Additional content provided by Tucker Beale, Analyst, Research

On May 12, President Donald Trump signed the “Delivering Most-Favored-Nation Prescription Drug Pricing to American Patients” executive order aimed at making prescription drugs more affordable for Americans. The premise driving the initiative is that drug manufacturers have deeply discounted their products in foreign markets and subsidized profits with elevated prices within the U.S.

Government subsidies for research and development, along with differences in prices between countries, have created a free-rider problem where the global benefits of improved pharmaceuticals are paid for disproportionately by the U.S. This is deemed unfair by the current administration, and steps to eliminate the practice have been proposed. The most recent solution is for Americans to pay a “most-favored” price no higher than the lowest price in other countries.

On its face, all of this seems to be mounting pressure on pharmaceutical manufacturers to lower prices domestically. All else equal, price reductions domestically would be difficult to completely offset by raising prices internationally. This has the potential to compress margins by eroding pricing power and would provide a significant headwind to drug manufacturer share prices.

While this is all correct, “middlemen” are highlighted as another source of potential cost savings. The middlemen in question are the Pharmacy Benefit Managers (PBMs). These PBMs sit between drug manufacturers, healthcare insurance providers, and pharmacies. PBMs facilitate drug distribution and negotiate with pharmaceutical drug manufacturers to lower prescription costs. These operators have come under scrutiny for opaque pricing practices, like retaining rebates from drug manufacturers and “spread pricing,” where PBMs pay pharmacies less than what they charge health plan participants for drugs. A Federal Trade Commission (FTC) report this January found that “Of the specialty generic drugs analyzed in this report and dispensed by the Big 3 PBMs’ affiliated pharmacies for commercial health plan members between 2020 and 2022, 63 percent were reimbursed at rates marked up by more than 100 percent over their estimated acquisition cost (NADAC) while 22 percent were marked up by more than 1,000 percent”(Specialty Generic Drugs: A Growing Profit Center for Vertically Integrated Pharmacy Benefit Managers). While markups occur at unaffiliated pharmacies as well, “more than twice as many drugs were marked up by over 1,000 percent when dispensed through the Big 3 PBMs' affiliated pharmacies compared with unaffiliated pharmacies.”

The “Lowering Drug Prices by Once Again Putting Americans First” executive order signed on April 15 includes provisions to increase transparency into PBM fees and requests that the role of these middlemen be reevaluated. This executive order questions the existence of the intermediary role of PBMs directly. CVS Caremark, owned by CVS Health Corp (CVS), Express Scripts, owned by Cigna Group (CI), and OptumRx, owned by UnitedHealth Group (UNH), are the biggest PBM companies. Their shares fell following these executive orders (UNH has since fallen further on its weak earnings outlook and reported fraud allegations). One of the proposed solutions is facilitating direct-to-consumer sales to American patients at the most favored prices. Eli Lilly (LLY) and Novo Nordisk (NVO) have already tried to avoid PBMs, showing a willingness and even preference for selling directly to consumers without needing to involve insurers. As an example of further disruption, Eli Lilly’s LillyDirect has announced a partnership with Amazon (AMZN) to work as a third-party dispensing provider to deliver to patients.

While some of the desired price savings will come from the PBMs, price controls remain a longer-term risk for manufacturers, particularly those with a high share of sales coming from the U.S. Increased transparency means that the amount of cost savings to be pulled from re-organizing the drug value chain (eroding PBM margins) should become clearer through time. What is yet to be seen is whether these savings are enough to stave off deeper cuts that impact manufacturers directly. It is also important to point out that PBMs are involved in about 80% of U.S. prescription drug claims and serve a function that cannot be replaced overnight. Longer-term, it also remains to be seen how much pricing power would be given back to manufacturers without PBMs negotiating for lower prices.

While many questions remain about how these executive orders will be implemented, after the initial news flow is digested, the net effect appears less detrimental to pharmaceutical drug manufacturers than to PBMs. That said, reworking the way Americans buy their medicine is going to take a long time. Along the way, efforts to support direct-to-consumer sales will support both the manufacturers leading the charge and those they partner with for distribution.

LPL Research’s Strategic and Tactical Asset Allocation Committee has a neutral view on healthcare and would be targeted within pharmaceuticals, by far the sector’s biggest industry group, until we get more regulatory clarity.