COVID-19 INDUSTRY BRIEF
EFFECTS OF THE CORONAVIRUS ON THE Pharmaceutical INDUSTRY July 1, 2020
- Market Sentiment: The coronavirus has had 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. 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 remained open throughout North America during the shutdown, with home delivery options expanding since March 2020.
- Drug Pricing Increases Continue: Branded and generic pharmaceutical industry revenues are forecasted to increase at annualized rates of 3.0 percent and 2.6 percent, 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 percent over the past 10 years, but by just 1.7 percent through May 2020.
- Supply Chain Concerns: 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. 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.
- Civil Action Ongoing: 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.
- 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 July 2021
- The COVID-19 pandemic has had a significant effect on health care spending and trends. Spending for non-essential medications fell, but investment in potential COVID-19 vaccines and treatment regimens soared. Analysts expect overall branded pharmaceutical spending to increase by 4.9% in 2021.
- Demographic fallout from the COVID-19 pandemic will negatively affect pharmaceutical spending. There was a 33% increase in overall mortality in 2020 compared to pre-pandemic per capita pharmaceutical spending forecasts.
- 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.
- Forecasters expect branded and generic pharmaceutical industry revenues to increase at annualized rates of 1.9% and 2.6%, respectively, through 2026, which is a reduction from pre-pandemic forecasts of 3% and 2.6%, respectively.
- U.S. pharmaceutical pricing increased by an average of 6.2% over the past 10 years but by just 1.2% year to date through May 2021.
By the numbers
Pandemic Fallout: There was a 33% increase in overall mortality in 2020, according to the U.S. Census Bureau, which will negatively affect pharmaceutical spending compared to pre-pandemic spending forecasts. Total U.S. health care spending decreased by $400 billion in 2020 because of the pandemic and the resultant reduction in elective procedures.
Initially during the pandemic a drop off in demand for non-essential medicines resulted in an overall drop in health care spending, in 2021 as hospitals and healthcare facilities have resumed elective procedures and vaccination levels have skyrocketed, overall healthcare expenditures have recovered to pre-pandemic levels. Broad campaigns to vaccinate at least 70% of the U.S. population have been a boon for pharmacies and pharmaceutical manufacturers.
While industry research firm IBISWorld projects $500 billion in spending growth for 2021, it expects overall growth will be just 2.9% annually from 2019 through 2021, which is below the 10-year average.
Branded Pharmaceutical Industry Drivers: Before the pandemic, IBISWorld projected the branded pharmaceutical segment in the U.S. would grow by 4.6% in 2020. However, actual sales of branded pharmaceutical products increased by 11% in 2020 over 2019, because of the high demand for COVID-19 vaccines and therapies.
IBISWorld expects branded sales to increase an additional 4.9% in 2021 but then taper off from 2022 to 2026 with an estimated annualized growth of 1.9% Sales are also expected to increase because of positive health care spending projections, higher biologics sales of biologics, oncology drug and therapy developments and higher prices on widely used specialty drugs.
Generic Pharmaceutical Industry Drivers: An aging population, an increased prevalence of chronic disease and a continuing focus by insurance companies and the federal government on trimming healthcare spending are all positive factors affecting the generic business. While the pandemic hit the industry hard with generic pharmaceutical sales dropping by 0.6% in 2020, sales are expected to bounce back by 5.3% in 2021 based on IBISWorld research in the generic space.
Absent pandemic influences, the industry is growing, with the expiration of patent protection for multiple high-revenue drugs including Abilify, Copaxone and Crestor in 2015 and 2016 and Viagra and Lyrica in 2019.
Additionally, there are a significant number of branded biologic products including Lantus, NovoLog, Rituxan and Remicade that have lost patent protection and can be converted to “biosimilar” products, which will have a positive effect on the industry. For these reasons, IBISWorld projects generic pharmaceutical industry sales in the U.S. will grow 2.9% annually from 2022 through 2026.
Increased Pricing Pressures: Pharmaceutical price controls remain a major focus for regulators and the public. Over the past 10 years, pharmaceutical pricing in the U.S. has risen by an average of 6.2%. However, the rate of price increases has eased since 2019. The Producer Price Index for pharmaceutical manufacturing rose 3.1% in 2019, a drop from 3.7% in 2018 and well below the five-year average of 5.2%, according to the U.S. Bureau of Labor Statistics (BLS). Pricing continued to fall in 2020, increasing by only 1.5%.
The BLS reports only a 1.2% increase on producer prices through May 2021. As most pharmaceutical companies adjust their prices early in the calendar year, this indicates 2021 price increases will likely be below the trailing five-year average for the fourth consecutive year. Pharmaceutical pricing at pharmacies and drug stores has likewise been limited, with producer prices in 2019, 2020 and year-to-date 2021 registering increases of 2.7%, 1.7% and negative 2.8%, respectively.
Supply Chain Concerns: The pandemic has increased the focus on risk management as companies reassess their supply chain strategies and footprints to become more agile and resilient to disruption. They continue to 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 supply centers are located far from their demand. The COVID-19 crisis 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. An article in the American Chemical Society’s Chemical & Engineering News notes the number of facilities in China supplying active pharmaceutical ingredients (API) has more than doubled since 2010, to 13% of all those serving the U.S. market as of 2020.
The U.S. remains home to the most API manufacturing plants worldwide, and the European Union is a close second, with both accounting for just over 25% of the total, according to Janet Woodcock, U.S. Food and Drug Administration’s (FDA) Center for Drug Evaluation and Research Director. China and India combined account for 31%.
Ongoing Opioid Legal Action: A federal class action lawsuit referred to as the National Prescription Opiate Legislation was filed on December 17, 2017, concerning the alleged improper marketing and distribution of various prescription opiate medications nationwide. Lawsuits have been brought by thousands of local governments across the United States.
However, because of the extent of the litigation over the addiction epidemic, it could take years to resolve and make up for some of the economic losses caused by the crisis.
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 remedy differences in purchase prices. They occur when a wholesaler sells a product to customers at a price lower than its purchase price from the manufacturer. The wholesaler can contractually charge back the manufacturer for the difference and thereby receive normal margin. Drug manufacturers do not often reimburse this chargeback in cash; rather, wholesalers typically receive a credit they can apply to future purchases. Accordingly, there are always payables due to the wholesaler for chargebacks and payables due to the manufacturer for the original inventory purchase.
Gordon Brothers typically assumes a wholesaler and, in turn, the secured party, will not receive the chargebacks in a liquidation, as the company would offset them against other account payables owed. This means the company would not realize the full contracted margins in a liquidation scenario.
While chargebacks were in the range of 5% to 6% of total sales 20 years ago, today they can be as high as 30% to 40% of total sales, especially on generic products. Additionally, companies did not track chargebacks at the lot level, and competitors would buy pharmaceuticals below cost in a liquidation and recover the chargeback when they sold the product, minimizing the chargebacks’ effect. Now, companies track at the specific lot level because of gray market pharmaceutical concerns and cross-border sales issues, and only the parties involved in the original purchase can recover them. Competitors who 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 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 likely would 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 influence it could have on recovery values.
Limited Distribution Increases Desirability of Some Inventory in Liquidation: The Drug Quality and Security Act signed into law in 2013, aimed to improve identification and traceability of all prescription drugs distributed in the U.S. To control distribution, manufacturers often strictly limit the number of wholesalers authorized to sell products. This means no one other than a potentially short list of wholesalers is authorized to buy this product from the manufacturer. If one of the authorized wholesalers were to go into liquidation, some wholesalers who were previously unable to acquire the product directly from the manufacturer may be willing to pay a premium for the product. So lenders may wish to consider how exclusive the wholesalers’ contracts are.
Aging an Important Consideration: All pharmaceuticals have expiration dates. Many retailers will not accept inventory within a year of its expiration date. Lenders should inquire about inventory age 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. Additionally, lenders should inquire about inventory management procedures and stock rotation programs in place.
Government Agencies Must Be Involved with Exit Strategies: The FDA is the primary agency that regulates pharmaceutical manufacturers and distributors. It requires manufacturers and distributors to register for permits and licenses and comply with the FDA, the Drug Enforcement Administration and various pharmacy state boards or comparable agencies.
Additionally, 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. The FDA, Federal Trade Commission and state authorities, whose regulations vary by state, regulate advertising for 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 learned the agency would work with a responsible party with transparency and in the interest of protecting public health. The FDA advises any such action that relates to a company’s inventory is under the direction of the existing company, which would likely be currently licensed to distribute the regulated products. No FDA license or authority is required for a liquidation. However, there are state distribution licenses typically regulated and administered by a state pharmacology board. Additionally, if the liquidation were to involve any dispensing of prescription products, a licensed pharmacist would likely need 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. ©2021 GORDON BROTHERS, LLC.
Reference sources: MCKINSEY, IBISWORLD, UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OF OHIO, THE WALL STREET JOURNAL, CHEMICAL AND ENGINEERING NEWS, NATIONAL PUBLIC RADIO, U.S. BUREAU OF LABOR STATISTICS, U.S. CENTER FOR DISEASE CONTROL AND PREVENTION, U.S. CENSUS BUREAU.