Date June 2018
By the numbers
- Increases in the price of branded products has decelerated over the last several years, but expectations are that regular price increases for branded products will accelerate in 2019 and 2020
- The industry and its investors continue to anticipate what changes may come from the federal government to regulate prices
- Recent pricing pressure, especially in the generic sector, has resulted in scrutiny on price hikes and a general margin compression in this sector
- The Affordable Care Act boosted drug spending, benefitting wholesalers; however, efforts to repeal and replace the act may put some reimbursements at risk
Pharmaceutical price increases decelerating: In response to scrutiny on the industry due to the Martin Shkreli-run Retrophin Inc. and Mylan EpiPen® price gouging scandals, and the recent action of multiple state attorneys general investigating price fixing in the generic pharmaceutical industry, many pharmaceutical manufacturers have been limiting the level of price increases to single digits versus the double digit growth that the industry had been seeing over the prior decade. With the public announcement by Allergan CEO Brent Saunders in late 2017 to limit price hikes to less than 10 percent annually as well as similar actions by Sanofi, which recently committed to limiting hikes to the level of official health inflation, projected to be 5.4% in 2017, many pharmaceutical companies are beginning to self-police the level of price increases they are implementing, potentially in the hope of dissuading regulators from taking action in regards to enhanced scrutiny and mandated price control. Elsewhere in the industry, Johnson & Johnson, Merck, and Eli Lilly have released high-level information about pricing, demonstrating a trend toward higher rebates to pharmacy benefit managers.
Currently, drug pricing talk has quieted in Washington, D.C., as no new controversies have fueled the issue in recent months and discussions of repealing the Affordable Care Act seem to have quieted from the public rhetoric. Despite the crisis seemingly quieting, drug pricing inflation has been moderated, and the industry is moving forward cautiously. Gordon Brothers has heard from industry sources that there is an expectation that pricing inflation will resume in the near future but has not seen any distinct sign of that in the numbers at this point.
Pharmaceutical chargebacks discounted in liquidation: Large hospital buying groups and retail pharmacies typically negotiate purchase prices for pharmaceutical drugs directly with manufacturers based on volume. Pharmaceutical chargebacks help to remedy differences in purchase prices charged to various types of buyers and typically are instituted in the following situation: when a wholesaler sells a product to customers at a price lower than its purchase price from the manufacturer, the wholesaler is allowed to contractually charge back the manufacturer for the difference and normal margin. Drug manufacturers often do not reimburse this chargeback in cash; rather, they are generally issued as a credit to be applied against future purchases. Thus, at any point in time, there are always payables due to the wholesaler for chargebacks as well as payables due to the manufacturer for the original inventory purchase. Gordon Brothers typically assumes that a wholesaler (and in turn the secured party) won’t receive the chargebacks in a liquidation, as they would be offset against other account payables owed; in essence this means that, in a liquidation scenario, the company wouldn’t realize the full contracted margins usually generated.
Fifteen years ago, chargebacks fell in the range of 5 to 6 percent of total sales; now it is not uncommon for chargebacks, especially on generic products, to be as high as 30 to 40 percent of total sales. In addition, previously, chargebacks were not tracked at the lot level, and competitors would buy pharmaceuticals in a liquidation below cost and recover the chargeback when they sold the product, thus minimizing the impact of chargebacks in a liquidation. Now, due primarily to gray market pharmaceutical concerns and cross border sales issues, chargebacks are tracked at the specific lot level and can only be recovered by the parties involved in the original purchase. Competitors that buy pharmaceuticals in a liquidation will not consider the benefit of a chargeback into what they pay for the product.
Government contracts pose risk: Some wholesalers sell a significant portion of their inventory under government contracts, which are negotiated between the manufacturer and the contracting agency. These contracts typically enable government bodies to purchase products at significantly discounted rates. In a liquidation, it is unlikely that inventory would continue to be sold to the government at those prices, which could pose a problem if the government is a significant buyer. In this scenario, liquidators would likely need to find alternate buyers and, depending on the volume, that could be challenging. Lenders should be aware of how much inventory is typically sold under government contracts and the impact it could have on recovery values.
Limited distribution increases desirability of some inventory in liquidation: The Drug Quality and Security Act (DQSA), signed into law in 2013, aims to improve identification and traceability of all prescription drugs distributed in the United States. To control distribution, manufacturers often strictly limit the number of wholesalers authorized to sell particular products. This means that no one other than a potentially short list of wholesalers is authorized to buy that product from the manufacturer. If one of those authorized wholesalers were to go into liquidation, some wholesalers that were previously unable to acquire the product directly from the manufacturer may be willing to pay a premium for the product. Thus, lenders may wish to consider how exclusive the wholesalers’ contracts are.
Gray market pharmaceutical issues: Title II of DQSA, the Drug Supply Chain Security Act (DSCSA), outlines steps to build an electronic, inter-operable system to identify and trace certain prescription drugs as they are distributed in the United States. The DSCSA requires wholesale distributors and third-party logistics providers to report licensure and other information annually to the Food and Drug Administration (FDA). Additionally, to further enhance the security of the drug supply chain, manufacturers, re-packagers, wholesale distributors, and dispensers are required to notify the FDA and other trading partners within 24 hours after determining a product is illegitimate. This legislation has evolved in order to limit the secondary sale of pharmaceuticals from wholesaler to wholesaler and shrink the so called “gray market” for these products; as a result, the secondary market for pharmaceuticals is not what it once was. The issue for pharmaceutical manufacturers was not so much safety as protecting margins. There has historically been a significant variation in the price charged for what is ostensibly the same product in various countries and regions of the world. As a result, with the advent of the internet as a major retail sales channel, online pharmacies started filling pharmaceutical sales across government borders. In order to protect regional and national margins (as well as protect against burgeoning counterfeit operations), pharmaceutical manufacturers and governments began to crack down on pharmaceuticals being sold outside of the intended national sales channel. This stifling of the gray market and the control of out-of-channel purchases has also had a negative effect on the secondary market for pharmaceuticals in a liquidation as there are fewer entities willing to purchase pharmaceuticals out of channel.
Aging an important consideration: All pharmaceuticals have expiration dates. Many retailers will not accept inventory that is within a year of its expiration date. Thus, lenders should inquire about the aging of inventory and beware of lending against any product that has a shelf life of less than one year. Often, wholesalers will return inventory with a shelf life of less than six months because of this concern. Lenders should inquire about inventory management procedures and stock rotation programs in place.
Exit strategies must be coordinated with government agencies: The FDA is the primary agency responsible for the regulation of pharmaceutical manufacturers and distributors. Manufacturers and distributors are required to register for permits and licenses and comply with certain regulatory controls of the FDA, the U.S. Drug Enforcement Administration and various state boards of pharmacy or comparable agencies. In addition, pharmaceutical manufacturers and distributors are subject to the requirements of the Controlled Substances Act and the Prescription Drug Marketing Act of 1987, an amendment to the Food, Drug and Cosmetic Act, which requires each state to regulate the purchase and distribution of prescription drugs under prescribed minimum standards. These laws regulate the manufacture, shipping, storage, sale, and use of such products and product samples. In addition, the FDA, Federal Trade Commission, and state authorities (regulations vary by state) regulate the advertising of prescription and over-the-counter products and enforce rules and licenses regarding filling, compounding, and dispensing prescription products.
Gordon Brothers has discussed hypothetical exit strategies with the FDA and has been advised that the agency would work with a responsible party in this type of event, assuming the party was acting in good faith, with transparency, and expressed an interest in protecting the public health. The FDA has advised that any such action in relation to a company’s inventory would best be taken under the direction of the existing company that would likely be currently licensed to distribute the regulated products. This being said, for distribution entities, there is no FDA license or FDA authority required for a liquidation; however, there are state distribution licenses typically regulated and administered by a state pharmacology board. In addition, if the liquidation were to involve any dispensing of prescription products, a licensed pharmacist would likely need to be engaged to handle and oversee these activities. In all cases, the selling entity would need to be licensed by the appropriate federal and state authorities as applicable under the situation. Lenders should be aware of these complexities in taking possession of pharmaceutical inventory and comply with the proper and legal processes for liquidating it.