ESRX-MHS: Antitrust Issues (2 of 3)

Welcome to Part 2 of my musings about the merger of Express Scripts (NASDAQ:ESRX) and Medco Health Solutions (NYSE:MHS). Here's the schedule:

Part 1: Strategic and Market Analysis (yesterday)
Part 2: Antitrust Issues (today)
Part 3: Second-Order Effects on Wholesalers, Other PBMs, and Walgreen (tomorrow)

Right now, I give the deal a 60% chance of being approved by the Federal Trade Commission. It’s going to be a very tough fight for antitrust approval, but perhaps not for the reasons you think.

The Agreement and Plan of Merger filed on Friday gives us a peek at the companies’ strategy for clearing the antitrust hurdles. But note that there is no termination fee if the companies don’t get antitrust clearance.

As I mentioned yesterday, I can only scratch the surface of the antitrust analysis on Drug Channels. Pembroke Consulting clients and Gerson Lehrman Group clients should feel free to schedule phone calls with me for additional comments beyond what I discuss below.

ANTITRUST BACKGROUND

The Horizontal Merger Guidelines (HMG) document published by the Federal Trade Commission (FTC) and Department of Justice (DOJ) provides a nice, concise overview of how the agencies will review the deal.

There's no doubt that the ESRX-MHS merger will get a lot of scrutiny because of the projected increase in the Herfindahl–Hirschman Index (HHI). (See page 19 of the HMG.) However, an HHI analysis is not sufficient to conclude that the merger will or will not succeed, as I discuss below.

If the HMG is too wonky, then the FTC has a fun (?) online cartoon that explains "how competition helps you get more for your buck at the mall". Actual, no-kidding, screen grab below. Can't wait to share this site with my kids when they get back from summer camp!

THE FAKE ANTITRUST ISSUE

The NCPA came out slinging mud in Pharmacists: Proposed Express Scripts-Medco Merger Would Reduce Competition and Raise Health Care Costs. Ironically, they encouraged the FTC to block the deal on anti-competitive grounds while simultaneously arguing in favor of legislation that would waive anti-trust laws so pharmacies could collude. Whatever.

NACDS joined NCPA in issuing a joint statement in NCPA, NACDS Issue Joint Statement to Oppose Express Scripts, Medco Deal: “Too Big To Play Fair”, stating that: “This combination will monopolize control of the supply line for brand and generic drugs…”

Alas, their complaints about "monopoly power" are misguided when describing the relationship between a PBM and pharmacies, manufacturers, or wholesalers. These organizations are not customers of a PBM in the context of the supply chain. They are sellers of goods or services. See the chart in my Strategic and Market Analysis post.

Forgive my economics geekiness, but the appropriate word here is oligopsony—a market in which there are many sellers but few buyers. Sellers in a oligopsonistic market are understandably concerned about their own self-interest when market power becomes more concentrated with fewer, larger buyers.

The FTC recognizes that an oligopsonistic market structure can be pro-competitive and favorable for customers, as the agency pointed out in its statement on the Caremark/Advance PCS deal:

"We also considered whether the proposed acquisition would confer monopsony (or oligopsony) power on PBMs when they negotiate dispensing fees with retail pharmacies. It is important not to equate market concentration on the buyer side with this kind of power. For example, a shift in purchases from an existing source to a lower-cost, more efficient source is not an exercise of monopsony power. Nor do competition and consumers suffer when the increased bargaining power of large buyers allows them to obtain lower input prices without decreasing overall input purchases. This bargaining power is procompetitive when it allows the buyer to reduce its costs and decrease prices to its customers."

Pharmaceutical manufacturers and pharmacies won't like this reasoning, but shouldn't be surprised when the FTC brings it up. (BTW, don't shoot the messenger, OK?)

THE REAL ANTITRUST QUESTIONS

The real antitrust questions for the FTC will derive from potential market power issues facing customers of a PBM—the plan sponsors or third-party payers.

The key question: Will competition remain strong enough to ensure that a portion of any cost savings (from bargaining power or efficiencies) get passed through to plan sponsors?

National market share is less relevant given the competitive dynamics of the PBM industry, which is why I am skeptical of the Herfindahl–Hirschman Index (HHI) analyses being put forth by Wall Street analysts.

Instead, I expect the FTC to examine the key question above on a market-by-market basis. The FTC is likely to look separately at the large employer/plan market, regional health plans, mid-market employers, and other PBM client markets.

A few representative questions should give you the flavor of their inquiries:

• Will there be enough competition for the business of large employers and large health plans with only two large PBMs?
• Will health plans view in-house PBMs as a more viable option (such as Cigna and Humana)?
• Will health plans be willing and able to create new jointly-owned PBMs (such as the Blues did with Prime Therapeutics)?
  
• Will OptumRx or Prime Therapeutics use the merger as an opportunity to go beyond their in-house customers and compete for the big deals as a third option?
• Will the mid-market PBMs step up to the next-level opportunities?

I haven’t seen any official public statements from PBM customer associations such as AHIP or BCBSA, but it’s still early in the game. If these type of groups vigorously oppose the deal, then it's unlikely to be approved.

FYI, I'll talk more about the other PBMs in tomorrow's post.

WHAT IF?

The companies certainly don’t view FTC approval as a slam dunk. For one thing, there's no termination fee linked to the failure to get antitrust approval.

Section 5.8(e) (page 68) of the Agreement and Plan of Merger lays out the steps that Express Scripts has already agreed to take to get the deal through the FTC:

• Divest or dispose of one mail order dispensing facility (except the Express Scripts facility in St. Louis, MO)
• Divest or dispose of a specialty pharmacy or infusion facility having a net book value less than $30 million (except the Express Scripts facility in Indianapolis, IN)
• Dump contracts with collective EBITDA less than $115 million in the previous 12 months (as long as these contracts have less than 35 million adjusted prescription claims in aggregate)

In the meantime, don’t be surprised if another bidder jumps into the fray—a scenario that is explicitly contemplated in the deal document.