Selling Drugs Is Harder Than It Looks

We believe the moaty nature of the pharmaceutical supply chain and the formidable competitive advantages that have insulated its major players could be underappreciated. Potential new competitors would face significant headwinds trying to break into any vertical along the chain, because the dynamics of the drug market are very difficult to navigate.

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In addition, the true end customer isn’t the drug consumer, but rather the insurer/employer/government that pays for the consumer’s health benefits. Accordingly, the expertise needed to profitably navigate the space precludes an easy entrance into the arena.

We think market participants and other stakeholders overlook three key variables when they analyze the potential for meaningful new competition in the pharmaceutical market.

Customers. The true customers along the chain are businesses and other providers of health benefits, not consumers. Providers of health benefits make almost all decisions regarding drug and pharmacy access. Businesses also source and supply all drugs in partnership together. This business-to-business market has developed because the use of drugs is health-insurance-based to treat medical ailments, not a consumer-demand cash-pay market. We estimate that less than 5% of all prescriptions are paid by the consumer directly on a cash-pay basis, or without insurance. This dynamic would take many consumer-based companies that have built their success in a consumer-demand-driven market outside of their core competencies if they were to get involved in the pharmaceutical space.

The price of pharmaceuticals. Drug pricing is the highest-profile issue in the pharmaceutical industry, and the perception is that new entrants, Amazon in particular, can instantly enter the space and cut the price of drug products. However, the actual prices of drugs are already low, given the massive amount of buying power the PBMs, drug wholesalers, and retail pharmacies have accumulated. A new entrant would hold a minuscule amount of purchasing power compared with the massive joint sourcing ventures that have developed over the last handful of years. Thus, the level of generic drug discounts and branded drug rebates a new entrant could command would pale in comparison with the major pharma supply chain players and make it difficult to be price-competitive.

Access to a global supply of drugs. To be a viable player in the PBM, pharma wholesaling, or retail pharmacy space, access to every legitimate drug is required. Because of the variability and demands of health insurance products, a viable pharma player needs to be able to have access to the plethora of drugs that are manufactured across the world. This level of access has been achieved by the major drug market companies, and if a new entrant cannot reach this level, it will not be an option for the clear majority of drug benefit providers, sellers, and purchasers of pharmaceuticals.

Consumers Aren't the True Customers The consumers of drugs do not choose which pharmaceuticals to use to treat their illness, and they have restricted choices on where to fill their prescriptions. These aspects of consumer choice are determined by providers of health benefits, as they seek to manage their plans according to how they have underwritten for risk. This dynamic means all parts of the pharmaceutical supply chain are a business-to-business market that falls outside of how Amazon has historically built its business-to-consumer success.

The major PBMs sell their services to thousands of health benefit providers, with the vast majority being insurance companies, businesses, and large government-sponsored health plans (Tricare, the federal employees program, Medicaid). Most of these entities do not view the consumer experience as a top priority, but rather maximizing positive treatment outcomes for their members at the lowest costs.

A new competitor would have to build the expertise to effectively service these large sophisticated clients and gain their trust that it can execute the various PBM services at a high level. This is a tough task for a new entrant, especially since the PBM submarket is dominated by a three-company oligopoly. Additionally, we believe health benefit providers would be hesitant to trust a new and unproven PBM with the critical drug treatment of their members. From our perspective, the perceived risk would outweigh any potential benefit.

The distribution of pharmaceuticals is quite a bit more nuanced and integrated than most other distribution-based businesses.

We believe cultivating these relationships would be a tough task for any potential new drug distributor. The sourcing and delivery of pharmaceuticals are only part of the services that are required of wholesalers. The efficient integration with all clients from both sides of the supply chain is a critical element that a company like Amazon would be challenged to replicate.

Approximately 95%-98% of pharmacy revenue is derived from businesses, with most of this from PBMs. Individual consumers don’t have a choice as to where they are able to fill their prescription. This is determined by their health insurer, and by proxy a PBM, which constructs retail pharmacy networks. Thus, retail pharmacies price their drugs at a level that will allow them to be part of these networks; by definition, that makes PBMs the true customers of these companies.

The primary customers for a retail pharmacy’s actual prescription drug operations are PBMs, which would force all new entrants into the space to negotiate and sell their services to these players. If a retail pharmacy is not a part of an

New Entrants Will Have Tough Time Matching Majors on Pricing Over the past five years, the major PBMs, drug distributors, and retail pharmacies have developed three enormous joint purchasing partnerships to source their entire supply of generic drugs. These partnerships can obtain the lowest pricing of generic drugs globally and give each of these companies a distinct advantage over any new entrant that would probably lack this purchasing power or supplier pricing leverage. These joint purchasing entities drive value-creating synergies and have reinforced the economic moats for the major players in the pharma market.

The Walgreens Boots Alliance Development partnership is the largest generic sourcing operation globally. We believe this consortium has a combined purchasing power of $40 billion in generic volume and represents close to half of all generic drug purchases in the United States. This joint purchasing venture has benefited and will continue to benefit its members, particularly

We estimate that the Red Oak partnership of CVS and Cardinal is close to $30 billion in combined purchasing power. Although it is materially smaller than the WBAD partnership, it is still a formidable force when negotiating pricing with suppliers and has given both companies an advantage, with some of the best generic pricing.

We estimate the ClarusONE partnership is close to $22 billion in combined purchasing power, making it the third largest of the major three. This is a fairly new partnership between McKesson and

Based on our estimates of the generic market, almost all generic purchases flow through the major pharmaceutical market players. This would be the case even if these companies did not partner and combine sourcing operations. However, by consolidating purchasing power, these companies have collectively been able to obtain generic drugs at the lowest prices possible. This dynamic has also reinforced the moats for these players and has created a tough pricing barrier for any new entrant. Any new competitor would be at a significant disadvantage when pricing generic drugs due to its purchasing power disadvantage.

Every health insurance plan is unique, reflecting a benefit provider’s membership makeup and coverage goals. This leads to a market where there are thousands of health insurance products; thus, a pharmaceutical services player is required to have access to massive amounts of drug treatments across close to a thousand global drug manufacturers. To be a legitimate player in the space, a pharma services entity would need infrastructure in place to source a vast variability of drug products and have them readily available for prescription fulfillment almost instantaneously. This dynamic is relevant for all major PBMs, drug distributors, and retail pharmacies, as they all ultimately provide services to health benefit providers either directly or indirectly. Accordingly, the cultivation of relationships across a vast global spectrum of manufacturers and wholesalers is required of any new competitor seeking to any subsector of the pharma services market.

We believe fundamental drug market variables are often overlooked when analyzing the competitive landscape of the space. The confluence of a business-to-business market, significant supplier pricing advantages for all current major players, and the requirement to have access to massive amounts of drug products from close to a thousand global manufacturers creates significant barriers to entry and forms the bedrock for moats in the space. We believe a new competitor would have a difficult time disrupting the market and displacing the major PBMs, drug distributors, or retail pharmacies, given the aforementioned macro drivers.

We believe there has been a major misconception regarding the ability of new competition, specifically from Amazon, to disrupt the PBM niche. PBM work consists of not only processing prescription claims but also underwriting for risk and managing the members of a client. PBMs work with their clients to build their drug benefit plan, which includes determining the risks of a client’s member cohort, developing programs to manage that risk, negotiating pricing with suppliers, and managing a client’s members’ treatment regimen to ensure patients are being treated correctly and cost-effectively. These services are health-insurance-related, and from our perspective, any entity seeking to enter the PBM space would fundamentally become a health insurer.

These health insurance services are clearly not in line with the core competency of an Amazon or any other consumer company. We believe this dynamic will keep new entrants at bay because it would take a significant amount of capital and effort to move from a consumer business to the health insurance business. Additionally, a new PBM would have to convince clients to migrate critical underwriting and patient healthcare services to an unproven player. If a new entrant were to make a move into any part of the pharmaceutical space, we believe it would probably partner with one of the major PBMs, if not all three.

Drug Distribution Only Appears Simple The dynamics of the drug distribution sector have shifted materially over the last handful of years as the entire healthcare market experienced rapid and significant change. Accordingly, many investors view the drug distributors in a permanently impaired position and vulnerable to new competition from entrants with logistical expertise. However, we believe it is essential to remember that no matter what variables are at play, the wide-moat advantages of the three major drug distributors remain the ultimate drivers of industry dynamics.

Amerisource, Cardinal, and McKesson have established integrated distribution and sourcing partnerships with their respective large retail pharmacy clients, changing the way the drug distributors and large retail pharmacies interact. To disrupt the space, new entrants would need to convince at least one or two major retail pharmacies to migrate over to their services. We believe this would be a difficult task, given the high level of integration all major pharmacies have established with their respective drug distributors--solidifying the wide moats of Amerisource, Cardinal, and McKesson.

Historically, large retail pharmacies sourced their generic drug supplies internally and self-distributed to their various retail locations. Now, most large U.S.-based retail pharmacies jointly source all generic drug supply and have ceded all distribution operations to their wholesale vendors. While not a total merger of operations, we believe the recent integrated contracts are nonetheless a partial merger of certain wholesaling and distribution operations among the drug distributors and most of their large retail pharmacy clients. It would take an enormous effort by any new entrant, including Amazon, to dislodge these large customers from the iron grip of their respective drug distributors.

The major three have also established integrated relationships with smaller independent retail pharmacies by providing services that help these companies manage critical business activities. These services include franchising, cash collection, supplier negotiation, and group purchasing services, creating a significant level of stickiness in the client book for the major three--offsetting major customer defections to a new entrant.

From our perspective, investors who see robust competition developing in the drug distribution space are overlooking the confluence of three factors.

Legal landscape. The regulations and legal requirements needed to procure and distribute pharmaceuticals in the U.S. are extremely onerous because of the absolute need for consumer safety. A new entrant would need to comply with the various federal agencies that claim regulatory jurisdiction over drug wholesaling and distribution, and also with countless state, municipal, and foreign agencies. Licensing and regulatory approval would take years for a new entrant to be fully compliant and able to provide full-service wholesaling. The administrative work and waiting periods would add significant time to the regulatory approval process.

Congress has instituted several regulatory acts over the past several decades. These regulations contain hundreds of pages of regulation that oversee how drugs are procured, shipped internationally and domestically, marketed, tracked through the supply chain, and ultimately sold. To have a process in place just to comply with federal regulators is complicated and eliminates competition from most logistical/distribution entities.

The asset investment required for a new competitor to build legally compliant infrastructure--including shipping vehicles, storage facilities, and security products--would also be significant. The burden and asset investment needed to be as legally compliant as Amerisource, Cardinal, or McKesson make entering the drug distribution space expensive and time-consuming.

Relationship building. A new entrant would need to replicate the relationships that Amerisource, Cardinal, and McKesson have built with the major branded pharmaceutical manufacturers. Branded manufacturers deal exclusively with the three major distributors for various legal and operational reasons, one of which is the ability to better control inventory and product pricing by limiting the number of distribution partners. Convincing the hundreds of individual branded manufacturers to trust a new entrant with efficiently distributing their product would be tough, especially considering all legal, product pricing, and supply chain implications.

The substitutability of many branded drugs is not as strong as it is for generics because of patent protection. Therefore, branded manufacturers do not need to encourage retail demand for their products through material discounts or extensive retail relationships. Accordingly, instead of dealing with hundreds of retail entities, branded manufacturers have the luxury of working only with the major pharmaceutical distributors, eliminating the need for additional logistical/distribution partners.

Branded manufacturers use the three major distributors as their logistical operations by paying incentives and fees to them for inventory management and order fulfillment of their branded products. Thus, branded manufacturers are able to leverage the logistical infrastructure of a third party and avoid extensive asset investment in internal distribution operations. So not only would a new entrant need to have sophisticated distribution operations, it would also need to be able to determine proper production runs, sales forecasts, and other logistical activities unique to the pharmaceutical industry.

Solid oligopoly. The combined 90% market share of the three major distributors and slim industry profits would make the path to consistent economic profitability rough for any emerging competitor. The asset investment alone that is needed to compete effectively with these players would be significant. For a pharmaceutical distributor to produce consistent economic profits, it would need to build an extensive distribution operation to source a global drug supply, move this supply to thousands of pharmacies (both independent and chain) across the U.S., and effectively manage inventory for branded manufacturers.

Given the consolidated nature of the retail pharmacy space, we believe a wholesaler would need infrastructure in place to procure and distribute billions in pharmaceuticals to large retail chains and independent pharmacy group purchasing organizations. From our perspective, a new competitor would need to build these assets in order to even have the opportunity to win business. Considering the small amount of market share not already owned by the big three and the slim profitability of the industry, we believe the heavy asset investment needed would not be advantageous for potential new entrants, even for those with top-tier logistical expertise.

Given our analysis of the estimated market share needed for break-even economic profits in the drug distribution, we believe the stalwart competitive positions for Amerisource, Cardinal, and McKesson will remain intact for years. A new entrant, even Amazon, would need to not only capture the balance of remaining market share not owned by the major distributors, but also win share from them. Irrational pricing could capture some share, but given the slim gross profits of the industry, it would be a painful exercise. Profits are already so slim that there is not much room to cut pricing. Additionally, we believe manufacturers and most sophisticated pharmacy operators would be hesitant to rely on an unproven distributor for critical logistical activities and drug supply. This would make capturing market share a tough proposition and not worth the heavy asset investment required, in our opinion. Complicated and onerous regulatory requirements compound these obstacles.

Retail Pharmacies Most Susceptible to Competition Of all the players in the pharmaceutical supply chain, we believe retail pharmacies face the greatest potential for disruptive competition. From our perspective, a highly successful consumer company such as Amazon would have an easier time breaching the competitive dynamics of the retail pharmacy space than other verticals in the pharmaceutical market. This is already the case when it comes to nonpharma products, where company like Walgreens, Rite Aid, and CVS Retail are competing with Amazon, which for many nonpharma consumer products offers superior service and fulfillment. We believe this trend will only intensify as products such as salty snacks, sodas, household products, health and beauty products, and groceries are offered by the efficient consumer operations of online retailers, especially those of Amazon and its Prime product. However, we believe infiltrating the pharmacy space to sell prescription drugs will be a tougher task that will require years of planning and building relationships with PBMs. Additionally, we believe an online-only strategy is not an easy route to success.

Pharmaceuticals are not analogous to other consumer products. They are actual medical treatment products that fall into the same category as surgeries, medical examinations, medical tests, and other healthcare-related treatments. Slashing the price of oncology drugs will not increase the demand for those products, just as cutting the price of heart surgery won’t significantly increase the demand for that procedure. Thus, there are nuances to selling pharmaceuticals that a new entrant would have to contend with if it were to make a move into the retail pharma space.

In order to have any kind of customer base, a retail pharmacy has to be included in at least one major PBM network. PBMs construct these networks on behalf of their clients and demand discounted generic drug pricing and other services from network pharmacies. If a pharmacy is not a part of a PBM network, it will not be reimbursed for the prescription drug. This likely means that if consumers were to fill a prescription through a non-network pharmacy, they would have to pay for the full cost of the prescription themselves. Thus, it would not make sense for a consumer who pays for health insurance to fill a prescription at a non-network pharmacy; he or she is directed by the PBM to fill the prescription at a retail pharmacy of the PBM’s choice. This dynamic eliminates consumer choice and creates a market where the true customers of the prescription drug market are PBMs and their clients.

To encourage the use of the lowest-cost pharmacy in a network, PBMs have further segmented their pharmacy networks between preferred and standard pharmacies. Preferred pharmacies usually offer the lowest-cost drugs, and in order to maximize the use of these preferred pharmacies, PBMs and their insurance clients offer lower copayments for all authorized prescriptions filled at these entities.

If Amazon or another competitor were to make a move into the retail pharmacy space, we believe it would have to develop the following four key essential variables to be a viable option for a major PBM: (1) have the ability to source and store almost all available drugs, (2) integrate prescription fulfillment and reimbursement systems with the PBM, (3) have pharmacists and pharmacy technicians on staff, and (4) be able to instantaneously fill all prescriptions.

If a pharmacy can’t execute one of these four key essential variables, it will probably not be included in any PBM retail pharmacy network. Through partnerships and internally developed operations, we believe new entrants in the retail pharmacy space could probably develop three out of the four key essential variables. We believe the fourth variable would be the biggest obstacle for Amazon or another new competitor.

Amazon Would Need to Change Its Business Model Most of Amazon's products are ordered online and delivered to a customer's home or business; however, most prescriptions are not filled this way. We estimate that approximately 80% of all prescriptions are filled through a physical location--a retail pharmacy, doctor's office, outpatient center, or hospital. Additionally, people are likely to fill their prescriptions as soon as possible after a doctor's visit at a retail pharmacy, either in a healthcare provider's location or at a pharmacy on the way home. This would require Amazon to open physical retail pharmacy stores, use its current Whole Foods locations, or develop an expedited delivery system that can fill a prescription quickly. The assets and investment required to build such an operation would be enormous. Given Amazon's easy access to debt and equity capital and its willingness to develop cutting-edge capabilities, we believe the company could possibly find these efforts as value-creative. Nevertheless, it would also have to put the other pieces of the retail pharmacy puzzle together, which include navigating the legal landscape (which would be even more complicated if the company chose to develop alternative delivery methods of highly regulated drug products) and building integrated relationships with PBMs, drug distributors, and branded drug manufacturers.

One additional retail pharmacy route Amazon may pursue would be to become an online mail-order pharmacy enterprise. This route is feasible and would require less work from an operating model and legal perspective. However, mail-order prescription volume has declined significantly over the past several years, making this market niche much less lucrative.

Most mail-order prescriptions are recurring and treat chronic conditions. The consumers of these recurring drug regimens usually skew older, and they have shown a preference to fill their prescriptions at physical locations. Additionally, this demographic may fall outside the target Amazon would like to capture and monetize. Also, many states have required PBMs to include any physical pharmacies that are willing to match mail-order pricing to be included in the respective pharmacy network. These considerations may not make the return on capital enough to overcome the economic cost of such an endeavor.

We would also point out one other dynamic that may present a major obstacle to a potential Amazon mail-order pharmacy: The three major PBMs--CVS, Express Scripts, and UnitedHealth--already own large mail-order pharmacies and are more than fulfilling the demand flowing through this channel. We believe Amazon or any other new entrant into the pharmaceutical market would need to partner with one of the three large PBMs in order to be a viable player in the retail pharmacy space.