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New Challenge for Medco

How will the big pharmacies overcome price pressure?

These days, pharmacy benefit managers can't seem to catch a break.

First,

Wal-Mart

(WMT) - Get Walmart Inc. Report

starts selling generic drugs so cheaply that some people have started questioning whether other drug sellers, including PBMs, should be charging less for generics as well.

Then, a firm which publishes the "average wholesale prices" of brand-name drugs accepts new policies that could lower prices on branded drugs to boot.

Some Wall Street experts have cooled on PBM stocks as a result.

UBS analyst Ricky Goldwasser this week downgraded the big three PBMs --

Medco

(MHS)

,

Caremark

(CMX)

and

Express Scripts

(ESRX)

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-- over concerns about lost profits from brand-name drugs in particular.

"While PBMs should still benefit from generics opportunity, we think AWP changes will offset upside," Goldwasser warned on Monday. "In our opinion, the risk/reward landscape has changed, and we see risk for additional downside potential."

Goldwasser now has neutral ratings on all three of the major PBM stocks. Her firm has an investment banking relationship with Caremark.

Shares of all three PBMs -- already battered by Wal-Mart's plans -- fell on Monday's downgrade.

Medco slipped 2.4% to $55.75. Caremark dropped 4.1% to $51.19. And Express Scripts spiraled 6.7% to $68.96.

Faulty Data

First DataBank, a division of Hearst that serves drug middlemen like PBMs, has been forced to change its ways.

PBMs rely on firms like First DataBank -- which portrays itself as the largest outfit of its kind -- to publish AWP rates for brand-name drugs.

PBMs charge their clients discounted AWP rates, pay manufacturers even lower rates for the drugs and then pocket the so-called spreads in between.

But those spreads could soon narrow.

Importantly, First DataBank has been accused of artificially hiking AWP rates on most brand-name drugs for years.

As part of a new legal settlement, the firm has agreed to lower its AWP rates by nearly 5% in coming months -- and stop publishing AWP lists altogether down the road.

Those who secured the settlement, fighting on behalf of union customers, claim the change will slash $4 billion from the nation's drug bill in 2007 alone. PBMs could see their profits, particularly for mail-order prescriptions, suffer as a result.

Goldwasser offers a simple example as evidence.

Say that First DataBank lists the AWP rate for a certain drug at $100. A PBM may offer its clients a 22.5% discount off that AWP rate, collecting $77.50 for the drug. It then pays the drug manufacturer a set rate of $73.50 and pockets the $4 difference as profit.

But if the new AWP for that drug drops by 5% to $95 -- and the PBM remains stuck with its fixed costs -- the profit on that same mail-order transaction would be measured in the pennies.

"Thus, in this analysis, the net impact to the PBMs is a reduction of $3.88 in gross profit and a reduction of 449 (basis points) of gross margin," Goldwasser notes. And "Medco would be the most impacted, as it derives the highest percentage of revenues through the mail brand channel."

Goldwasser has, therefore, scaled back his expectations for the company. She now believes that Medco will earn $3.11 a share next year -- 6 cents less than her earlier prediction -- and has cut his price target on the company's stock from $74 to $66 as a result.

She has lowered her outlook for Caremark and ExpressScripts as well.

Potential Fallout

Cowen analyst Kemp Dolliver is more optimistic.

For starters, Dolliver notes that the proposed 5% rollback on AWP prices will affect just 13% of all drugs currently on the market.

Moreover, he says, those cuts should impact just 8% of the drugs that PBMs regularly sell.

"Our analysis does not provide a definitive answer," Dolliver admits. "But

it appears to confirm our suspicions that the $4 billion savings estimate -- 1.5% of drug spending -- implied in press reports overstates the true economic impact. ... We're staying with our recommendations" on PBM stocks.

Dolliver has a neutral rating on Medco and outperform ratings on both Caremark and Express Scripts.

His firm makes a market in Express Script securities and hopes to do business with the companies it covers.

Meanwhile, Goldwasser has apparently taken her own analysis a little further.

She starts by noting that 200 drugs account for some 70% of all drug sales in the country. Of those 200, she says, 95% are subject to AWP rate cuts.

Even after excluding some of those drugs, such as specialty treatments and those with generic equivalents, he estimates that nearly half of the drug sales carried about by PBM mail-order pharmacies might be threatened by the change.

Robert Garis, a Creighton University pharmacy professor who specializes in PBM research, foresees a possible hit as well.

"The PBMs could see their total revenue go down," Garis says. "So their balance sheets would look much worse on that side. ... But what I think will happen in reality -- and even the analysts mention this -- is that the PBMs will just make up for this with extra markups on the generic side of the business."

Still, Wal-Mart could dampen those plans.

Notably, the heavyweight retailer has started selling 30-day supplies of certain generic drugs for just $4 apiece.

To be fair, Wal-Mart has included just a fraction of all generic drugs on its $4 list. However, Garis feels, the company has made an important statement in the process.

"Wal-Mart has said with its actions, 'Look, guys, generics shouldn't be that expensive,'" Garis states. "And, in fact, they aren't. Wal-Mart is going to at least break even on this promotion."

Giant employers and health plans, who rely on PBMs to secure the cheapest drug prices possible, could take notice and demand low-priced generics for themselves.

Garis, for one, hopes they do. If that happens, he says, those clients could see their total drug costs actually go down -- reversing an expensive trend -- a few years down the road.

That said, he still questions whether PBMs will suffer in the process.

"I think the PBMs will have to find another place to generate their big cash flows," Garis says. "And they always do. As much as I hate to admit it, they have made strategic moves that look very, very astute. They've always managed to stay ahead of the ballgame."