Health-Care Reform Hits Drugmakers' (and Your) Pockets

Patients won't see many of the benefits of health-care reform for years -- mandated coverage for pre-existing conditions doesn't take effect until 2014, for instance -- but drug companies begin paying for the reform this year. In fact, some of the new required discounts are retroactive to the beginning of the year.

Now that drug companies have released their first-quarter financials, we have a good idea of how much the reform is costing them.

Sources: Company press releases and conference calls.

* Not meaningful because Pfizer did not report on a pro forma, combined-entity basis following the Wyeth merger.

** Merck reported pro forma, combined-entity total revenue, but not U.S.-only revenue following the Schering-Plough merger.

Most of the lost revenue comes from Medicaid, which is now entitled to a 23.1% discount off the average selling price of drugs, up from 15.1%. The number of entities entitled to the discount also increased by about 2,000 because hospitals treating certain patients -- children and those in rural areas, for instance -- now get a break on the price of drugs.

Some companies will also take a one-time hit to their GAAP earnings because they're no longer receiving a tax benefit for providing drug benefits for their retirees. But that's a non-cash charge, and the lack of a tax break certainly won't break the companies.

More ahead
Next year, additional costs are expected to hurt drugmakers when Medicare cuts kick in. Seniors enrolled in a Medicare drug program get coverage for a certain amount of drugs, and then they're on their own -- commonly referred to as the doughnut hole -- until catastrophic coverage kicks in. As part of the reform, drugmakers are required to give discounts to seniors while they're in the doughnut hole.

The discount isn't a complete loss for drugmakers, though. Some seniors simply stop taking medications when they have to start paying the full price on their own. From those patients, some revenue, even at a reduced gross margin, is better than nothing. There's also the potential of gaining full-priced sales when seniors leave the doughnut hole on the other side and the government picks up the cost again.

Run away
It's tempting to say that investors should focus on companies that have a large presence abroad, but that's not necessarily the answer, either. European governments often set the price of drugs, and with their budget woes, the price of drugs is headed in the wrong direction there, too.

The obvious solution to get around pricing discounts is to avoid the government -- all governments -- as much as possible. That's not easy for pharmaceuticals, but there are plenty of drugmakers that have expanded into related fields.

Over-the-counter products may not bring in a lot of revenue individually, but added up they can have a meaningful effect on revenue. The diversification, including launching an over-the-counter version of its allergy drug Allegra, was one of the reasons sanofi-aventis purchased Chattem.

Drug companies also have non-medical products on the store shelves. Merck and Johnson & Johnson sell sunscreen. And Abbott and GlaxoSmithKline sell nutrition products, which might be subject to a snack tax but are safe from price controls.

And there are plenty of drugmakers helping out four-legged patients. Pfizer's animal-health division got bigger after the acquisition of Wyeth, and Merck is so in love with Merial that it reacquired half of the company after letting it go to complete its acquisition of Schering-Plough.

How much should you really be worried?
At this point, I'm not sure that changes in government pricing are a reason to pick one drugmaker over another; new drug approvals will still rule the revenue growth charts. It's better to find a drugmaker that's growing revenue by 10% and taking a 4% hit from reduced drug prices than one whose diversification has helped deaden the hit to 2% but leaves revenue flat.

But Fools do need to keep an eye on pricing, especially in the U.S., where high margins are the norm. If forced discounts spread from government programs to private payers, you'll want to run from the sector as quickly as possible.