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Drug Prices Up, but Don't Read Too Much Into It
  Motley Fool,
August 26, 2010
AARP is out with its annual report on the cost of medications, and it's more of the same: bad news if you're a consumer, but good news if you're invested in drugmakers.
Well, at least the headline is good news: In 2009, the average price for the top 217 branded drugs rose an average of 8.3%, beating inflation by a wide margin. Of course everything isn't perfect for the drug industry. Price increases boost revenue, but generic utilization is on the rise, so the drugmakers are garnering higher prices, but they're doing it with fewer patients. The price of the higher dose of Pfizer's Lipitor, for instance, rose 24% over the past five years, but total sales have fallen over the past few years after generic versions of Merck's Zocor came on the market.
The industry is also burdened with the discounts imposed by health-care reform. Medicaid gets a discount this year, and drugmakers will have to start giving seniors in the Medicare doughnut hole discounts next year. It doesn't take a Nobel Prize in economics to see that drugmakers are better off taking a discount off an increased price, which could account for some of the rise last year.
Can it last? That's the billion-dollar question, now isn't it? History would say yes. Drug prices have outpaced inflation for many years. Health insurance creates a disconnect between supply and demand. Average consumers don't know the retail cost of drugs because they just hand over their copay and walk out of the drugstore. I'd bet most insured individuals would be shocked at the prices of some of the highest-price medications that are prescribed to seniors.

But there has to be a ceiling somewhere. I have a hard time seeing how prices can spiral upward forever. And the government and voters seem as ready as they've ever been to accept change in the health-care system. At some point the party is going to end and the only drugs capable of commanding high prices will be the ones that add value beyond the increasing number of generics.
Examples please It's likely that cancer drugs will continue to be priced at high levels as long as they can show that the drug improves survival. Some will argue that the end-of-life care -- these aren't cures after all -- isn't worth the insanely high prices, but the moral hazards of setting a price on life will likely keep cancer drugs raking in the dough.
Drugmakers that can fill an unmet need will also be able to command high prices. Current hepatitis C treatments only cure about half of those who take the drug, leaving the market wide open for new treatments. Vertex Pharmaceuticals and Merck are in the lead -- with Vertex taking a slight advantage -- but there are plenty of drugs in the queue behind them. Considering that the eventuality of hepatitis C infection is liver failure, paying high prices for meds should be the least of patients' and insurers' worries.
Diabetes is another good example. Controlling glucose levels now will reduce costly complications later. GLP-1 drugs like Novo Nordisk's Victoza and Eli Lilly's and Amylin Pharmaceuticals' Bydureon have the added benefit of causing diabetics to lose weight, which should help further reduce diabetic complications.
Read past the headlines If you read the news about the industries you're invested in, you're doing better than a lot of your fellow investors. But it's important to think critically about the rising prices. It's great that drug prices are going up, but you have to ask yourself: Why is this happening? Can it last forever? And who's going to benefit if there's a push back in prices? Assuming the answer to the second one is no, finding innovative companies that add value should be more important than basking in the glory of increasing prices.
Health-Care Reform Hits Drugmakers' (and Your) Pockets
Patients won't see many of the benefits of health-care reform for years -- mandated coverage for pre-existing conditions doesn't take effect until 2014, for instance -- but drug companies begin paying for the reform this year. In fact, some of the new required discounts are retroactive to the beginning of the year.
Now that drug companies have released their first-quarter financials, we have a good idea of how much the reform is costing them.

Most of the lost revenue comes from Medicaid, which is now entitled to a 23.1% discount off the average selling price of drugs, up from 15.1%. The number of entities entitled to the discount also increased by about 2,000 because hospitals treating certain patients -- children and those in rural areas, for instance -- now get a break on the price of drugs.
Some companies will also take a one-time hit to their GAAP earnings because they're no longer receiving a tax benefit for providing drug benefits for their retirees. But that's a non-cash charge, and the lack of a tax break certainly won't break the companies.
More ahead Next year, additional costs are expected to hurt drugmakers when Medicare cuts kick in. Seniors enrolled in a Medicare drug program get coverage for a certain amount of drugs, and then they're on their own -- commonly referred to as the doughnut hole -- until catastrophic coverage kicks in. As part of the reform, drugmakers are required to give discounts to seniors while they're in the doughnut hole.
The discount isn't a complete loss for drugmakers, though. Some seniors simply stop taking medications when they have to start paying the full price on their own. From those patients, some revenue, even at a reduced gross margin, is better than nothing. There's also the potential of gaining full-priced sales when seniors leave the doughnut hole on the other side and the government picks up the cost again.
Run away It's tempting to say that investors should focus on companies that have a large presence abroad, but that's not necessarily the answer, either. European governments often set the price of drugs, and with their budget woes, the price of drugs is headed in the wrong direction there, too.
The obvious solution to get around pricing discounts is to avoid the government -- all governments -- as much as possible. That's not easy for pharmaceuticals, but there are plenty of drugmakers that have expanded into related fields. Over-the-counter products may not bring in a lot of revenue individually, but added up they can have a meaningful effect on revenue. The diversification, including launching an over-the-counter version of its allergy drug Allegra, was one of the reasons sanofi-aventis purchased Chattem.
Drug companies also have non-medical products on the store shelves. Merck and Johnson & Johnson sell sunscreen. And Abbott and GlaxoSmithKline sell nutrition products, which might be subject to a snack tax but are safe from price controls.
And there are plenty of drugmakers helping out four-legged patients. Pfizer's animal-health division got bigger after the acquisition of Wyeth, and Merck is so in love with Merial that it reacquired half of the company after letting it go to complete its acquisition of Schering-Plough.
How much should you really be worried? At this point, I'm not sure that changes in government pricing are a reason to pick one drugmaker over another; new drug approvals will still rule the revenue growth charts. It's better to find a drugmaker that's growing revenue by 10% and taking a 4% hit from reduced drug prices than one whose diversification has helped deaden the hit to 2% but leaves revenue flat.
But Fools do need to keep an eye on pricing, especially in the U.S., where high margins are the norm. If forced discounts spread from government programs to private payers, you'll want to run from the sector as quickly as possible.
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