Selling drugs has never been such a tough business. In the not-so-distant past, patients picked up their prescriptions at the most convenient drugstore and did not think very long about the price, since it was primarily paid by insurance. Unlike with automobiles and many other consumer products, the actual cost of the drug paid by the pharmacy, the wholesale price, was not disclosed. Moreover, prescription drugs never went on sale. You have seen hundreds of Lipitor commercials, but have you ever seen Lipitor on sale? Among the thousands of products advertised with sale prices in the Sunday newspaper, did you notice an ad with a sale price for a prescription drug? Selling prescription drugs has been a terrific business because few people thought about price and comparison-shopped.
Things changed in September, when the Godzilla of all retailers, Wal-Mart (NYSE: WMT ) , loudly announced that it would start selling a few hundred generic drugs for the bargain-basement price of $4 a month. As noted in a prior article, Target said it would match prices in the locations where the $4 generic drug program is starting. Kmart touted its existing plan in which patients can buy 90-day supplies for $15 as being a better program, since customers do not have to go to the store as often. Walgreen (NYSE: WAG ) , CVS (NYSE: CVS ) , and Rite Aid (NYSE: RAD ) did not match the program price and stated that they did not believe it would affect their business.
In October, First DataBank agreed to a tentative settlement of a lawsuit alleging that the company colluded with drug wholesaler McKesson (NYSE: MCK ) to systematically increase how much consumers paid for prescription drugs from 2002 through 2006. Drug pricing is more cryptic than Da Vinci Code clues. In short, prescription drug companies like Pfizer, Merck, and others do not disclose the price at which they sell their medications to drug wholesalers like McKesson. First DataBank filled this void of information by publishing a list of prices called the average wholesale price, or AWP. Pharmacies and pharmacy benefit managers (PBMs), middlemen and facilitators in the drug purchasing system, charge insurers roughly 15% less than the AWP for the prescription drugs that members fill.
Insiders joked that AWP really stood for "ain't what's paid," but no one knew how true that saying really was. The suit alleged that in 2002, First DataBank's published AWP jumped from 20% more than the acquisition cost, where it had been for years, to 25% more than the acquisition cost. The lawsuit alleges that the increase in pricing was influenced by McKesson, and the suit against the wholesaler continues.
Since pharmacies and PBMs were paying the same amount to drug manufacturers and wholesalers for the pills, but were charging more to customers and insurers, thanks to the increased AWP, their profits increased. Barbara Martinez in The Wall Street Journal reported that an economist hired by the plaintiffs felt that lowering the AWP back to 20% would save $4 billion, although the actual amount might be lower if pharmacies and PBMs negotiated higher fees. She also notes that Walgreen's net income has nearly doubled in the past five years, and CVS income tripled during that time.
As part of the proposed settlement, First DataBank will reduce many of the drugs' AWP from 25% to 20%, stop publishing its AWP in two years or less, and work with different stakeholders to establish benchmarks for drug pricing. In late October, PBM Express Scripts (Nasdaq: ESRX ) warned that the changes in the AWP calculations could reduce its profit margins, and its share prices slumped to reach a 52-week low.
The most surprising news yet was last week's news that CVS is buying PBM Caremark (NYSE: CMX ) for more than $21 billion. The new company, CVS/Caremark, will be a drug-selling leviathan with sales of $75 billion. The company plans to use its muscle to bargain for better deals from drug manufacturers and wholesalers.
But is just being Brobdingnagian enough to justify its market cap?
For starters, although CVS operates the most U.S. drugstores, Walgreen has nearly as many stores, greater sales, more profitability, and better name recognition. Walgreen has its own PBM, which serves some of Caremark's functions. As we discussed, First DataBank's reduction of the AWP will place downward pressure on future margins. Since the insurers were not aware of the increase in the AWP, they will be tougher negotiators on the next round.
And then there is Wal-Mart. Patients have asked me to check to see when the local Wal-Mart will be selling those $4 generic drugs locally. With Americans more and more conscious of health-care costs, companies that provide the lowest-cost drugs will have a big advantage. Sure, the new behemoth will gain bargaining power with drug companies, but how much greater will that power be relative to Walgreen or Wal-Mart? Everyday low drug prices may be good for patients, but not for the companies selling the medications.
Fool contributor Dr. Michael P. Cecil, M.D., is a cardiologist and the author of Drugs for Less: The Complete Guide to Free and Discounted Prescription Drugs. If you would like to discuss this article, email him at email@example.com. Dr. Cecil does not own any of the stocks mentioned in the article. The Fool has a disclosure policy.