Another Perspective to Frame the Role of the “Big 3” Pharmacy Benefit Managers.

Contained within UnitedHealth Group (UNH-NYSE, $504.68), The Cigna Group (CI-NYSE, $352.38) and CVS Health Corporation (CVS-NYSE, $69.65) are three separate divisions poorly understood by retail, and to some extent, glossed over by institutional investors in terms of business upside. These divisions, known as Pharmacy Benefit Managers (abbreviated as PBM) are sometimes intimated by investment media to be shadowy middlemen that permit/promote sales of certain prescription drugs over others to Health Maintenance Organizations, through pharmacies, through the creation and administration of a prescription drug formulary.

So large are these PBM businesses by revenue, as a percentage of the total HMO revenues for the big three, that on a pretty regular basis, the various heads of the big 3 PBM operators are hauled before US government committee hearings to answer questions about their roles within the health care system. Senators or congressmen thunder out accusatory questions about profiteering and rail on about access restrictions of certain drugs, for the benefit of election commercial soundbites.

Accusations, framed as questions, are immediately and succinctly rebuffed by PBM spokespersons, who indicate that gross revenues are only a form of pass-through volumes on their systems, that gross profits are expressed in basis points rather than percentage points, and in fact, those basis point profits are generated by negotiating volume discounts from the pharmaceutical companies themselves, rather than on the backs of the public, the government or the HMOs.

Finally, the spokespersons note that without the existence of PBMs, individual HMOs, the government, and ultimately, the consumer member of any HMO, would likely pay considerably more for a prescription drug due to an inability by any of the prior parties to obtain similar volume discounts on a product.

“So are you, or are you not, a wholesaler and if you are, are you adding unnecessary costs to the health care system?, restate varying US House committee members, hoping to score a “gotcha” for media likes.

“No,” respond the divisional heads of the PBMs. “Just the opposite. We don’t even distribute or ship the products. All we do is negotiate volume discounts for health insurers and place the drugs with the best discounts on a formulary, so that an HMO obtains the best possible value for their member. We ensure that these discounts are properly recorded in the myriad of medical categories that you, the US government, created. Were we not to exist, drug companies would price their products separately, to each insurer, on the basis of the number of customers they serve. We level the playing field for all, obtaining a volume rebate for all due to our efforts, holding back just a fraction of that rebate, some basis points, for our work. If it seems complex, it is because you, the representatives of the US government, have legislated it to be so.”

Accusations repudiated, questioning at a dead end, at the conclusion of each and every hearing, not being any more informed about the business mechanics of PBMs than when they started, US senators or congressmen get bored, grumble a “you had better continue to behave or we will see you soon” to the PBM heads and everyone goes back to their day.

Maybe this knowledge gap on PBMs exist, because we, apparently, require an easy comparable in the global business world to facilitate our understanding as to what a PBM does. Most search, in vain, for the appropriate health care related sector to frame their thinking.

Perhaps an easy comparable does exist. It is a completely different industry, to be sure, but could fit the bill just fine.

Visa, Mastercard and American Express operate interchange networks, managing the payment flow between a vendor of a product and a buyer. These three payment network operators immediately move money from a buyer to a seller globally.

Like a PBM, the interchange payment network operators have a very large schedule of unique categories, through which any item sold, is cleared for reimbursement, roughly equivalent to a formulary. Similar to a PBM operator, the interchange network operators do not actually touch a product, but maintains an inventory record of gross dollar volumes (GDV) moving through their networks.

Like a PBM operator, revenues are expressed, not in percentage points of sales, but as basis points of GDV. Like a PBM, the big three financial payment network operators don’t actually give a fig what is being sold by a manufacturer to a consumer, middleman or end user. All the interchange payment networks care about is the volume of payments moved through their individual networks. So long as annual payment volumes flow, interchange network operators, realistically not having any capital on the line for purchases or sales of the products themselves, earn a significant profit margin on a fractional per ticket charge.

As costs of network operations are largely fixed, any volume increases result in a disproportionate improvement in the bottom line, even with a gross profit margin indicated expressed at levels far below 1% of any transaction. With virtually no actual capital put on the line, an extremely high percentage of the gross profit, as low as it is on a dollar basis, becomes EBITDA. Like a financial interchange, a PBM that has economies of scale requires little operating capital and as a result, throws off significant cash on an ongoing basis.

Like a PBM, it is the seller, not the buyer, that directly funds the interchange network expense, via a reduction in the gross payment received by the seller. Yes, consumers gripe about interest charges on credit cards, but that isn’t the business of Visa and/or Mastercard, although it is part of the Amex model (as a direct credit issuer).

Finally, like the PBM business, where 3 competing divisions control roughly 80% of the prescription drug flow through the entire US health care industry, the big 3 payment interchange networks of Visa, Mastercard and, to a far lesser extent, Amex, process the vast majority of payments on credit and debit globally. Both PBM and financial interchanges operate as technological oligopolies, making it difficult for competition to wrest market share.

Just as with the payment interchange operators, one critical key to differentiating the big 3 PBM companies is how they choose to spend their profits.

CVS Healthcare, loosely speaking, attempts to operate a quasi-American Express type model with their PBM, featuring higher pricing and, in exchange, offering a suite of some services intended to maintain loyalty in the network. Significant profits generated by the CVS pharmacy benefit manager are used to support investment initiatives in the retail pharmacy chain, to backstop investments in clinics within the chains, to support growth of the HMO insurance business as well as providing various other divisions of CVS with capital.

At CVS, the PBM represents a source of cash to be spent elsewhere. My issue with CVS is that every other business that CVS spends PBM profits on are far less profitable, on an EBITDA margin basis, than the PBM. Therefore, all the good works undertaken at the PBM division are, to some extent, wasted by poor capital decisions in other divisions.

UnitedHealth Group considers the PBM to be a key source of profit, with a goal towards becoming THE largest source of profit for the company. UNH relies upon acquisitions of medical networks to drive prescription flows towards the PBM. In effect, UNH tries to operate a closed loop system with a goal of capturing 100% of a health care dollar within the UNH system.

At Cigna, the company has chosen a stripped down simplicity, based upon capital return. Cognizant of the “capital-light” nature of a PBM, management chooses to grow the PBM business as quickly as it can, utilizing cash generated within the division to seek additional contract wins at growth oriented HMOs outside of the Cigna system. In my view, it is the closest business model to that of Visa and/or Mastercard within the PBM subsector. To Cigna, the pharmacy benefit manager represents the crown jewel of the entire business, THE driver of growth.

Were one to evaluate a pharmacy benefit manager, less as a healthcare asset, more as a payment interchange network, the business structure comes into focus, as does the growth potential and risk/reward.

Government gripes about Visa and Mastercard are the same each and every year, as are the merchant gripes. Yet, without the massive interchange networks of Visa/Mastercard, the modern day internet commerce and consumer payments wouldn’t even exist. Merchants have long forgotten that Visa and Mastercard are the very reason that global commerce is as it is, entirely due to the efforts of the financial interchange systems to facilitate simple payments.

So too it is with the pharmacy benefit managers. Seemingly interminable, biannual, government attempts to excoriate the PBM businesses represent a distraction. Low per-ticket profits at a PBM mask the absurdly high EBITDA returns earned on a capital light structure. Growth in the business represents a multiple of GDP growth, based upon population demography.

Finally, just like financial payment interchange networks, the more expensive the unit price of any prescription pushed through a PBM, the greater the volume discount accruing to the PBM, so inflation represents a tailwind, rather than a headwind.

To my way of thinking, and I am aware that my views typically represent a minority opinion, my entire viewpoint of a PBM is hung on a framework that they are far closer to a financial interchange than anything else.

I believe that a PBM represents the health care equivalent, more or less, of a Visa/Mastercard financial interchange network. Once comfortable with that assessment, my only follow-on is an estimation as to which company, or companies, will capture the lion’s share of future growth through their “formulary network”, and will they invest those profits wisely, or do they fritter the profits away on fruitless ventures?

For some time, my investment model is anchored on a premise that the largest of the three PBM, by US market share, seems a horribly mismanaged dinosaur, teetering badly off course, overpricing its suite of services when compared to the more nimble operators and is therefore ready to be dethroned by the #2 player in the space. As a result, the Gnostic Portfolio owns the #2 and #3 participants based upon 2023 market shares, with a view that they will take over the top and second spot respectively, in the years to come.