The new year probably can't begin soon enough for Diplomat Pharmacy (NYSE:DPLO) shareholders. Shares of the nation's largest independent specialty pharmacy have dropped over 50% so far in 2016. Can Diplomat turn things around in 2017? Maybe, but to do so the company will have to address a couple of key issues.
Diplomat got hit hard in the third quarter by a big increase in direct and indirect remuneration (DIR) fees. These DIR fees were originally intended to only reflect rebates for Medicare Part D prescription drugs. However, over time the term has grown to include an assortment of fees that payers and pharmacy benefits managers (PBMs) charge pharmacies.
The biggest problem for Diplomat and other specialty pharmacies is that some PBMs maintain that the DIR fees can't be determined at the time of claim adjudication. Instead, the fees sometimes won't be assessed until months later.
Diplomat's chief complaint is the lack of transparency in the process. The company was blindsided by the huge increases in DIR fees that hit during the third quarter (with many of the fees retroactive to the first quarter).
Interestingly, while the DIR fees were a major issue for Diplomat, the fees weren't mentioned at all by CVS Health (NYSE:CVS) or Express Scripts (NASDAQ:ESRX) in their third-quarter earnings calls. The companies operate the two largest specialty pharmacies in the U.S. Not coincidentally, they also operate the two largest PBMs in the country. The synergies between their specialty pharmacy and PBM businesses give CVS Health and Express Scripts a leg up on independent specialty pharmacies like Diplomat.
What can Diplomat do? The company has joined forces with others in the industry to lobby Congress. Legislation was recently introduced in both the U.S. Senate and the House of Representatives to improve transparency and prohibit retroactive DIR fees. Diplomat is also trying to figure out how it can best play the game as it stands right now. Something will have to give for the company to grow earnings significantly in 2017.
Hepatitis C weakness
Another major challenge for Diplomat is dealing with slowing hepatitis C drug sales. This is another area where CVS Health and Express Scripts have an advantage. Because of their PBM operations, the companies benefit from lower hepatitis C drug costs. For Diplomat, though, lower hep-C prices hurt the bottom line.
Growth of newer hepatitis C drugs, particularly Gilead Sciences' Epclusa, should help somewhat. The more important way that Diplomat can address the softness in hepatitis C sales, though, is by selling more new specialty drugs for other indications.
Oncology continues to be a strong point for Diplomat. It's the company's largest therapeutic category. Oncology sales soared 57% year over year in the third quarter, with 36% organic growth not due to acquisitions. Growth from new drugs and new indications for existing drugs should help Diplomat at least partially offset its hepatitis C woes.
Around half of the drugs currently in biotechs' pipelines fit well with Diplomat's core therapeutic categories. Even better, around 80% of the overall drug pipeline is being developed by small and mid-sized biotechs -- the ones that best match up with Diplomat's service offerings.
Diplomat Pharmacy should be able to turn things around over time. Will it happen in 2017? It's too soon to tell.
Bipartisan support for the legislation to prohibit retroactive DIR fees could be good news for Diplomat and other independent specialty pharmacies. Several U.S. senators and representatives are also putting pressure on the Centers for Medicare & Medicaid Services (CMS) to address the issue. Still, there's no way to know for sure what will happen in D.C.
I do expect some better news on the hepatitis C front. For one thing, my hunch is that the big hep-C sales drops experienced in 2016 will at least stabilize to some extent in 2017. Also, as mentioned earlier, new drugs from biotechs' pipelines should help Diplomat in the new year.
Still, Diplomat only projects flat to modest earnings growth next year. The specialty pharmacy's recovery could extend well into 2018 and beyond.