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Using CVS’s 2018 10-K reports to the SEC and its 2018 Drug Trend Report, we convert its PBM segment (a.k.a. Caremark) reseller gross profits business model to a single transparent fee-for-service expressed in terms of dollars per member per year (PMPY).

We end this paper with a cautionary note to those looking to disrupt the Big 3 PBMs via a transparent FFS business model. It begins with the reminder that total pharmacy 2 benefit costs is the sum of FFS for managing the benefit plus trend delivered as measured by PMPY.

It is certainly possible to compete with the Big 3 PBMs by offering a lower, transparent FFS to their opaque gross profits converted to a PMPY FFS equivalent. But, it will be hard for smaller PBMs to compete with them on trend. 


This is because however misaligned the Big 3 PBM formularies are -- preferring high list brands over lower net price therapeutic equivalents -- the Big 3 rebate bargaining power exercised in aligned formulary choices -- choosing lowest net price among equivalents -- is sufficient to overcome this power exercised in misaligned choices -- choosing highest list price but not lowest net price equivalents.

We present the case that there has been three distinct phases of the pharmacy benefit manager (PBM) business model over the past 15 years. Each phase has been demarcated by a major shift in the dominant source of gross profits.


It is instructive to understand why PBMs had to recalibrate their business model twice now in the last 15 years. In today’s terminology, what “disrupted” this powerful cartel? Our examination of recent history suggests that government regulations and lawsuits have had little impact on PBM decisions to change their business model. Rather, our view is that the disruptors have been “rent-seekers” whose business models were not in alignment with the rest of the cartel. This included the emergence of a vertically integrated PBM in the form of CVS-Caremark and the powerful outsider Walmart with a business model that allowed for the retail pharmacy to be a “loss-leader”.

Consider this meta:  CVS opaquely is substituting one opaque source of gross profits -- guaranteed net cost markup -- for another opaque source -- retained rebates.

The pharmacy benefit manager (PBM) CVS Caremark has offered its self-insured corporate clients an alternative business model called “Guaranteed Net Cost”.  The pricing scheme features 100% pass-through of drug rebates and the end of rebate retention as an opaque source of PBM  gross profits.  

But, CVS has glossed over the fact that their “guaranteed net cost” price to plans is not the same as the net costs to them.  Until CVS tells us otherwise, the new business model allows for a opaque markup on top of PBM net cost.  In graphs below, we demonstrate how a markup of guaranteed net costs serves as an opaque offset to foregone rebate retention.  

Opportunity: Misaligned Big 3 PBM (Express Scripts, CVS Caremark, OptumRx) business model dependent on retained rebates resulting in PBM national formularies that are far from cost-effective. (see founder’s 15-year analysis of PBM misalignment at ) 

Value Proposition: ● Misaligned national formularies of the Big 3 PBMs which are uncritically adopted by plan sponsors. ● Deliver 10%-plus incremental drug trend dollar reduction via changes to client’s PBM-generated formulary in four targeted therapeutic classes and via exclusion of scores of individual high-priced orphan drugs and off-patent brand drugs. ● Total PMPY Rx Spend — $1,100 (source Express Scripts Trend Report 2016) ● Our Target 20% trend reduction – $220 PMPY (per member per year)

The purpose of this paper is to present the case that the difference in profitability between Wellpoint’s PBM business and other PBM operations stems more from differences in business models than from differences in the efficiency of operations. And Express Scripts is paying a premium for Wellpoint’s business on the expectation that it will be able to convert (“decapitate”) some of Wellpoint’s fixed premium and ASO plans to more profitable benefits reseller plans.

Searching 10-Ks for Windfall Profits from a Change in AWP-Markup Ratio

Outlined mark-up sequences in the supply chain, but could not easily find windfall-profits 

From a look at 10-Qs of PBMs

On April 13th 2009, Express Scripts, the third largest independent pharmacy benefit manager (PBM), acquired the captive PBM business of Wellpoint, one of the largest integrated healthcare insurance companies and the largest Blue Cross Blue Shield (BCBS) licensee in the United States. The deal was for $4.675 Billion, little of which was for the rights to physical assets and human capital. Most of Express Scripts’ valuation was based on obtaining a 10 year contract to service the 25 million people, and their 265 million prescriptions, currently managed by Wellpoint’s PBM.


The purpose of this paper is to present the case that this merger would be anti-competitive as measured by increases in risk-adjusted prices paid by plan sponsors and their members for pharmacy benefits. The Federal Trade Commission should not allow this merger to close without an extensive investigation.

The purpose of this paper is to present the case that the difference in profitability between Wellpoint’s PBM business and other PBM operations stems more from differences in business models than from differences in the efficiency of operations. And Express Scripts is paying a premium for Wellpoint’s business on the expectation that it will be able to convert (“decapitate”) some of Wellpoint’s fixed premium and ASO plans to more profitable benefits reseller plans.


Medco has touted its business model as being aligned with the interests of plan sponsors, who obviously prefer that its members use cheaper, therapeutically equivalent, generics instead of more costly brands. Previously, we analyzed Medco’s alignment claim by recasting 2002-3 data gathered by the FTC for their study of PBM conflict of interest. 


 By combining FTC estimates of unit margins by drug type and channel with our estimates of script share by drug type and channel, we found that only 38.9% of gross profits of large independent PBMs were derived from generics. 


Our update presented above now finds that Medco generates 58.4% of gross profits from generics.

Medco has chosen medicine therapy management (MTM) as the focus of new business development. While this makes sense in terms leveraging Medco’s existing infrastructure and customer base, we will show that the MTM business would be a stretch for its revenue model and value proposition.


 We estimate that the fees now charged for a typical MTM program would double to quadruple the total fees that Medco currently charges for all of its PBM services. 


Medco will attempt to win new MTM business by covering low ball MTM fees with transactional margins generated by its personnel who steer MTM members to Medco captive pharmacies and to PolyMedica, its newly acquired diabetic supply operation. Its long term strategy is to dominate the disease management business generally using the same deceptive pricing strategy.

A disaggregation of CVS’s income statement for the last six years is presented to support the contention that there is a significant disparity in operating income of CVS’s pharmacy business versus the rest of its business known as the front store. 


We contend that CVS has sought out this merger in order to motivate Caremark to name CVS as its exclusive retail preferred provider. This would help CVS weather a new era of price competition by generating greater traffic without store expansion to offset lower margins on retail prescriptions. 

By comparing state maps of drugstore concentration with maps of the dominant healthcare plan by state, it is possible to derive a number of insights into the coming drugstore preferred provider war: 


(1) The pairing of CVS and Caremark makes sense, but the merger seems defensive r rather than designed to expand CVS’s share in swing states.


 (2) Rite-Aid will be the biggest loser of market share. Second will be supermarket pharmacies. Community pharmacies are still needed to satisfy coverage requirements and will not lose market share. 


(3) Walgreen does not need to partner with any of the Big 3 PBMs to win the coming preferred provider war. 


(4) WellPoint is the single most important strategic partner of the war.

The CVS-Caremark merger is supposedly a merger of equals based on the prospects of greater purchasing power. But, really it will be Caremark attempting to save CVS as it transitions its business model from being dependent on a profitable pharmacy operation subsidizing a front store with low to nil net profits. 


This merger is an attempt to cope with a new era of “competition by price” replacing an era of “competition by convenience”. The tipping point has been the Wal-Mart announcement and the First Databank admission of an arbitrary increase in the AWP mark-up ratio. These recent events will trigger demands by plan sponsors that their PBM vendor negotiate steeper discounts with retail pharmacies. No longer will PBMs be allowed to “hold up” retail reimbursements so as to make it easy to show that their captive mail order operations are cheaper.

A statistical comparison of the business models of Express Scripts and Medco is presented. While both have similar rebates retention rates, Medco extracts significantly higher rebates per prescription. The source of the difference is due to different approaches to formulary compliance, rather than formulary design. We present the case that Medco appears to abstain more from discretionary brand to generic therapeutic interchange than Express Scripts


 If any PBM is committing “sins of omission”, it is Medco.

Pharmacy benefit managers (PBMs) engage in exclusionary practices favoring their own captive mail order pharmacies. They justify this practice by pointing to mail order’s price superiority to retail pharmacy outlets. We will present evidence from two sources indicating that the second largest independent PBM, Medco Health Solutions, has been pricing brand drugs dispensed from its mail order pharmacy at, or near, acquisition costs. While these prices are significantly below retail levels, they cannot be said to be competitive until the possibility of recoupment elsewhere is investigated. 


The true value of captive mail order to PBMs is not as a source of dispensing and procurement efficiencies, but as source of cost containment achieved by through retrospective therapeutic interchange and enhanced power to extract rebates from brand name drug manufacturers. By recasting Medco’s margins by revenue “driver” rather than by revenue source, we demonstrate that mail order gross profit margins are in the competitive range of 7% -- neither too high nor too low. This means that Medco is within the “rule of reason” of antitrust law. 


Still, market forces are at work to counter Medco’s pricing strategy. Customers are demanding a more transparent business model with 100% pass-through of rebates. This will require Medco to raise mail order prices to compensate for these losses, thus undermining the justification for exclusionary practices such as mandatory mail order and mail order only 90-day prescriptions. Furthermore, the trend toward transparency will provide new opportunities for independent mail order pharmacies that heretofore have been relegated to niche markets.

In an effort to make its business model more transparent, Medco Health Solutions, the 2nd largest independent pharmacy benefit manager, first disclosed in 3Q2004 that its rebate retention rate was 40.5%. In the nine months since disclosure, Medco has allowed its rebate retention rate to drop to 28.1% and it has seen rebate’s share of gross profits decline from 71.7% to 48.0%. Yet, Medco has been able to maintain its overall gross profit margin by moving toward cost-basing pricing for its captive mail order operations and claims processing. 


While the transition has been smooth so far, the stage has been set for disruptions after 2006. The rise in mail order prices has weakened Medco’s justification for exclusionary practices favoring its captive mail order operations. In 2006, there will be a significant number of rebate generating brand drugs that will lose their patent protection. Medco cannot continually recover rebates losses by increasing service-based fees. It will be forced to levy significant management fees based on headcount or the number of prescriptions processed. Medco will be challenged after 2006 to retain market share as it begins to offer contracts with significant management fees that can easily be compared to rivals’ offers

In an effort to make its business model more transparent to investors and customers, Medco Health Solutions, Inc. released new detail on drug manufacturer rebate receipts during the third quarter of 2004. 


Based on a theory of market share rebates as exclusionary, rather than share-shifting, devices, we have estimated that Medco has a rebate negotiation competitive advantage over smaller entities equal to 4.8% of all ingredient costs. That figure is an estimate of the cost to clients of switching to entities with more transparent business models.


In order to offset that loss, smaller entities would have to manage formularies aggressively and produce a generic utilization rate that is 4.8 percentage points greater than Medco’s current 46.8%

The purpose of this paper is to raise the transparency issue with regard to a major institution in the pharmaceutical supply chain – Walgreens – the dominant retail chain drugstore in the country. The key result is that in 2003, there was considerable disparity between the net profitability of Walgreens front store operations – 1.4 % -- and the net profitability of its pharmacy operations – 8.3%. 


The front store drives a disproportionate share of Walgreens labor and occupancy operating expenses – 61.5% -- versus 38.5% for the pharmacy operation. Even though the front store enjoys a higher gross profit margin than the pharmacy – 36.1% versus 21.6% -- it incurs an even greater operating expense margin – 34.6% versus 13.3%. 


This disparity may be interpreted as a cross-subsidy and that this may become an issue as Medicare is extended to cover outpatient prescriptions of the elderly.

The purpose of this paper is to estimate the rebate-retention rate of pharmacy benefit managers (PBMs).  The rebate-retention rate is the ratio of net rebates retained to gross rebates received from drug manufacturers. What isn’t retained is passed on to health care plan sponsors. 


A different estimating approach is required for each component of this ratio. For a variety of reasons, PBMs want to keep this rate a secret and normally bury these figures in aggregate financial statements disclosed to the public.


Recently, Express Scripts, Inc, the second largest independent PBM, changed how it accounted for rebates. This presented a unique opportunity to cut the estimating effort in half because the company was required to disclose gross rebates received for the past three years. 


Based in part on this data, we have estimated the rebate-retention rate for Express Scripts to be 31.5%, 35.0%, and 38.0% for fiscal years 2000, 2001 and 2002, respectively.

About the author:

I have a B.A. in Economics from Amherst College

and a Ph.D. in Economics from Washington University in St. Louis.

I am retired and post often on twitter @larrywabrams on isslues relating

to PBMs, biosimilars, biotech and high tech stocks in my portfolio

and issues relating to North Monterey County, California where I reside.

My writings are at the intersection of economics, accounting, financial

fanalysis, and high tech.  I have received no remuneration for these articles

and have no financial relation with any company written about in these articles.

In 2002, I started looking at the 10-Qs and 10-Ks of the drug store chains and pharmacy benefit managers

after an "aha moment" in a Mountain View CA.  Longs Drug store (later bought out by CVS). 

I had gone there to to pick-up my renewal Rx of Type 2 diabetes drug Glucophage. 


Several things happened that night piqued my interest in PBMs and big drug store chains. 


First, I found out my Rx for Glucophage was now an Rx for Metformin without my prior knowledge. 

I asked the pharmacist what was going on.  He mentioned that my Rx now had a cheaper generic available

and my drug benefit plan manager made the switch automatically.

That night I was also struck by the fact that here was a 12,000 square feet store and all the customers were lined up

at the pharmacy counter in the back.  I asked myself,  "Could it be that hole in the wall in the back generated

all the profits while the front store was just a relic of the bygone days of lunch counters and shopping on Main Street?

The question of relative source of pre-tax profits -- pharmacy vs front store  -- piqued my interest all the more

as I compared the pathetic merchandising I saw in this big drug store chain versus the amazing health product

merchandising I saw a week earlier at the first Whole Foods store on the West Coast in downtown Palo Alto, CA.

Lawrence W. Abrams, Ph.D. Economist
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