Medco and Its Peers Brace for a Flank Attack - TheStreet

The embattled pharmacy benefit management industry could soon face competition from its own customers.

For years, major employers have simply trusted PBMs such as

Medco

(MHS)

,

Caremark

(CMX)

and

Express Scripts

(ESRX)

to hold prescription costs down. But some big companies have grown frustrated by the industry's lack of transparency and have come to doubt that the professed savings are real. Thus, dozens of companies -- including big names like

IBM

(IBM) - Get Report

-- have joined forces in an effort to directly negotiate with drug manufacturers for discounts on their own.

The HR Policy Association, which formulated the idea, calls the group "the largest private-sector drug purchasing coalition ever assembled." Meanwhile, a number of states -- some seeking to regulate the industry -- have launched a similar effort.

The potential group buyers have surfaced at a time when drug costs are soaring and PBMs face intense government scrutiny for their pricing and business practices. Despite the strong negotiating power enjoyed by PBMs -- which provide about 80% of the drug coverage in the U.S. -- prescription drug costs actually doubled between 1995 and 2000 and have continued to rise since then. Critics blame PBMs for allegedly charging far more for drugs than they actually pay to manufacturers. They insist that PBMs engage in secret deals that allow them to pocket much of the savings that they are supposed to pass on to their clients.

But the loosely regulated industry -- monopolized by the three big for-profit companies -- staunchly defends itself. It points to government reports that say that PBMs slash billions of dollars from prescription drug costs annually. And it argues that some of the savings would evaporate if regulators forced PBMs to disclose trade secrets that enable them to reduce costs for their customers.

There is no dispute, however, about the industry's growing profitability. Medco, the nation's largest PBM, recently posted a 21% jump in net income even after losing some major contracts. Caremark, which won some of that business, reported "record" second-quarter results -- with cash flow tripling -- following a big merger that further reduced competition within the industry. And Express Scripts, the No. 3 PBM, saw its own cash flow more than double in the same period.

It's in those lush profits that some customers see the prospect for further savings. That said, all three of the companies have big fans on Wall Street. Analysts point to strong financial results when recommending the stocks -- and remain willing to look past the customer dissatisfaction that, so far, has triggered few material changes in the industry.

Shifty Business

Still, Tom Beauregard of Hewitt Associates, the firm tapped to negotiate on behalf of the big employers, foresees a major shift in the PBM business.

"When you get this many large companies standing up and saying, 'This financial model is unacceptable,' it is inevitable that the financial model will, in fact, change," he said.

It's not that the employers would dump the PBMs altogether. But under the plan they're exploring, big companies would simply pay a flat fee for administering their prescription benefits. That would allow them to stop relying on PBMs to negotiate cheaper drug prices that don't always materialize.

Beauregard fully expects other employers to follow his group's lead -- and eventually alter the current PBM business model as a result.

"The majority of their income doesn't come from administration fees," he explained. "If you eliminate payments from manufacturers, it changes their business model pretty significantly."

For their part, the PBMs say they save customers money by negotiating rebates from manufacturers on certain drugs. But critics say that PBMs keep much of the rebates for themselves and leave their customers with high-priced drugs as a result.

Beauregard says his group is prepared to pay PBMs a significantly higher administrative fee to help offset their lost payments from drug manufacturers. He is also convinced that PBMs will still profit from the deal. But he stops short of guessing whether PBMs will remain as profitable as they are today.

Public Outcry

PBMs face pressure from the public sector as well.

Two years ago, Maine Senate Majority Leader Sharon Treat had no idea what a PBM even was. Now, she is seeking to change the entire industry. She has already authored a state law -- currently stalled in court -- that would greatly enhance government oversight of PBMs. But she is not stopping there. When her term ends this year, she will become executive director of a multistate coalition that's in the process of forming its own nonprofit PBM due to mounting frustration with the for-profit players.

"We have the political will to change things," she insisted. "Nobody is going to give up on this."

Still, she sees a challenging road ahead. Her state battled all the way to the U.S. Supreme Court before it won approval to secure rebates from drug manufacturers. Now, it must show that it has the power to regulate PBMs without exposing their trade secrets. But Treat expects her state -- or another fighting for the same cause -- to prevail in the end.

The PBM industry argues that the federal government has already shown that heightened regulation is unnecessary. But Treat, for one, sees evidence to the contrary.

"Given the billions of dollars these companies have paid in reparations, it's hard to take that seriously," she said.

A pharmacy professor who published the first-ever academic study of the PBM industry doubts other government studies as well.

Loaded Weapons

When New York Attorney General Eliot Spitzer took aim at Express Scripts this month, accusing the PBM of overcharging state customers by up to $100 million, an industry trade group rushed to the company's defense with some pretty impressive artillery.

"Every objective analysis -- from the U.S. General Accounting Office to the Congressional Budget Office to the Federal Trade Commission and the Harvard Business School -- has found that competing PBMs are the key to reigning in prescription drug costs," argued Mark Merritt, president of the Pharmaceutical Care Management Association. "Today's assertions from the New York state attorney general's office fly in the face of everything we know about the value PBMs provide to the system."

But Robert Garis, who spent the past five years researching PBMs at Creighton University, suspects that the government knows less than it thinks. He says the government relied heavily on the PBM industry itself when gathering information for its studies. And he believes that the resulting reports were based on "dubious assumptions" because of this.

Garis says his own exhaustive research shows that PBMs drive up prescription drug costs instead. Rather than relying on the industry for information, Garis tracked down actual invoices that showed how much PBMs paid and charged for drugs. He said the spread -- which PBMs sometimes get to keep -- could be amazing.

"The granddaddy of them all was a $200 spread for a prescription of ... generic Zantac," he said.

Garis claims that PBMs also collect a number of fees that "most people, most plan sponsors and most intelligent non-insiders are not aware of."

"This industry is so poorly understood," he said. "People quite naturally hold on to what little they know about any given subject. And what employers seem to know is that if they get a big discount, a low administration fee and the promise of big rebates, this has to be the best way to go."

But 54 companies, including IBM, are starting to think otherwise. By next year, they will no longer be relying on PBMs to secure drug discounts for the 5.5 million people they insure.

Beauregard says the coalition has already made some important progress toward that goal.

"We've met with most of the major drug manufacturers," he said. "And they're receptive to this idea, given the volume we bring and our objective of transparency. ... We're optimistic about the opportunity to change the market."

Garis views employer awareness, like that exhibited by the coalition, as the key catalyst for a revolution in the PBM industry. And he suspects that the PBMs will finally suffer if that happens.

"They would still be profitable," he said. "But they wouldn't be the money machines they are right now. The amount of hidden cash flows they get is just staggering."