COVID-19 INDUSTRY BRIEF
EFFECTS OF THE CORONAVIRUS ON THE Pharmaceutical INDUSTRY March 30, 2020
- Market sentiment: Pharmaceutical demand is linked to basic demographics, but has been impacted in the short term by consumer and retail dislocation due to the coronavirus. While most of the recent news and events in this space have been linked to potential vaccine development and treatment options related to COVID-19, the basic pharmaceutical marketplace remains intact. Pharmacies are considered essential services, and have remained open throughout North America, with home delivery options being expanded in recent weeks.
- Growth in E-commerce: E-commerce sales have been on the rise with average order values for online e-commerce pharmaceutical consumers increasing by almost 100 percent in March 2020 versus March 2019.
- Opioid and Pricing Reform on Hold: The diversion of the attention of the Food and Drug Administration and other governmental agencies to coronavirus-related issues may have a slight positive impact on distributors under pressure due to opioid-related litigation and pricing reforms for generic drugs. Legal and regulatory pressure may ease as governmental resources are assigned to other areas due to the pandemic outbreak.
- Valuation Outlook: In Gordon Brothers’ view, with the exception of product-level demand spikes, valuation dynamics for both machinery and equipment and inventory in the space remain relatively unchanged due to COVID-19.
Date June 2020
- The coronavirus is having a significant impact on health care spending and trends. Spending for non-essential medications has fallen, but investment in a potential COVID-19 vaccine and treatment has soared.
- Branded and generic pharmaceutical industry revenues are forecasted to increase at annualized rates of 3.0% and 2.6%, respectively, through 2025, despite attempts by the federal government to regulate drug pricing.
- Recent pricing pressure has resulted in scrutiny on price hikes and general margin compression, especially in the generic sector. Pharmaceutical pricing in the United States increased by an average of 5.1% over the past 10 years, but by just 1.7% through May 2020.
- Recent concerns regarding the quality and efficacy of generic drugs and the reliance on? overseas supply chains may have a meaningful impact on the pharmaceutical industry in the future.
- A multijurisdictional civil action is ongoing against pharmaceutical manufacturers and distributors involved in the opioid space. Several legal actions were filed against distributors of opioids resulting in major criminal convictions and settlements in 2018 and 2019, as well as an ongoing criminal case involving a major manufacturer.
By the numbers
COVID-19 Impact: The initial shock of COVID-19 was seen in February and early March 2020, when the Chinese supply chain for both active pharmaceutical ingredients and other chemicals used in pharmaceutical manufacturing was shut down. Although there was significant concern over shortages, due to the relatively rapid resumption of China-based manufacturing and active management on the part of pharmaceutical companies, no significant end-product disruptions were reported for pharmaceutical products. As a result of the disease spreading into a global pandemic by March 13, demand for a vaccine and retro viral products related to the treatment of influenza-like symptoms exploded. As of May 21, the New England Journal of Medicine had reported on the status of eight major vaccine programs that were in process around the world, and noted that there were more programs underway. In addition, the COVID-19 pandemic has been a boon for online pharmacies; despite a decline in demand for “non-essential” medications, the Wall Street Journal reported that mail-order prescriptions grew 21 percent from the previous year in the last week of March, and CVS saw a 10-fold increase in pharmacy home deliveries during the first three months of the year, mostly since waiving fees in early March.
On the negative side, sales of medications used in hospitals declined due to the focus on COVID-19 patients, the reduction in elective procedures, and the patient concerns related to COVID-19. Additionally, clinical trials for a variety of new drugs in development have been impacted due to social distancing measures, restrictions on elective and non-essential procedures, and the closure of many university laboratories. Demand for other pharmaceutical products has also been limited due to the decline in the number of patients seeking non-emergency and elective treatments.
From a financial perspective, the industry has been deemed essential, so the sector has remained relatively stable throughout the pandemic, although there have been disruptions. Several major mergers have been delayed through the period due primarily to regulatory delays. Pfizer and Mylan delayed the close of their generics megamerger until the second half of 2020, citing unprecedented circumstances surrounding the COVID-19 pandemic as well as delays in the regulatory review process. The AbbVie merger with Allergan was also delayed by regulatory issues related to COVID-19, but the deal closed in May 2020.
Branded Pharmaceutical Industry Drivers: Before the onset of COVID-19, the branded pharmaceutical segment in the United States was projected to grow by 4.6 percent in 2020. This forecast was revised to 2.6 percent due to the current limited sales of non-essential medications. Moving forward, sales are expected to increase due to higher sales of biologic drugs and higher prices on widely used specialty drugs. In addition, a focus on high-priced specialty therapies and orphan drugs, which typically have a smaller disease population and shorter clinical trial periods, is expected to increase sales. Sales will be tempered by pricing pressure trends as well as further pressure from the generic sector. Due to these factors, market research firm IBISWorld projects that branded pharmaceutical industry sales in the United States will grow 3.0 percent annually from 2020 to 2025.
Generic Pharmaceutical Industry Drivers: Positive aging demographics, an increased prevalence of chronic disease, and a continuing focus by insurance companies and the federal government to trim healthcare spending are all positive factors impacting the generic business. Multiple high-revenue drugs including Abilify, Copaxone, and Crestor, lost patent protection in 2015 and 2016, and the recent expiration of patent protection for Viagra and Lyrica has also presented opportunities for generic manufacturers. In addition, there are a significant number of branded biologic products—including Lantus, NovoLog, RITUXAN, and REMICADE—that are coming off patent protection and will have a positive impact on the industry going forward. Due to these factors, IBISWorld projects that generic pharmaceutical industry sales in the United States will grow 2.6 percent annually from 2020 through 2025.
Increased Pricing Pressures: Pharmaceutical price controls remain a major focus for regulators and the general public. Over the past 10 years, pharmaceutical pricing in the United States has risen by an average of 6.2 percent. However, the rate of price increases has eased measurably since 2019. The Producer Price Index for pharmaceutical manufacturing rose 3.1 percent in 2019, a drop from an increase of 3.7 percent in 2018, and well below the five-year average increase of 5.2 percent, as reported by the U.S. Bureau of Labor Statistics (BLS).
Producer price increases on a year-to-date basis have been muted in 2020 with only a 1.7 percent increase reported by the BLS. As most pharmaceutical prices are adjusted early in the calendar year, this likely indicates that 2020 price increases will be below the trailing five-year average for the third consecutive year. Pharmaceutical pricing at pharmacies and drug stores has likewise been limited, with producer prices in 2018, 2019, and year-to-date 2020, registering increases of 3.1 percent, 2.7 percent, and 1.5 percent, respectively. The rate drops have been the result of scrutiny on the sector, as well as several proposals by the current administration to allow drugs to be imported directly from other countries, including Canada, and to effectively adopt foreign price controls on Medicare Part B drugs by implementing an international pricing index. In addition, there have been suggestions to rein in the use of pharmacy benefit managers (PBMs), which are third-party administrators of prescription drug programs. Other current pricing initiatives fall into several different areas:
- Study Bills – establish a task force or authorize a study focused on various aspects of drug costs and pricing.
- Reporting Bills – require some or all drug manufacturers to report to state governing bodies certain information regarding their drug prices and company costs. In addition, some legislation may require PBMs or health plans to report information to states regarding their prescription drug costs and/or rebate agreements with manufacturers.
- Notification Bills – require certain manufacturers planning to launch or increase the price of a high-cost drug to notify states and other payers of price increases.
- Marketing/Advertising Bills – add requirements and/or restrictions to pharmaceutical marketing and advertising activity.
- Price Control Bills – establish limits on the prices of certain drugs.
- Pharmacist Disclosure Bills – prevent PBMs and plans from prohibiting pharmacists from informing patients about drug prices and lower-cost options.
- Manufacturer Cost-Sharing Assistance Bills – limit or prohibit manufacturers from offering discounts or reductions in an individual’s out-of-pocket costs, or require reporting on such discounts.
These bills threaten to severely restrict and limit future pharmaceutical price increases. The rate of drug inflation has declined significantly in the face of these proposals and the general scrutiny on the sector.
Supply Chain Concerns: COVID-19 has increased the focus on risk management, as companies reassess their supply-chain strategies and footprints to make them more agile and resilient to disruption. These considerations may include excess capacity , dual sourcing, and geographic diversification requirements. Make-versus-buy decisions will also be impacted, and will depend on the way companies evaluate their suppliers and weigh solvency risks, the amount of control they desire, the need to choose partners based on diversifying locations and other considerations that balance cost versus risk. There has long been an underlying sense of unease in the industry, as core centers of supply are located far from their demand. The COVID-19 crisis has reinforced this unease and forced companies to consider moving a portion of last-mile production-supply capacity closer to end markets.
There are also concerns regarding the supply chain reliance on China and India; the number of facilities in China supplying active pharmaceutical ingredients (API) has more than doubled since 2010 to 13 percent of all those serving the U.S., market as of 2020. The United States remains home to the most API manufacturing plants worldwide with approximately 25 percent of the total. The European Union is a close second, with xx percent. China and India combined account for 31 percent. It is estimated that upward of 80 percent of chemicals used to make drugs sold in Europe now originate from China and India. India now supplies 40 percent of generics to the world market.
In addition to the concentration of the supply chain in India and China, concerns about the efficacy of drugs produced in Asia are also an issue. An exposé by investigative journalist Katherine Eban in her book Bottle of Lies brought to light concerns regarding pharmaceutical manufacturing practices and the limitations of Food and Drug Administration (FDA) oversight on these operations. The book highlights the limitations of the FDA to hold overseas manufacturers accountable, non-compliance with the FDA’s Good Manufacturing Practice regulations in certain overseas operations and problems with the efficacy of certain lots of generic drugs.
It is likely that, due to the supply chain concerns brought to light by COVID-19 as well as underlying concerns related to quality, the next few years will see a diversification of the global pharmaceutical supply chain and a rise in regulatory pressure to bring some of the supply chain back to North America.
Opioid Legal Action: The use of opioid prescription pain medication expanded significantly over the last few decades to the point that these types of medications were being overprescribed. As a result, a significant amount of legally-produced opioids were being sold as recreational drugs and a large number of chronic-pain patients were addicted to the medications. According to data from the Centers for Disease Control and Prevention, the opioid epidemic claimed the lives of nearly 400,000 people in the United States between 1999 and 2017. Congress passed the Substance Use-Disorder Prevention that Promotes Opioid Recovery and Treatment for Patients and Communities Act’ on October 24, 2018, which further regulated the distribution and use of opioid pain medications, placed a variety of restrictions on how opioids can be used and prescribed through the Medicare program, and made additional legal provisions related to the FDA’s handling of opioid distribution, post market prescription monitoring, disposal of unused prescription opioids, and other actions to control the opioid market.
Multiple state and local governments sued the pharmaceutical industry on the grounds that the manufacturers of prescription opioids misrepresented the risks of long-term use and distributors failed to properly monitor suspicious orders, contributing to the opioid epidemic. Not unlike the groundbreaking legal action taken against the tobacco industry in the 1990s, the prescription drug industry has been hit hard by lawsuits and settlement payouts over the past decade related to the opioid medication crisis.
A federal class action lawsuit was filed on December 17, 2017 (referred to as the National Prescription Opiate Legislation), concerning the alleged improper marketing of and inappropriate distribution of various prescription opiate medications nationwide. This class action, which included 2,400 cases filed by local and state governments, is still proceeding and has resulted in several settlement actions between municipalities and various pharmaceutical manufacturers and distributors. Under an October 2019 proposal, four state attorneys general (from North Carolina, Pennsylvania, Tennessee, and Texas) are pushing a $48 billion global settlement framework with three major drug distributors and two drug manufacturers. This proposal would resolve all state and local government opioid claims against those companies in all 50 states and the District of Columbia. Representatives of certain local governments—particularly those that have cases pending in the national class action—have, however, already voiced their public rejection of this settlement framework.
In addition to the class action lawsuit, other legal action has been taken as a result of the opioid crisis. In April 2019, the U.S. Drug Enforcement Agency (DEA) announced criminal charges as well as an agreement between the agency and Rochester Drug Cooperative Inc. (RDC) for unlawfully distributing oxycodone and fentanyl and conspiring to defraud the agency. A similar high-profile cases was brought against Ohio-based pharmaceutical distributor Miami-Luken, which announced it was winding down operations after facing mounting lawsuits for distribution of massive quantities of opioids in West Virginia, A federal grand jury indicted two of Miami-Luken’s? former officials and two pharmacists with conspiring to distribute controlled substances in July 2019. After years of investigations and lawsuits over the marketing of the highly addictive opioid painkiller OxyContin, in 2017, Purdue Pharma and its controlling owners the Sackler family pleaded guilty to a federal felony and paid over $600 million in criminal and civil penalties. In March 2019, Purdue Pharma settled with the state of Oklahoma for approximately $270 million. Opioid manufacturers and distributors Teva, Cardinal Health, AmerisourceBergen and McKesson settled with plaintiffs on the eve of the first day of court proceedings in the OxyContin? class action suit in October 2019. The $260 million settlement deal resolves claims filed by Ohio’s Cuyahoga and Summit counties that alleged the manufacturers and distributors were responsible for fueling the opioid crisis.
As a result of the litigation, Purdue Pharma filed for Chapter 11 bankruptcy protection on Sept. 15, 2019, citing the pressure of thousands of lawsuits filed in state and federal court. Purdue Pharma is also reported to be under investigation for a kickback scheme related to boosting opioid prescriptions. The class action suit was reported to be on hold through October 2020 to give negotiators more time to reach a settlement.
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 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 thereby receive? normal margin. Drug manufacturers often do not reimburse this chargeback in cash; rather, wholesalers typically receive a credit to be applied against future purchases. Thus, 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) will not 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 would not realize the full contracted margins usually generated.
Around 2005, chargebacks fell in the range of 5 percent to 6 percent of total sales. Currently, it is not uncommon for chargebacks—especially on generic products—to be as high as 30 percent 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, which, depending on the volume, 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, interoperable 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 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 of determining a product is illegitimate. This legislation has evolved to limit the secondary sale of pharmaceuticals from wholesaler to wholesaler and to 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 providing 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 DEA, 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, 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, which 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.
Note: This publication is provided for informational marketing purposes only. The material contained herein should not be regarded as advice, nor relied upon to make financial, operational or other decisions; nor should it be used as a substitute for an asset appraisal. Actual recovery values may vary from transaction to transaction and the recovery values referenced herein are for representative transactions without regard to specific key factors. This material may be redistributed only in its entirety, including notice of copyright. All rights reserved. ©2020 Gordon Brothers, LLC.
Reference sources: congress.gov, mcKinsey & company, new england journal of medicine, wall street journal, fierce pharma, congressional research service, chemical & engineering news, npr, purdue pharma, ibisworld, FRED, reuters, pricewaterhousecoopers,u.s. District court- northern district of ohio