The Great Drug Pricing Debate: Could Value-Based Pricing be the Panacea?

By Igor Golalic, CFA
November 2017

Last year I read a Bloomberg article that was, in many ways, one of the most informative I’ve come across regarding the nature of the pharmaceutical pricing problem in the U.S. As the veil that hung over drug pricing was being lifted by increased public scrutiny over unpalatable price increases, this article laid it all out in relatively simple terms. It told a story about a blues guitarist named Mick Kolassa who had founded consultancy firm Medical Marketing Economics LLC, and in the process set the basic principles for how drug prices are derived today. Kolassa claimed that new branded drugs should be priced at whatever the market would bear, never lower than competitors’ prices, and should take into account the value that society may derive beyond those immediately visible benefits. The question is: given recent experience, how sustainable is that pricing model over the long term?

In the article, Kolassa argued that drugs provide many sources of potential value to varying stakeholders. To the person taking them, they bring relief and a potential cure with other forms of utility in the long run. To employers and payers, they bring tangible savings relative to their opportunity costs. To the society, they bring an unproductive member of the workforce back into the usable resource pool. Moreover, new drugs may have ancillary pricing aspects. Do they address large sub-populations where a cure is needed? Do they treat an aggressive disease where time is critical? Are they less toxic than the current standard of care? It then follows that drugs should be priced such that they not only minimize the consumer surplus (meaning the area under the demand curve that symbolizes value retained by the consumer and foregone by the supplier at any given price point), but also recognize all of those additional sources of potential value for society.

This pricing paradigm has been employed by drug manufacturers for the last 25-30 years, and it worked well for the industry during that time period. Annual, sometimes bi-annual, price increases improved the industry’s topline to double digits from what would otherwise have been population-like growth levels. New branded drugs commanded price premiums for innovation irrespective of efficacy and encountered limited pushback. Pharmaceuticals became a growth industry in the 1990s and early 2000s, and returns on equity improved significantly. However, the last 10 years have brought a sobering of sorts. Under the pressure of increased generic competition, with prices 80-90% below their branded counterparts and relatively similar efficacy, the picture became more tenuous. Having already saturated many major therapeutic areas such as lipid management and cardiovascular, the industry then turned towards specialty indications and oncology, where companies felt they could continue to enjoy strong pricing power.

As a result, most oncology drugs today are very expensive, often priced in excess of the benefits they deliver. Memorial Sloan Kettering’s Drug Pricing Lab offers a tool called Drug Abacus, which compares the company’s price to one based on the value proposition of the drug (see table below).

Source: drugpricinglab.org (Drug Abacus values based on $84,000 per life-year.)

As health care expenditures started to drain federal and state budgets, pressure by payers to control drug pricing has become even stronger. As a result, investors have come to recognize the likelihood of slower growth prospects ahead and no longer ascribe the pharmaceutical industry a price/earnings premium to the market.

Note that in Kolassa’s construction of the pricing equation, there was no mention of the costs – only the value – that new branded drugs bring to society. For example, one may wonder if higher prices beget lower patient access, which may have a cost of its own. Experience has shown that when a drug goes generic and its price is lowered, volume tends to increase. Enter Obamacare and managed care organizations for a change of perspective. Expanded access from health care reform made the managed care industry, including the pharmacy benefit managers (PBMs), increasingly more focused on drug formulary management as a way to control the rising pharma cost burden. PBMs have been more demanding in terms of the value proposition a new drug must bring, not only to justify a potential price increase but even to be included in the formulary.

In recent years, this pressure has given rise to innovative commercial arrangements under the umbrella of value-based pricing. In an outcomes-based arrangement, the manufacturer reimburses insurers and patients when the drug does not work as expected. In an indication-based arrangement, the manufacturer will gain access to the formulary and price the drug depending on the indication it is being prescribed for, allowing for significant discounts in therapeutic areas where the drug’s benefit may not be as clear. In theory, both of these mechanisms should allow for a more efficient use of health care dollars. Patients should get better prices and access to multiple therapy options; manufacturers should get a big portion of the expected compensation while getting expanded access to the formulary; and the payers should be able to create increased competition and lower cost trend. Given this, is value-based pricing then a panacea that can stem the rising tide of prescription drug cost increases? And what does the early evidence show?

When Novartis signed value-based price agreements with Aetna and Cigna for its congestive heart failure (CHF) drug Entresto in May 2016, it looked like the dawn of a new age. Novartis promised that it would reduce the price of the drug if the rate of heart failure hospitalization of patients exceeded a previously specified threshold. With close to six million people in the U.S. living with CHF and 500,000 new cases diagnosed each year, the potential savings to payers looked promising enough to enter into this agreement. Thus far, Entresto sales have benefited from “improved access and sales force expansion,” according to the company. And without these payer arrangements, it is likely that Entresto would not have been an option for millions of patients due to cost or lack of access.

Amgen signed a similar agreement with Harvard Pilgrim for its novel lipid therapy Repatha in November of last year. Amgen promised to lower the $14,000/year cost of the drug through “enhanced discounts” if the reduction of lipid levels for the health plan’s members turns out to be weaker than expected. This agreement, like the one signed by Novartis, ensured increased market access for the drug and clear differentiation from the competition. Early signs point to a solid trajectory of growth for Repatha as well, and Amgen has credited better access to the drug. Patients who are statin-intolerant now have a viable therapeutic choice that otherwise may not have been available to them.

Since the Entresto deal, Novartis has also launched Kymriah, its novel therapy approved for acute lymphoblastic leukemia, with another value-based pricing arrangement, this time directly with the U.S. government. Kymriah was priced at $475,000 for this particular indication, with full refund if there is no patient response to the treatment after one month.

While it remains to be seen if the value-based arrangements will affect the overall cost trend of pharmaceutical prices over time, for now they look promising in that they use sensible commercial parameters to assess the market-clearing price while keeping all of the relevant interests in mind. These examples stand out because they were innovative, creative, and positive for the long-term drug pricing dynamics. However, they also stand out because they are exceptions to the norm that continues to dominate the drug pricing landscape. If the industry wants to get to a more optimal and sustainable state for pricing, it needs to adopt these mechanisms more rapidly. Yes, there are obstacles that need to be solved before value-based pricing can become the new norm. These initiatives require substantial data infrastructure to be in place to evaluate them. They require the understanding of what relevant outcomes should be measured and how. They need to account for patient adherence or lack thereof. Still, the industry’s goal should be to move gradually towards a more sustainable long-term model. We, as long-term investors, would welcome that. As Sir Andrew Witty, recently departed GlaxoSmithKline CEO, once said, “The patients look at their investment in their health care over their lifetime. We ought to be trying to develop a system that is more in step with that desire of the people who ultimately pay for the system.”

Which leads me back to Kolassa’s comments about never pricing new drugs for less than those that are already on the market. With multi-billion dollar sales forces, the industry could afford to operate with this commercial model. However, Kolassa underappreciated that such a model would not be sustainable over the long term because of external costs of this pricing behavior (for example, the intense public scrutiny of Turing Pharma after it raised the price of a drug by more than 5,000% in 2015). Thus, the drug pricing model needs to change.

Value-based pricing looks like a pragmatic long-term solution that ought to be implemented more broadly. In Europe and Japan, companies have grappled with limited pricing power for decades, yet they have survived and continue to innovate. The U.S. pharma industry has largely paid lip service to value-based pricing. The longer it waits, the more damage it will do to itself in the long run. Because of this complacency, coupled with uninspiring valuations, we have been selective about which of the major pharmaceutical companies we invest in, buying those that have broader portfolios that are more defensible from a pricing standpoint (Pfizer) or have recognized the new pricing reality (GlaxoSmithKline, UCB, Takeda), and shorting those that have yet to face it (Merck, Celgene, Bioverativ).

As of October 31, 2017, Diamond Hill owned shares of AET, GSK, PFE, UCB, and Takeda. As of October 31, 2017, Diamond Hill held short positions in MRK, CELG, and BIVV.

Originally published on November 15, 2017.

The views expressed are those of the research analyst as of November 2017, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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