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Here’s How Drug Prices Actually Work

April 26, 2016, 7:12 PM UTC
Photograph by Spencer Platt Getty Images

Drug company investors may be worried about the industry’s wrong ailment.

On Wednesday, the soon-to-step-down CEO of controversial drug company Valeant Pharmaceuticals Michael Pearson is set to testify in front of a Senate panel investigating Valeant and other companies that have made a practice of increasing the prices of older drugs. Hedge fund manager Bill Ackman is scheduled to make an appearance as well.

Investors last year were spooked about the growing scrutiny by Washington and regulators on drug prices. But even as the Senate is digging in, the real problem for big pharma companies, like AstraZeneca, Pfizer, and Merck, may be that their ability to enforce higher prices has actually come to an end.

At least, that’s the view of recent research from consulting firm Bain & Co. Rising competition from generic drug companies are forcing the drug companies to offer bigger rebates on their drugs than ever, Bain found. For investors, though, it’s really difficult to tell how this is will affect the drug company’s future earnings.

“Rebating has become a standard practice for many drugs, but ever rising rebates are economically unsustainable,” Bain’s report says. “They also fuel the perception that the industry is pushing drug prices higher and higher by factoring in big discounts before they negotiate with payers and providers.”

Pharmaceutical pricing is complicated, but goes something like this: Drug companies like Pfizer (PFE) set the sticker price for their drug. They then negotiate prices on these drugs with insurance companies and vendors, like ExpressScripts (ESRX) that put them in the hands of patients. The higher-rebated drugs might move their way up a “drug formulary” list, meaning they are more likely to show up on a preferred benefit plan, and patients are more likely to buy them.

So when Pfizer is negotiating a deal with a vendor, they give a big “rebate.” It has two benefits: Sticker prices appear to remain high, and continue to rise. Rebates give them priority.

It “creates less transparency in the system,” says Roger Sawhney, partner in Bain’s healthcare practice and author of a recent report on the topic. They “offer less to some payers and more to others.”

The rush to cut the cost of drugs has quickened as generic drugs have made gains in the pharmaceutical business. According to research from McKinsey & Company, net revenue of generic drugs grew 8% per year between 2009 and 2012, 1.5 times faster than drugs of the companies that originally patented them. Returns to shareholders of generic drug companies have been bigger too—5.8% versus 5.4% for Big Pharma.

Once a drug goes off patent, multiple other producers can come into the market. Prices can go down 90%-to-95% in the first six months, says Sawhney. As a result, these rebates skyrocket. Rebates for AstraZeneca (AZNCF) have gone to 57% from 30% in 2007, according to Bain’s research. Novo Nordisk has jump to 47% rebates, from 32%. Merck (MRK) has gone to 32% from 13%. Pfizer’s rebates are 31%, up from 17%.

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“Leading pharma companies have offered rebates for some products that cut revenue by nearly 50% or more, sharply compressing margins,” the Bain report says.

According to Pratap Khedkar, managing principal and global head of the pharmaceutical practice at sales and marketing firm ZS, believes that rebates cut as much as $60 billion out of the drug industry’s sales, up from $40 billion in 2012. He attributes strong competition and tough negotiations with insurance companies on rebates.

The trouble is that no company reports this number for a single drug, and a single pharmaceutical company can have hundreds of medications. Some drugs are currently more competitive than others, like diabetes inhibitors and inhalers for chronic obstructive pulmonary disease. But for an investor, it’s hard to know exactly which drugs are being affected, and how much. It’s a “hidden cost,” Sawhney says.

Over the past two years, stock prices of large pharmaceutical prices like Merck and Pfizer have been stagnant. Part of the problem is this dynamic. For example, “while Pfizer holds a diversified product portfolio there is some product concentration with the company’s largest drug Lyrica representing 6% of total sales,” says Morningstar analyst Damien Conover in a recent report. Imagine what happens to Lyrica’s revenue once it starts handing out bigger rebates.