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Why drug prices keep going up

Pharmaceutical giant Mylan (MYL), which has recently dominated headlines over the skyrocketing 400% price increase of its allergy drug, made the decision on Monday to introduce a lower-priced generic EpiPen competitor.

This whole ordeal has left us with questions: Why do drug prices keep going up? And how is it that CEO Heather Bresch came up with a lower-priced alternative so suddenly?

According to Bresch, it’s “the system.” According to many critics, it’s a matter of corporate ambition. As it turns out, it’s both.

Pharma and biotech companies want bigger profits

Above-average price inflation on Mylan’s EpiPen franchise is certainly nothing new. As Raymond James’ Elliot Wilbur pointed out: If you Google the term “EpiPen price increase(s),” you get over 120,000 hits from 2011 to just prior to this latest story breaking.

Since Mylan acquired the EpiPen from Merck (MRK) in 2007, the company increased the price 24% annually, over twice the already-steep 9.5% average annual increase for the branded pharmaceutical industry. In other words, pricing has been an integral component of Mylan’s EpiPen growth strategy.

This has sparked outrage from politicians and consumers alike—especially parents looking out for their kids with allergies—but RBC’s Randall Stanicky laid out the case for Mylan.

“In Mylan’s defense, its focus should be to maximize profit and protect (i.e., via Citizen Petitions to block generics) and grow (i.e., via raising price but also awareness) its EpiPen franchise, and it has done just that,” he said.

But when comes to the healthcare industry, the concept of incentives becomes more complicated.

Last fall, Martin Shkreli’s Turing Pharmaceuticals and Michael Pearson’s Valeant (VRX) became the poster children companies for greed in the pharma space, bringing the sector’s drug-pricing practices into the public consciousness.

But these two cases stand apart from Mylan, which abides by a more traditional pharma model. While Turing and Valeant turned the entire industry on its head by focusing solely on marketing and boosting prices of acquired drugs, traditional drug development involves hundreds of millions of dollars in research and development (R&D).

At traditional biotech and pharma companies, increased drug pricing is at least purported to incorporate the cost of developing the drug and to incentivize the companies to innovate and develop new formulations. This has been the defense of Gilead (GILD), which has come under scrutiny for the high prices of its Hepatitis C drug. (The cost to develop a new drug and win FDA marketing approval is pegged at about $2.6 billion, according to a report from the Tufts Center for the Study of Drug Development.)

Nevertheless, as Raymond James noted, the research and development needs of a generics-focused company like Mylan are lower than a company developing new, branded drugs.

Mylan’s gross profit margin stands at about 55%, “normal” for the industry according to analysts. But the question is what “normal” should be.

“For Mylan or any manufacturer, there is a grey area in what is viewed as appropriate versus aggressive price increases, especially on critical care drugs with near-monopoly positions that have large pediatric or elderly populations,” Stanicky added. “EpiPen pricing clearly moved beyond the grey area based on the political and media response.”

In the end, it seems pharma and biotech CEOs have focused on enhancing shareholder value, which may conflict with consumers’ best interests.

“It’s the system”

Mylan CEO Heather Bresch has deflected blame away from her company and onto the healthcare system as a whole.

“I am hoping that this is an inflection point for this country,” Bresch told CNBC in an interview last week about the EpiPen outcry. “Our health care is in crisis. It’s no different than the mortgage financial crisis back in 2007.”

Bresch explained while the “list price” for EpiPens is $608, Mylan takes $274 of that—with the remaining $334 incremental cost coming from an intermediary step of pharmacy benefit managers, insurers, wholesalers, and pharmacy retailers. In other words, according to Bresch, much of the price increase is coming from “the system” versus Mylan specifically.

“This isn’t an EpiPen issue, this isn’t a Mylan issue. This is a health care issue… the system is broken,” she said.

Source: Mylan
Source: Mylan

PBM names, including Express Scripts (ESRX) and CVS Health’s (CVS) Caremark division, sold off last week over worries that they could be the next shoe to drop when it comes to pricing practices scrutiny.

Insurance companies rely on PBMs to manage costs while drug manufacturers rely on PBMs to put their products in front of customers. PBMs negotiate with pharmacies and drug manufacturers to get discounts on drug prices that they pass to insurance companies; meanwhile, they negotiate contracts with pharmacies to create a network of retail locations for drug distribution.

But while Bresch was quick to blame the system, Mylan’s ability to respond to the recent outburst of criticism shows it could have done more earlier, according to analysts.

Last Thursday, Mylan responded to the pricing outcry, announcing it would cover up to $300 of out-of-pocket cost at pharmacy, which would reduce patient cost by 50% off Mylan list price. Then on Monday, the company followed up with an announcement that it would launch a generic version of the EpiPen, for a list price of $300 for a two-pack carton.

Given the choice, Mylan would probably have continued taking price increases on EpiPen prior to the recent media firestorm, according to analysts. Historically, Mylan has taken two price hikes on the EpiPen per year, with the second one coming in early November.

After all, the current pricing system reflects a reliance on medical insurance companies, which means that pricing is not based on consumer demand or ability to pay but instead on how much insurance companies will cover, as noted by Bloomberg View’s Matt Levine.

In the end, though the optics of this latest move suggest Mylan will be taking an immediate revenue hit. Raymond James noted a simpler generic sales process that bypasses the complicated branded system means the company could net the same amount.

While Bresch stated years ago that the practice of branded companies issuing their own generics is a threat to the generics industry (Mylan’s focus), she now emphasized the positives of bypassing the brand system, which she said incentivizes higher drug prices.

“Because of the complexity and opaqueness of today’s branded pharmaceutical supply chain and the increased shifting of costs to patients as a result of high deductible health plans, we determined that bypassing the brand system in this case and offering an additional alternative was the best option,” Bresch said in a statement on Monday.

Raymond James estimates that Mylan will net $250 on the generic version of the EpiPen, close to the $274 from the branded version.

“Though the company could take a moderate hit on top-line sales, we believe the company can make up this ground relatively easily via significant selling and marketing expense reductions,” Raymond James’ Wilbur said, adding that the lower cost could increase volume as well.

No competition

Meanwhile, monopolies have built up for different drug categories.

Specifically, in the last few years, backlog has built up at the Food & Drug Administration (FDA) for approvals, as shown in the chart below.

For the EpiPen, a generic version of the drug, developed by Teva Pharmaceuticals (TEVA), was rejected by the Food and Drug Administration (FDA) last year while a competitor developed by Sanofi (SNY) faced dosing issues and was discontinued.

What does this mean for the industry

The big question that remains is: Will this change anything?

Presidential candidate Hillary Clinton’s tweet against Mylan’s EpiPen price increase reflects how political an issue drug pricing has become.

Political and consumer pressure does seem to be setting off select company-specific changes, though many pricing issues remain throughout the issues.

RBC’s Stanicky believes the recent outcries will deter companies to some degree from boosting price.

“This will shift focus back to drug pricing and we have to think it will be another disincentive to companies to use price (brand or generic) as a mechanism to offset the potential gross margin pressure that we still see ahead for the generic/hybrid sector,” he wrote.

Bresch is correct that in some ways “the system” encourages high prices, in part because insurers can negotiate for discounts on drug prices. But drug makers are also incentivized to make drug prices higher to protect their bottom line for shareholders—and they’re empowered to do that because many drug makers have monopolies on sought-after medications. There are clearly a lot of challenges that need to be addressed.

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