ABC/CAH/MCK: US Generic Inflation Continues in 1Q15

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Richard Evans / Scott Hinds / Ryan Baum

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@SSRHealth

April 21, 2015

ABC/CAH/MCK: US Generic Inflation Continues in 1Q15

  • On a sales-weighted basis, prices (paid by retailers) for US generics rose 4.7% in 1Q15, substantially faster than in 4Q14 (0.5%), and on par with the average pace of inflation (5.1%) seen since early 2013
  • All else held equal, generic price inflation aids the gross margins of drug wholesalers (e.g. ABC, CAH, MCK), thus the healthy generic inflation observed in 1Q15 is a bullish early indicator for these names’ 1Q15 results. Despite carefully trying, we observe no correlation between generic manufacturers’ participation in US price inflation and either the quality of their immediate earnings or their relative share price performances
  • In a February note we showed that US generic inflation isn’t about supply disruptions or small numbers of manufacturers producing the products whose prices inflate. Instead, we found two patterns: one in which manufacturers of products with very low prices inflated these products’ prices toward the median price for all generics (explaining ~75% of inflation); and, another in which manufacturers of products with median prices but very low volumes (and thus very modest sales) inflated these products’ prices beyond the median (explaining the remaining ~25% of inflation). Inflation in 1Q15 also is explained by these two patterns, thus whatever’s driving inflation continues apace
  • A plausible explanation is that generic manufacturers, having fallen to near historic low levels of financial performance (e.g. ROA, GM), are cooperating to raise the prices of products whose characteristics (low sales due to either very low prices or very low volumes) accommodate price inflation. An alternative and/or over-lapping explanation is that wholesalers, who benefit from generic inflation and who have recently taken responsibility for the majority of US generic purchasing, are at the very least passive with regard to generic inflation
  • If inflation is explained largely by strapped generic manufacturers cooperating, then it can’t last very long – the manufacturers’ financial results are improving, and the number of manufacturers required to cooperate is far too large for the cooperative spirit to remain stable
  • Conversely, to the extent generic inflation is the result of wholesalers’ actions, generic inflation is likely to continue until and unless such actions are challenged
  • We intend to publish an index of US generic inflation at least quarterly, and anticipate that as long as the inflationary trend continues, that US wholesalers’ gross margins will expand, with commensurate gains in earnings

Where we’re BULLISH: Biopharma companies with undervalued pipelines (e.g. VRTX, BMY, SNY, ROCHE); Biopharma companies with pending major product approvals (e.g. ALIOF, ALKS, AMGN, BDSI, EBS, ENDP, HLUYY, HSP, ICPT, JAZZ, NVS, PTCT, RLYP, RPRX, TSRO, UCBJY, UTHR, VRTX); ABBV and ENTA on sales prospects in Hep C; SNY on undervalued basal insulin franchise and sales potential for Praluent (alirocumab), in addition to its undervalued pipeline; AZN and LLY on the likelihood that excess SG&A/R&D spending must be reined in, in addition to pending major product approvals; CFN, BCR, CNMD and TFX on rising hospital patient volumes; XRAY and PDCO on rising dental patient volumes and rising average dollar values of dental products and services consumed per visit; CNC, MOH and WCG on bullish prospects for Medicaid HMOs; and, DVA and FMS for the likely gross margin effects of generic forms of Epogen

Where we’re BEARISH: Biopharma companies with overvalued pipelines (e.g. GILD, ALXN, SHPG, REGN, CELG, NVO, BIIB); PBMs facing loss of generic dispensing margin as the AWP pricing benchmark is replaced (e.g. ESRX, CTRX); Drug Retail as dispensing margins are pressured by narrowing retail networks and replacement of AWP (e.g. WBA, CVS, RAD); Research Tools & Services companies as growth expectations and valuations are too high in an environment of falling biopharma R&D spend (e.g. CRL, Q, ICLR); and, suppliers of capital equipment to hospitals on the likelihood hospitals over-invested in capital equipment before the roll-out of the Affordable Care Act (e.g. ISRG, EKTAY, HAE)

 

Overview

From February 2013 to April 8, 2015, sales-weighted average prices (paid by retailers) for generic prescription products rose by just over 47 percent (Exhibit 1). This is remarkable price inflation for any setting, never mind one in which the long-term norm is steady price deflation

Earlier this year we presented a comprehensive analysis of generic inflation over the period February 2013 – December 2014[1]. We utilized National Average Drug Acquisition Cost (NADAC) data to measure price, as unlike any other available benchmark they are a close reflection of drug retailers’ true acquisition costs, are available contemporaneously, and are available even for products with small numbers of manufacturers. We firstly divided the 2,891 generic prescription products into those with or without ‘excess inflation’, or ‘EI’, which we defined as monthly price growth of 30 percent or more at any point in the time series[2]. 744 of the 2,891 products met the EI criteria, accounting for 30% of retail generic prescriptions and 29% of retail generic sales. On a sales-weighted basis, these products accounted for over 100% of total inflation over the period, growing nearly five-fold in price versus a nearly 20% decline for products that did not meet the EI criteria

We found that three-quarters of inflation was driven by straightforward median reversion. Very low priced products were over-represented in the EI product group; and 593 of the 744 EI products simply took pricing actions that brought them within range of non-excess inflation (‘NEI’) median prices (Exhibit 2). We designated these excess inflation, median reverting products as ‘EI_MR’. The majority of EI prescriptions (96%), dollar sales (93%), and total sales-weighted inflation (75%) were accounted for by EI_MR products. The remaining 151 EI products took pricing actions that moved their prices well beyond a statistically reasonable range (> ~3x) of the peer median – we designated these excess inflation, non-median reverting products as ‘EI_nMR’

EI products tended to be older products with lower prices and higher prescription volumes than products without excess inflation. EI_MR products tended to be older products with sharply lower prices and higher prescription volumes than NEI products; while EI_nMR products tended to be very low volume products with average prices but well below average sales, and fewer manufacturers (Exhibit 3)

Continued inflation in 1Q15

We have updated our previous analysis to monitor retail generic inflation in the first quarter of 2015. Exhibit 4 shows sales-weighted total inflation of 4.7 percent in 1Q15, an acceleration over the previous quarter and just under the quarterly average pace of 5.1 percent since 2Q13

Recall that our 30 percent monthly price growth inclusion rule for EI products explained over 100 percent of total inflation from February 2013 to December 2014. If we maintain that rule, 140 of 2,926 generic products fall into this category for 1Q15; however their 34 percent sales-weighted inflation explains only 42 percent of total inflation in that quarter. Alternatively, if we consider that 1Q15 inflation was driven by less aggressive monthly price hikes and apply a revised 10 percent monthly price growth inclusion rule for EI products, these 620 EI products again account for more than 100 percent of inflation in the quarter (Exhibit 5). The original 30 percent monthly threshold was set to explain long-run inflation while mitigating considerable ‘normal’ price volatility in many other products; hence our finding may suggest that this normal volatility was a more important factor in this quarter’s inflation

Even when we apply the lower EI threshold, the products comprising the EI category in the most recent quarter still very much resemble the products that drove inflation from February 2013 to December 2014. Exhibit 6 shows that the majority of 1Q15 EI products, sales, and sales-weighted inflation was again driven by products increasing prices to within range of the universe median as opposed to far above it. In fact, 45 percent of sales-weighted inflation was driven by products that also were categorized as EI in our previous analysis, which plainly reinforces the belief that this quarter’s inflation patterns were in large part a continuation of the prior two years. These ‘legacy EI’ products specifically explained 42 percent of median reverting inflation and 62 percent of non-median reverting inflation in 1Q15. This appears to be due to non-monotonic inflation patterns and multiple successive price increases still within the range of the median in the EI_MR subset; and a continuation of more extreme pricing behavior in the EI_nMR subset

Challenging fundamentals for generic manufacturers are a plausible explanation, and displacement of AWP may be a catalyst

The median reverting (EI_MR) products that explain three-quarters of observed inflation had extremely low relative prices to begin with, and it’s obvious why manufacturers would want these prices to rise. It’s also clear that having so many product prices median revert in such a limited time frame is unusual – we know this because the median reversion seen since February of 2013 would have been large enough, on its own, to drive an unprecedented rate of inflation for the overall generic market. So while it’s clear manufacturers should want to increase prices on very low priced products, it’s not obvious why such an unprecedented wave of median reversion occurred over such a limited time frame

Conversely it’s not entirely clear whether inflation of the non-median reverting (EI_nMR) products’ prices is an unusual occurrence – had the EI_nMR pattern been the only driver of price growth in the period analyzed, overall generic inflation for the period would have been unremarkable. It is easy to understand why and how manufacturers would raise prices on the EI_nMR products – despite having more or less median prices to begin with, the EI_nMR products had very low sales (and by extension very low unit volumes), and fewer manufacturers. It’s obviously easier to raise prices when fewer manufacturers are involved; and, higher prices are less likely to result in either pressure from payers or entry by new competitors when overall sales levels remain quite small, even after large price increases

Our previous analysis sorted through the candidate explanations of supply disruptions, actions of dominant manufacturers, and / or simple need borne by present fundamentals. Taking them in turn, supply constraints would be expected to influence generic prices at retail in any of several ways. Gradual pressure on active pharmaceutical ingredient inputs to the manufacturing process would be expected to raise costs for all or most manufacturers, leading to a rise in generic prices to retailers. However in the presumably more common scenario of a more sudden / less predictable supply disruption, we would expect to see either or both of two effects on the TRx trend – TRx volumes would change abruptly; and/or one or more manufacturers of a given product would abruptly lose significant share of TRx’s for that product, whether or not overall TRx volume changed

We concluded that supply disruptions were a minor contributor to retail generic inflation over the period analyzed, and this remains true for inflation observed in 1Q15. The odds of a product with NO evident supply disruptions (as screened above) exhibiting excess inflation were significantly higher than the odds of a product WITH evident supply disruptions exhibiting excess inflation (33 percent v. 17 percent). Alternatively, while the odds of products on ASHP’s[3] shortage list exhibiting excess inflation were greater than the odds of products not on the list showing excess inflation (36 percent v. 24 percent), these ASHP-listed products nonetheless explained only 5 percent of total inflation from February 2013 to December 2014. In the most recent quarter, there was no significant difference in the odds of ASHP-listed and non-ASHP-listed products exhibiting excess inflation (22 percent v. 21 percent); and ASHP-listed products explained only 28 percent of total inflation

We also explored the possibility that inflation was driven by a subset of larger manufacturers, who by virtue of their scale might be expected to have relatively large amounts of seller power, at least as compared to the smaller manufacturers. To test this we compared the percentage of the total generic sample made by each manufacturer, to the percentage of EI_MR and EI_nMR products made by that manufacturer. Companies that are contributing more to inflation should have a larger percentage of their products in the EI_MR sample than in the total generic sample, and/or a larger percentage of their products in the EI_nMR sample than in the total generic sample. Exhibit 7 summarizes companies that manufacture at least 2 percent of the products in the total generic sample, and who manufacture at least a 1.2x greater percentage of products in either the EI_MR or EI_nMR categories. The column to the far right is a weighted average of the company’s ratio of EI_MR / total and EI_nMR / total

All of the companies in Exhibit 7 are over-represented in the EI categories as compared to their peers – nevertheless the picture simply is not one of larger manufacturers (presumably those with the most seller power) driving inflation. The seven companies that are most highly represented in the EI categories are very small – on average they make only 3.5% of the products in the generic sample. Conversely the three largest companies in the table – MYL, ENDP, and ABC – make only a modestly higher percentage of the products in the EI categories than they do of products in the total generic sample. We conclude that the overall generic inflation trend cannot be explained as one in which the larger manufacturers used their greater seller power to drive prices higher. Appendix 1 contains a summary of 1Q15 sales-weighted inflation for manufacturers deriving a significant portion of total revenues from US generics

Having ruled out these popular arguments, ultimately we’re backed into a plausible – if not compelling – alternative explanation: that an industry with weak sales and poor productivity has reached a collective understanding that price gains are, more than ever, very badly needed. Despite rapid inflation, sales growth for the generic manufacturers remains depressed (Exhibit 8); and ROA’s have generally remained below 3 percent for several years despite a rebound in ROA’s for the broader market since 2009 (Exhibit 9). In response, it appears the manufacturers may be cooperatively taking price gains where they are most readily available – older products with extremely low prices (EI_MR products), and very small (in sales terms) products made by relatively few manufacturers (EI_nMR products)

Lastly, we believe the steady displacement of the Average Wholesale Price (AWP) benchmark by more accurate benchmarks such as NADAC and Average Manufacturer Price (AMP) changes the incentives of parties in the generics supply chain, and certainly enables the observed inflationary trend. Because AWP bears no relation to actual acquisition costs, and does not move with actual acquisition costs, all players are motivated to acquire generics as cheaply as possible; i.e. the lower the acquisition cost, the greater the absolute dollar spread available from handling a given product. In contrast, NADAC does move with true acquisition costs, hence on a cost-plus basis, products with very low acquisition costs are likely to generate very low absolute spreads

No one benefits – either manufacturers or wholesalers – by driving the EI_MR products’ $0.29 pre-inflation average cost to $0.20, since under NADAC the absolute dollar spread for handling those products will fall proportionally. Conversely everyone benefits if the $0.29 average cost on the EI_MR products rises toward the median price of the broader market – which is precisely what occurred. NADAC is not yet the predominant pricing benchmark, but it’s steadily displacing AWP, and in all likelihood will eventually replace AWP entirely

If strapped makers of very low priced products are using pricing transparency to cooperatively shift the products’ prices higher, this raises the question of how far the process of cooperation will go. We believe it will go little further than the point at which price cooperating and price competing are equally attractive options. I.e., once rates of generic price growth and rates of return among generic manufacturers return to more tolerable levels, we doubt price cooperation goes much further. It could very well be that we’re approaching that point. ROA’s have improved modestly since the most recent round of generic inflation began (Exhibit 9, again), and this appears to be the by-product of pricing driven gains in gross and operating margins (Exhibits 10, 11)

  1. “Motive & Opportunity: The Convoluted Tale of Generic Price Inflation”, SSR Health LLC, February 9, 2015
  2. We recognize that 30 percent is a rather large threshold; however given the significant noise in generic prices over time this threshold is appropriate. Also we recognize that filtering on monthly price increases, rather than on price increases across the entire period of analysis, might miss products whose prices grew more gradually. Because the observed pricing actions tended to be abrupt rather than gradual, filtering on monthly price changes captures the great majority of products whose prices grew significantly during the period analyzed
  3. American Society of Health-System Pharmacists. The ASHP shortage list is generally more comprehensive than the list maintained by the FDA, hence its selection
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