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The pharmacy benefit manager (PBM) sector evolved significantly in 2019. S&P Global Ratings' outlook on the industry since the beginning of 2019 remains negative. In this report, we reflect on the industry turbulence from the plethora of regulatory proposals in 2019, offer our thoughts on the regulatory front in 2020, reiterate the increasing competitive gap between the scale and subscale PBMs, and predict heightened mergers and acquisitions (M&A) potential in the middle-market PBM segment in 2020.

Table 1

All Quiet On The Regulatory Front?

The PBM industry dodged all the regulatory bullets in 2019 (Chart 1). Investor concerns about the PBM business model stayed elevated since the U.S. Department of Health and Human Services' (HHS) January proposal to remove rebates in the government markets, which culminated in executives from the major PBMs testifying before Congress in April. The rebate rule was abruptly withdrawn by the administration in early July, a win for the industry.

However, uncertainties returned in late July, when two Senate committees presented bills addressing health care costs. Both contained damaging provisions targeting spread pricing, another revenue source for PBMs, in addition to provisions that could disrupt the Medicare Part B and Part D markets, which could have downstream impacts on PBMs. Neither bill gained enough traction.

Investors' fears spiked again in early December, with an updated health care bill by the House Committee on Energy and Commerce (E&C) and Senate Committee on Health, Education, Labor, and Pensions (HELP). It sought to eliminate spread pricing and require PBMs to pass 100% of rebates and discounts to plan sponsors. However, year-end government funding bills did not contain provisions that would have been damaging to PBMs, providing a sigh of relief for investors and capping a roller coaster year.

Chart 1

We have three predictions for PBMs on the regulatory front in 2020:

• We do not expect proposals to prohibit rebates to return any time soon. While there is much speculation about the reasons behind the rebate rule withdrawal, we think the most important factor is the potential for higher Medicare Part D premiums for seniors, because rebates are a way for plans to reduce costs. This is a very unpalatable message to deliver in an election year.
• We believe the only meaningful federal PBM-related proposal left is the updated Lower Health Care Costs Act (LHCC), which bans spread pricing and requires PBMs to pass 100% of any rebates or discounts to clients. Although the year-end appropriation bill punted on these issues, they could resurface in May 2020 when Congress has to address a few outstanding health care issues. (The appropriation bill extended the decision on how to fund a few health care programs until May 2020, at which time politicians will have to address them again.)
• And we fully expect some negative political rhetoric on the 2020 presidential campaign trail that could directly or indirectly affect the PBM industry. However, we believe the risk for meaningful legislation that could hinder the PBM industry is significantly reduced in an election year.

Three Points On Spread Pricing

Spread pricing is when a PBM charges a plan sponsor more for a drug than the PBM pays the pharmacy. A few regulatory proposals targeted this revenue source, and we offer our take on this issue.

First, we think there is limited political appetite to target spread pricing. The concept is less understandable for voters (more obscure than rebates). The Congressional Budget Office (CBO) projected only $1 billion in savings over the next 10 years if spread pricing is prohibited in Medicaid.

Second, we believe large PBMs (Caremark and OptumRx, in particular) have limited exposure to spread pricing contracts in state Medicaid markets. Within the commercial markets, all leading PBMs offer both spread-based and administrative fee-based contracts, and it is up to clients to choose.

Finally, we believe middle-market PBMs could have larger exposure to spread-based contracts, because their clients are smaller and prefer the certainty of knowing their own ingredient costs upfront.

Diverging Fortunes Between The Haves And The Have Nots

We do not expect rating pressure on UnitedHealth Group Inc. and, CVS Health Corp. They operate a diversified business are supported by strong parents' balance sheets. In 2020, we believe it is likely that larger PBMs will continue to grow at the expense of smaller competitors. Scale is the most important competitive advantage for PBMs, as the number of covered lives directly correlates to a PBM's ability to move market share and drive rebates from manufacturers (Chart 2). Now that the Big 3 PBMs are owned by insurers/pharmacies, they can offer even lower rates (because of scale), more services, or design more innovative risk-sharing arrangements with their customers.

That said, we are still monitoring certain aspects of their businesses. 2020 will be an execution year for CVS and Cigna. It is still too early to tell whether managing both medical and pharmacy benefits would be an effective client pitch and move market share. Most large sophisticated employers today still carve out pharmacy benefits from medical benefits (using an unaffiliated insurer to manage medical benefits and contracting directly with a PBM for pharmacy benefits). In addition, the Big 3 PBMs all have sizable pharmacy operations, which are facing unabated reimbursement pressure.

Chart 2

However, the three-year collaboration agreement between Prime Therapeutics and Express Scripts Inc./Cigna announced in December is an early sign that subscale PBMs acknowledge the unquestionable purchasing power of large-scale PBMs. Also, we think this announcement could mean that the concern that health plan clients may be reluctant to work with a PBM affiliated with a competing insurer because of conflicts of interests may be unwarranted. For background, Prime Therapeutics is the sixth-largest PBM, with 28 million covered lives and is owned by 14 Blue Cross/Blue Shield plans. Under the agreement, Express Scripts (75 million covered lives) will provide retail pharmacy network contracting services and manufacturer rebate contracting services to Prime under the pharmacy benefit, while Prime will continue negotiating for all drugs under the medical benefit.

Middle-Market PBMs: We Expect Consolidations In 2020

Middle-market PBMs risk falling further behind larger peers if they cannot gain scale. In our opinion, the biggest lesson of Diplomat Pharmacy's rapid downfall is the power of vertically integrated payers/PBMs to direct the most profitable prescriptions to their captive pharmacies. Reimbursement cuts and poor PBM strategy execution only exacerbated Diplomat's difficult situation.

As a result, we expect consolidation among middle-market PBMs in 2020, particularly with the lower regulatory overhang. These PBMs need to increase scale and diversify services to remain relevant in the market. Specifically, we think Carlyle-owned WellDyneRx LLC is in good position to scale up with the initial accounting issues behind it. In addition, we think family-owned MedImpact Holdings Inc. could be an acquirer after its contemplated divestiture of noncore business. EnvisionRx (owned by Rite Aid Corp.) has been rumored to be an acquisition target for many years amid Rite Aid's restructuring. Lastly, we also think UnitedHealth could divest the two small PBM assets gained through the acquisition of Diplomat Pharmacy. Acquisitions could increase leverage for these companies and put pressure on ratings.

Conclusion

We maintain our negative outlook on the PBM industry despite the removal of regulatory overhang plaguing the industry for most of 2019. The Big 3 PBMs are more insulated because of massive scale and ownership by stronger parents.

However, their acquisition theses to improve overall cost trends still must be proven out by market share gains. Middle-market PBMs will likely engage in M&A to boost scale and remain relevant, which could lead to rating pressure.

Related Research

• Rite Aid Corp. Senior Unsecured Note Rating Raised To 'CCC-' From 'D' Following Completion Of Cash Tender Offer, Dec. 20, 2019
• Full Analysis: UnitedHealth Group Inc., Dec. 20, 2019
• Full Analysis: Anthem Inc., Dec. 19, 2019
• Full Analysis: Cigna Corp., Dec. 18, 2019
• Full Analysis: MedImpact Holdings Inc., Aug. 30, 2019
• Full Analysis: Magellan Health Inc., Aug. 12, 2019
• Full Analysis: WD Wolverine Holdings LLC, July 17, 2019
• Full Analysis: CVS Health Corp., June 17, 2019