Express Scripts (NASDAQ: ESRX ) -- the largest pharmacy benefit manager, or PBM, in America -- is also one of the most important companies in the health care industry. PBMs fill approximately two-thirds of prescriptions in the United States, of which Express Scripts fills 1.4 billion annually. The company's position as the market leader, which it solidified last year with its $29.1 billion acquisition of Medco Health Solutions, gives it tremendous negotiating power with drug manufacturers and retail pharmacies.
How do PBMs work?
A PBM is a middleman that charges clients a discounted price from the retail price for prescriptions, then pays pharmacies a lower price to keep the difference. The wider the spread between these two prices, the higher its revenue. In addition, PBMs are often paid by drug manufacturers through rebates to include their drugs in the program.
This business model allows it to have enormous clout with drug manufacturers -- since they don't want to be cut off from consumers -- as well as drugstores, which rely on PBMs to generate steady retail pharmacy revenue. Some critics claim that PBMs are too powerful, and that Express Scripts' acquisition of Medco gives it far too much influence over drug choices and pricing for consumers and drugstores.
Novo Nordisk feels the pain
Recently, insulin specialist Novo Nordisk announced that it lost a major contract with Express Scripts to rival Eli Lilly (NYSE: LLY ) . Novo's stock dipped as analysts stated that the loss of Express Scripts could cause the Nordic company to miss profit targets.
Novo lost the contract with Express Scripts to provide diabetes treatments including its top-selling insulin NovoRapid and Victoza to Express Scripts. Victoza is a once-daily orally administered drug that mimics a hormone called GLP-1 to stimulate natural insulin production. Yet Express Scripts chose Bristol-Myers Squibb and AstraZeneca's Byetta and Bydureon over Victoza, and Lilly's insulin instead of NovoRapid.
The loss of the Express Scripts contract could decrease Novo's annual revenue by up to 2%. He also noted that it will now be "challenging" for Novo to hit its forecast for 15% EBITDA growth in fiscal 2014. DNB Markets analysts estimate that Express Scripts, with its 40 million to 50 million customers, accounted for 15% to 20% of Victoza's U.S. sales.
Sales of Victoza rose 32% year-over-year last quarter, but this latest setback could throttle the drug's growth for the rest of the year. Novo's struggle is a cautionary tale for other pharmaceutical companies -- sticking with a dominant PBM is a critical component of preserving revenue growth.
Yet Walgreen learns to smile again
As I stated earlier, PBMs like Express Scripts generate revenue from the spread between client payments and its payments to retail pharmacies. Therefore, lower payments to big pharmacies like Walgreen boost its sales.
Express Scripts' dominance of the drug market was challenged in 2011 when Walgreen, the largest drugstore chain in America, denied its request to lower the required payments. Instead of agreeing to the new terms, Walgreen terminated its long-running partnership with Express Scripts in 2012 in a high-stakes game of chicken.
Walgreen lost that challenge, as its Express Scripts customers -- which accounted for 80 million annual prescriptions -- flocked to CVS Caremark and Rite Aid, which announced that they would fill Express Scripts prescriptions during the dispute. As a result, Walgreen's prescription sales plunged 8.1% by the fourth quarter of 2012.
Realizing the error of its ways, Walgreen made amends with Express Scripts, agreed to its new terms, and resumed their partnership last September. Since then, the outlook for Walgreen has improved considerably. Walgreen recently announced that August sales had improved 5.6% over the previous year, and pharmacy sales had risen 6.4%. This marks Walgreen's sixth consecutive month of rising sales, and is a clear confirmation of the strength of Express Scripts.
The Foolish bottom line
By analyzing Express Scripts' relationships with pharma companies like Novo and Lilly, and its dominance of pharmacies like Walgreen, its easy to see why some critics are concerned that the company has too much clout and pricing power.
However, that power is precisely what makes Express Scripts a lucrative long-term investment. Although shares have remained fairly flat over the past year, the stock has climbed more than 80% over the past five years and nearly 800% over the past decade.
Pharmaceutical companies must curry Express Scripts' favor, pharmacies must agree to its prices, and consumers must choose from the rugs that it offers. With its acquisition of Medco last year, Express Scripts is now the 800-pound gorilla that sits at the center of the pharma universe -- and it's always a sound idea to invest in industry leaders.
Rising health care costs continue to be a hotly debated topic, and even legendary investor Warren Buffett called this trend "the tapeworm that's eating at American competitiveness." To learn more about what's happening to the health care system -- and how to potentially profit from this trend -- click here for free, immediate access.