a value reported by manufacturers to the Centers for Medicare and Medicaid Services (CMS); and, unlike WAC, is generally reflective of the actual price at which goods pass from manufacturers to direct purchasers. CMS applies AMP to reimbursement by calculating ‘AMP-based federal upper limits’ (AMP-based FULs = 1.75x AMP). States are free to pay pharmacies whatever they wish on a generic drug by generic drug basis; however in order to receive Federal matching funds for payments to pharmacies, states’ aggregate reimbursements for Medicaid beneficiaries’ generic prescriptions may not exceed FUL

This raises a practical problem – because generics’ AWPs are not reflective of true generic acquisition costs, states that reimburse pharmacies using AWP-based formulae have no reliable means of keeping reimbursement within range of AMP (i.e. acquisition cost) based FULs. Enter NADAC (National Average Drug Acquisition Cost), a monthly survey of pharmacies’ drug acquisition costs[2]. NADAC is based closely on actual invoices paid by pharmacies for drugs they purchase from wholesalers, and is closely correlated with AMP. Thus by shifting pharmacy reimbursement formulas to a NADAC basis, states are better able to keep their aggregate payments to pharmacy within the AMP-based FULs. Most states use NADAC or a close cousin (AAC) at least in part; several states[3] have adopted NADAC or AAC as their primary basis for pharmacy reimbursement

CMS was supposed to shift to AMP-based FULs in 2010 and has not yet done so; however after several false starts the Agency is indicating that AMP-based FULs will be finalized in July of this year[4], in time for the start of states’ fiscal 2015. In preparation, providers of drug pricing data to pharmacies’ point-of-sale information systems have formally announced the inclusion of NADAC prices in their data streams. First DataBank and Medi-Span are the two dominant drug pricing data providers; First DataBank announced the availability of NADAC to its customers on December 5^th of last year[5]; Medi-Span announced the inclusion of NADAC in its pricing data last Friday[6] – making NADAC pricing data generally available to retail pharmacies nationwide

Why This Matters: The Role of AWP in Generic Dispensing Margins

Commercial pharmacy contracts – e.g. between employers and PBMs, between wholesalers and retailers, etc. – generally rely on the average wholesale price (AWP) benchmark, which creates a large buyer : seller information asymmetry, and in turn enables large generic dispensing (or wholesaling, or administration) margins on generics[7]. As an example, PBMs charge employer sponsors for generic drug claims that are priced (from the PBM to the employer) in AWP terms, but acquire generics for substantially less than AWP (and at acquisition costs that have no consistent percentage relationship to AWP). Having no insight into the AWP : acquisition cost spread employer sponsors have been less able to negotiate the spread; and, having no alternative pricing benchmark to AWP employer sponsors have been forced to live with the asymmetry

Because NADAC closely mirrors acquisition costs, this information asymmetry is dramatically narrowed.  By shifting their commercial contracts to a NADAC benchmark, plan sponsors can negotiate for PBM services in far more precise ‘cost plus’ terms; all else equal PBMs’ margins on employer-sponsored contracts are likely to fall[8]

The major drug pricing compendias’ decisions to include NADAC in pharmacy point-of-sale systems, and CMS’ all-but-final shift of Medicaid reimbursement to a format that forces adoption of NADAC by the states, mean: 1) NADAC is available for broad use as an alternative to AWP; and 2) NADAC is here to stay

Now that NADAC’s status is all but assured, we expect larger employer sponsors whose PBM contracts are up for renewal to insist on NADAC, rather than AWP, as their benchmark. The commercial contract shift from AWP to NADAC will take several years, as larger employers set the path for mid-sized and smaller-employers, and as recently agreed AWP-based contracts take time to expire. Nevertheless as PBMs’ commercial contract portfolios shift from AWP to NADAC, we expect margins to come under significant pressure

PBMs are most negatively affected by the AWP to NADAC shift; and, the more levered to mail order (e.g. ESRX) the greater the negative effect[9]. Retailers are less negatively affected than PBMs[10] (CVS is most negatively affected than other retailers because of its large PBM operation), but more negatively affected than wholesalers[11], at least in the short term. In the mid- to longer-term, the shift from AWP to NADAC may reduce the number of independent retail outlets, which has the potential to severely pressure drug wholesalers

ABC may be an exception to the ‘wholesalers are least affected’ hierarchy. ABC took over WAG’s generic sourcing last year, in a broad deal that made WAG an ABC client and putatively included ABC in the global WAG / Alliance Boots drug sourcing arrangement. At a minimum, this means ABC is more levered to generic volumes than its peers (CAH, MCK). At the time the deal was reached, both ABC and WAG would have known that displacement of AWP by NADAC was likely, and that generic margins might fall. As a result of the uncertainty WAG and ABC almost certainly will have had different notions of the dollar value of WAG’s generic volume. Because ABC arguably was the price-taker in the agreement (ABC was essentially negotiating to be WAG’s wholesaler), we think it’s more likely that ABC overestimated the value of handling WAG’s generic volume (i.e., that ABC assumed generic margins would remain higher than WAG assumed). If the replacement of AWP by NADAC pressures generic margins more than ABC assumed it would when they made the deal with WAG, then the value of the WAG deal to ABC could be less than they expected[12]