H.B. 371 signed by Gov. Bush (UPDATED)

H.B. 371, the controversial bill that modifies Florida's pedigree law, was signed by Governor Bush today. Despite all of the hyperbole, H.B. 371 actually brings Florida closer to the requirements of the PDMA, which takes effect on December 1. (See my previous post for more on the FDA’s PDMA decision.)

The altered pedigree requirements of HB 371 may not make good local news sound bites, but they make good supply chain sense. Manufacturers will need to take greater responsibility for monitoring and protecting their products. This will be a boon for channel commerce vendors, but unpleasant news for pedigree and RFID companies.

What Really Happened in Florida

Basically, products moving through a one-step channel (Manufacturer-Wholesaler-Customer) are subject to different pedigree requirements, while products moving through a two-or-more step channel (Manufacturer-Wholesaler-Wholesaler-Customer) will require a standard pedigree with lot number, transaction dates, etc.

Narrowing the scope of full pedigree makes it more likely that we can catch the bad guys. A fundamental rule of economics is that life is full of tradeoffs. While theoretically desirable to track every product all the time, the time and attention devoted to the effort would take focus away from the real problems in the secondary market. (If you slept through your college Econ 101 course, I recommend Gregory Mankiw’s Principles of Economics featuring his classic “Ten Principles of Economics.”

Frequent flyers in an airport security line have probably thought about tradeoffs. I personally fly almost 150,000 miles per year. I buy tickets with a corporate credit card. I’m happy to put my luggage through the x-ray machine and walk through metal detector. But think about it: every minute that TSA spends making me take my shoes off or pulling me aside for special screening is a minute that will not be spent searching more likely suspects.

Why doesn’t the TSA let me submit to additional “licensing” each year so that I can avoid the indignity of the shoe removal? In a nutshell, that’s what H.B. 371 does for the drug supply chain. Wholesalers in the one-step channel now submit to more stringent licensing and certification requirements, but are presumed innocent for the purposes of pedigree. In other words, they still have to walk through the metal detector but no longer have to remove their shoes.

Winners and Losers

The extra costs and burdens of a two-or-more step channel provide an incentive for more direct purchases from manufacturers. If other states adopt the Florida HB 371 approach (or just accept the PDMA standard), then more volume will be flowing through the one-step channel. So, either:

• The large wholesalers (MCK, CAH, ABC) will pick up volume from (secondary) physician distributors such as PSS and Henry Schein, which have small volumes of Rx product in their mix, or
• Manufacturers will compensate wholesalers for fulfillment to secondary distributors --another area of possible margin expansion for wholesalers.

OTOH, the effect could be negative if manufacturers begin selling directly to more distributors. This may happen in some situations, but most pharma manufacturers do not want to handle too many more customers. [ADDENDUM: PSS World Medical just announced their intention to buy more products directly.]

As a result of the legislative changes, manufacturers will also have a greater responsibility to monitor this one-step wholesaler channel. The big winners from this approach will be channel commerce software vendors such as Edge Dynamics, which can turn wholesaler data about order flow, inventory levels, and customer shipments into actionable product security monitoring. (Fee-for-service agreements compensate wholesalers for providing data to drug makers in the form of EDI transaction documents.)

And as I understand the technology, enterprise systems such as Edge can then provide a tool for meeting the FDA’s goal of “secure business practices” in a way that data aggregation and reporting systems can not. Manufacturers with enterprise-level software can perform real-time analyses of the channel data to evaluate the suitability of wholesaler orders, balance inventory levels in the channel, prevent leakages into the secondary market, and limit unauthorized distribution. I presume that all transactions can be archived and available for auditing or use by law enforcement personnel.

On the other hand, pedigree and RFID vendors should start lowering their forecasts. The greatest demand for pedigree technology will be from smaller wholesalers and retail pharmacies with a wholesale license. These companies are least able to pay for technology, suggesting that pedigree technology vendors will have to create very inexpensive, easy-to-deploy solutions. Full enterprise pedigree systems will not take off but remain a niche market.

I also view this news as a blow to the RFID software and hardware vendors who have piled into the market. The FDA’s decision to lift the PDMA stay was widely (mis)interpreted as a mandate for RFID, which is was not. But RFID is not the same as pedigree. It is simply a means to an end, like all technologies.

Despite all of this reasoning, I fully expect hyperventilating opinion pieces to start spewing forth from the Florida media. I’ll post the more ludicrous ones as they appear.

Winners and Losers in the Zocor Wars

This week saw a new addition to the Dictionary of Pharmaceutical Business Strategy:

zocor (v)

1. To cause damage or pain to oneself that results in greater harm to a rival
2. To make a move that worsens one's short-term strategic advantage while simultaneously impairing a competitor's long-term advantage
   
   Example: Lighting McQueen chose to zocor himself in the Piston Cup Championship, thereby making winner Chick Hicks look ruthless and self-centered.

As reported by Heather Won Tesoriero at the Wall Street Journal, Merck will be selling Zocor at a lower price than the generic to major managed care companies, accelerating the market price decline of simvastatin.

Before PBMs and payers open the champagne for simvastatin's new lower pricing, they should consider the possible long-term effects on their business model if other pharmaceutical manufacturers decide to zocor their generic competitors.

Let's look at the winners and losers from this week's news.

Teva and Ranbaxy: Losers

Patents grant market exclusivity for a limited period of time, providing pharmaceutical manufacturers such as Merck with incentives to innovate by allowing them time to recoup their investment in R&D. The Hatch-Waxman Act provides an analogous 180-day period of marketing exclusivity for the first generic drug manufacturer to file an Abbreviated New Drug Application (ANDA).

Merck's pricing strategy now makes the 180 day exclusivity periods enjoyed by Teva and Ranbaxy worth a lot less. As the WSJ notes, "Merck's pricing strategy could set off a bidding war among generics manufacturers, which likely will have to slash their prices to maintain a foothold in the market for simvastatin, the generic name for Zocor."

Dr. Reddy's: Loser

Dr. Reddy's, whose authorized generic launched on Friday, will now end up with a lower market price than they expected when they signed up. I wonder how Merck's "partner" feels about this!

Merck: Winner

Unlike Merck's strategy, empirical research has found that pharmaceutical manufacturers typically increase prices after generic entry. (Click here to download a classic article on the topic.) This is a price discrimination story. Physicians or patients who are loyal to the brand are also less price sensitive, so the counter-intuitive, but logical, strategy is to extract as much revenue as possible during the period of generic penetration.

By pursuing the opposite strategy, Merck is accelerating the loss of sales for a $4.4 billion blockbuster. Since they would have lost the sales anyway, they get to capture extra revenue dollars that would have gone to the generic manufacturer.

PBMs: Winners or Losers?

The short-term effect of Merck's move is clearly beneficial because the market price of simvastatin will decline faster, consistent with FDA research showing a correlation between more generic competition and lower prices relative to a brand. Thus, PBM stocks rallied this week after falling in May when the original 180 day exclusivity period was announced.

However, the real risk comes from the long-term competitive effect on future ANDA filings. Will generic manufacturers be deterred in the future by the threat (real or implied) that the brand name competitor will reduce the value of the 180-day exclusivity period?

The FTC is currently studying the alleged anti-competitive effects of authorized generics such as Dr. Reddy's simvastatin. From the FTC's Federal Register notice in March:

"Many generic manufacturers assert, however, that in the long run, consumers will be harmed because an expectation of competition from authorized generics will significantly decrease the incentives of generic manufacturers to pursue entry prior to patent expiration. For a generic manufacturer, the additional competition from an authorized generic may result in significantly less profit during the period of 180-day exclusivity than if the generic manufacturer had no authorized-generic competition during that time."

PBMs have been able to deliver substantial value to payers through generic substitution and estimate that each 1 percentage point increase in generic fill rate decreases plan sponsors' pharmacy spend by 1 percent. (Click here for more details.) Gun-shy generic manufacturers will do long-term harm to PBM's ability to keep delivering savings.

So, is a dollar of savings today worth more than the chance that there won't be a dollar tomorrow? This is the real unknown behind Merck's strategy. I'll reserve public comment until I see the FTC's report.

Ka-Chow!

One more thing on Walgreen's

Today’s WSJ has a fascinating article about Walgreen’s success with Part D called “Getting an ‘A’ in Part D.”

My dead canaries post speculated on merger possibilities between chains and PBMs. This article provides some further supporting evidence. The WSJ article states:

“Part D reimbursement rates -- which are set by insurance companies but reviewed by the government -- vary widely but are usually so low that many independent pharmacies worry they will be put out of business. . . .Some small pharmacies, unable to pay their employees, already have closed their doors. Others are refusing to honor insurance plans with the lowest reimbursement rates.”

In other words, independents and small chain have to (a) play ball at lower rates, (b) lose business by turning away customers, or (c) shut down.

However, the tables are turned for a chain with strong store loyalty and a high share of outlets in a given geographic market. Leveraging countervailing power against payers allows the channel to extract adequate compensation for access to customers, creating another advantage under Part D for larger players.

These battles can continue indefinitely, as happens in many U.S. distribution channels. Walgreen’s role as PBM for UnitedHealth’s plan illustrates the alternative approach of vertical consolidation between channel and payer. No mandatory mail order here!

Walgreens' Future: I see dead canaries

Walgreens announced that it will not fill prescriptions for Midwest Health Plan, a small HMO based in Michigan. On the merits, this is not really big news. There are many other companies managing Medicaid plans in Michigan, so this is not a market-disrupting move. Walgreens is a distant third in the Detroit area behind CVS and Rite-Aid.

But I look at this small news item as another dead canary in the coming war for control of the last mile (last counter?) in the pharmacy supply chain -- and perhaps a harbinger of a future chain pharmacy /PBM merger.

Before you accuse me of starting a market-moving rumor (if only!), let's look at retail pharmacy today:

• Pharmacy continues to grow as a percent of sales at the large chains. (70% of sales CVS and 65% at Walgreens.) This trend will continue because both the prices and utilization of drugs are growing faster than band-aids, lipstick, candy, cigarettes, soda, and all the other CPG stuff in the front of the store. (Come to think of it, you'll be a good candidate for prescription drugs if you spend enough in the front-end of a pharmacy.)
• The big 3 PBMs now process more than half of all retail store prescriptions, effectively turning chain stores into a PBM-managed fulfillment channel. Add in Medicare Part D, and it sure looks like chains are losing control of their destiny.
• The channel is rapidly consolidating. Combined pharmacy sales for Walgreens and CVS were $56 billion in 2005, meaning these two chains accounted for 30% of all non-mail order retail prescriptions last year.

Both CVS and Walgreens are trying to grab market share as quickly as possible. Normally acquisition-shy Walgreens bought venerable regional chain Happy Harry's. CVS is looking for more acquisitions now that it has digested the Sav-On and Osco drugstores.

My take: retail chains want to control access to patients and gain the power to tax anyone who wants access, such as HMOs, PBMs or manufacturers. A more powerful downstream channel can demand that suppliers defray its costs, especially when higher margin content is delivered through lower margin channels. (For example, slotting fees for new products paid by CPG manufacturers in the supermarket industry.)

Walgreens continues to signal a willingness to rumble. GM and Walgreens parted ways last year when GM removed Walgreens from the pharmacy network for its 1 million employees and retirees. (Recall that the UAW and GM moved its members into mandatory mail order for chronic meds in 2004.) Walgreens also won't fill prescriptions for state employees in Ohio. In the Midwest Health Plan situation, Walgreens didn't get additional compensation to make up for Medicaid cuts, so they flexed their muscles.

Fear of the channel's power led Merck to buy Medco, but that was a poor fit because the businesses are so fundamentally different. Plus, everyone was skeptical about conflicts of interest when a manufacturer controls the formulary. ("Acquiring the hen house" strategy?)

But a retail/PBM combination seems much more logical to me. I estimate that the drug channel (wholesalers, retailers, PBMs, insurers) accounts for 30 cents of every U.S. retail pharmacy dollar. Managing drug costs will require directing consumers to the most efficient pharmacy channels. PBMs do this by dispensing via mail order, a highly profitable business (see my previous post. And don't forget that Walgreens and CVS have small PBM and mail order businesses, allowing them to learn how to connect these operations to their core.

The combined market cap of Medco, Caremark, and Express Scripts is roughly the same as Walgreens market cap. If PBM P/E ratios return to pre-2005 levels, they will be tempting targets for the retail chains.

Added bonus: Few pharma manufacturers are prepared for this scenario, in part because the Trade Relations department handles pharmacies while a separate Managed Markets/Contracting department deals with PBMs.

P.S. Any investment bankers reading this column should feel free to send me 1% of their fee if they do one of these deals.

FDA blind to the supply chain’s evolution

In a marvelous fluke of timing, the new FDA report on counterfeiting was released in the middle of last week’s Healthcare Distribution Management Association conference in Phoenix. The biggest news was the FDA’s decision lift the stay on the long-delayed PDMA, which is 172 days from implementation as of today.

I was at the HDMA meeting in Phoenix and talked with executives from the major drug makers and their wholesalers. The general consensus from my conversations is that the FDA made a good decision. (This post was almost called “HDMA OK with FDA Play on PDMA Stay.”)

I agree. The PDMA’s view of pedigree is much more sensible than the “all transactions, all the time, no matter what, or you’re in trouble, Buster” approach of Florida’s pedigree law. Hopefully, Gov. Bush will sign HB 371 before July 1 and inject some business reality into the Florida law. (BTW, the more I learn about HB 371, the more I like it.)

Nevertheless, I was extremely disappointed that the FDA did not acknowledge how much free market innovation has already improved the safety and security of the US drug distribution channel.

Page 25 of the original 2004 FDA report states: “For government efforts against counterfeit drugs to be successful, drug producers, distributors, and dispensers will have to take effective actions to secure their business practices.”

And guess what? The industry responded, driven as much by business concerns as by regulatory threats. Wholesalers such as AmerisourceBergen and Cardinal Health publicly renounced secondary market sourcing, the HDMA tightened its membership requirements, and major pharmacy chains such as CVS committed to secure sourcing.

In addition, manufacturers signed fee-for-service agreements with their wholesalers that limit product leakage into the grey market, closing a significant entry point for counterfeiters. Drug makers literally pay for greater product security by purchasing data from wholesalers to monitor orders, inventories, and product movement in real-time. Perhaps the FDA forgot to read my HBR article from last August or even the letter submitted by CVS.

But instead of encouraging further innovation in commercial practices, the FDA chooses to scold the industry for not meeting its unrealistic timeline behind track-and trace.

I laughed out loud when I read this zinger on page 11: “The technology vendors uniformly told us that their RFID and e-pedigree solutions and technologies are ready to go, but manufacturers, wholesalers, and retailers are slow to implement them.”

Don’t they recognize that a track-and-trace infrastructure can not be built without the solid foundation of secure business practices for the distribution channel? I guess it’s easier to blame companies for not spending enough money on premature solutions than to understand the real-world complexity of having 160,000 unique points of drug dispensing.

The U.S. drug distribution system has made enormous progress in reducing counterfeits by implementing new, more secure business practices. The FDA’s “disappointment” at RFID progress should have been tempered with acknowledgment of how far we have come in the past three years and a clear call for further innovation in channel management.

And if the FDA really cared about counterfeits, they would immediately prohibit all personal importation of drugs. Or did they already forget one of the conclusions reached by HHS’ Task Force on Drug Importation:

So-called “track and trace” technologies, such as radio-frequency identification (RFID) and sophisticated bar coding, can provide effective monitoring of a drug’s movement from the point of manufacture and through the U.S. distribution chain. Although these new and emerging technologies are promising, until they are fully adopted internationally they cannot be adequately relied upon to secure the safety, efficacy, and integrity of the global market to safely import prescription drugs into the U.S.

Should I start saving up for an at-home RFID scanner instead of a plasma TV?

McClellan and the magic AMP

Mark McClellan recently announced that CMS will postpone release of Average Manufacturer Price (AMP) data until later this year. Current AMP calculations were originally scheduled to be released on a website July 1. (The full text of his remarks is available from CMS here.) Note that an article on the speech inaccurately reported that CMS will be delaying the implementation of AMP-based reimbursement, which I do not believe that McClellan has the power to do.

This decision was prompted by a little-noticed OIG report released last week. Main conclusion: “Existing requirements for determining certain aspects of AMPs are not clear and comprehensive, and manufacturers’ methods of calculating AMPs are inconsistent.”

The best part of this report is the appendix with letters from pharmacy, wholesale, and manufacturer trade associations. (Where was PCMA?) My mind was reeling at the complex (and often contradictory) guidance provided by different parts of the drug channel. We can now look forward to some intense lobbying over the proper definition of AMP.

Regardless of the ultimate definition, I see AMP ultimately having a much bigger impact than many people expect. Here are a few predictions:

• Private payers will migrate to AMP-based pharmacy reimbursement.
• PBMs will find their profit model under pressure as payers gain visibility into spreads.
• Wholesalers, Retailers, and PBMs will battle for a fixed generic profit pie. (See my earlier post on generics.)
• “Class of trade” pricing difference will become standardized across manufacturers.
• Manufacturers will increase direct sales to self-warehousing pharmacy and mass market chains. See my September 2005 paper “Preparing for the Future of Retail Pharmacy Supply Chain” for my rationale.
• Manufacturers will reduce or eliminate prompt pay discounts by shifting this channel compensation to fees.

Suffice to say, I see AMP triggering some significant changes in business practices and sparking new competitive battles in the pharmaceutical industry. How come no one else is talking more about the follow-on impact of AMP?

The 3PL vs. Wholesale battle heats up

Some big news yesterday should make drug makers and their wholesalers sit up and take notice.

OTN just announced that UPS Supply Chain Solutions will be handling distribution for their oncology network. This is a MAJOR win for UPS, which opened a new facility for this purpose last year.

I think the UPS agreement also signals some broader risks for wholesalers. As forward-buying profits and other forms of indirect compensation fade away, drug wholesalers will increasingly find themselves on a collision course with logistics companies and large retail chains for control of the pharmaceutical supply chain. Logistics companies offer manufacturers much more control versus a traditional wholesale channel.

This move highlights the further integration of oncology care and specialty products distribution. Wholesalers either have to own their customer or risk disintermediation. Take a look at the intertwined channel arrangements at the top five community oncology GPOs:

• ION, the largest community oncology GPO, has an exclusive distribution arrangement with Oncology Supply. Both organizations are part of AmerisourceBergen’s Specialty Group.
• Onmark switched its business from McKesson to CAH in April. Onmark is part of OTN, the oncology distribution business owned by Bristol until last year. Three weeks later, Onmark’s parent company OTN acquired 80% ownership in Cardinal Health’s oncology distribution business.
• US Oncology ended its distribution agreements with Cardinal last year in favor of self-distribution.
• Matrix Oncology, a smaller GPO, is supplied by CuraScript. Both companies are part of PBM Express Scripts.
• In April, McKesson acquired National Oncology Alliance, one of the smaller GPOs in the market.

Self-distribution, whether by a large chain pharmacy or an oncology GPO, provides greater control along with new opportunities for supply chain integration. (See my September 2005 white paper for a deeper analysis of retail chains.)

Two big unknowns for this channel:

1. Genentech has narrowed the distribution channel for its blockbuster drugs Avastin, Rituxan, and Herceptin. Will other biotech manufacturers follow?
2. What will payors do now that specialty drug costs are going up more than 3 times the rate of overall spend?

Specialty spending keeps soaring

Medco's latest Drug Trends report points us toward the future of drug channels.

A few highlights that caught my attention:

• Specialty drugs accounted for 9.7% of total pharmacy spending in 2005, up from 8.5% in 2004.
  
• Specialty drug spending grew by 16.9% in 2005, significantly faster than the 5.4% average trend for drug spending as a whole.
  
• The rapid growth in specialty drug spending is primarily due to a large increase in utilization. However, unit costs for specialty drugs increased by 6.6% during 2005 vs. a 2.7% increase for prescription drugs as a whole.

Three therapeutic classes contributed more than 80% of the specialty increase:

1. Rheumatoid Arthritis (46.0%)
2. Cancer (19.2%)
3. Multiple Sclerosis (16.9%)

Crucial differences between conventional oral solids drugs and new biopharmaceuticals created the specialty pharmacy/distribution channel. Major differences for specialty, especiallylargeg molecule drugs:

• Cost (higher)
• Patient population (smaller)
• Handling (more complex)
• Reimbursement (trickier)
• Treatment location (much more diverse)

As I argued over two and half years ago, the big 3 wholesalers were so busy pursuing scale economies through consolidation that they ignored the opportunity to take a leadership position in the fast growing, higher margin business of bringing biopharmaceuticals to market. (See the transcript of my Lehman Brothers-sponsored conference call from January 2004, page 11.)

Today, McKesson is spending heavily to catch up, while Cardinal seems to be moving away from specialty. AmerisourceBergen has been best positioned because of the ION/Oncology Supply relationship and recently reported that specialty distribution is at an $8.5 billion run rate, equal to almost 17% of ABC's non-bulk drug distribution revenues.

I'll comment on what this means for the oncology channel tomorrow.