Botched PBM merger highlights health care industry challenges

The changes in the health care industry have led to botched mergers with PBMs in the past.

It's worth explaining the challenges facing drug companies, the emergence of PBMs and their impact on drugstores like CVS. The upshot? Companies are trying to cut the cost of health care for their employees to improve their profits. Up until the 1970s, there was a simple health care model: drug companies would invest hundreds of millions in research to developed patented products; their sales forces would offer doctors in private practice lots of goodies like all expense paid trips to Bermuda; if the drugs worked, the doctors would prescribe them regularly; and insurance companies would reimburse the companies who bought the drugs for their employees, regardless of price.

But with the emergence in the 1980s of Health Maintenance Organizations (HMOs) and PBMs, this profitable club began to collapse. HMOs, whose drug formularies saved money for their corporate clients by encouraging their doctors to prescribe the lowest cost drugs available to treat a disease, took market share from private physician practices. For example, between 1986 and 1992, HMOs share of drug sales rose from 7% to 22% while private physician practices' share declined from 60% to 43%.

In 1946, the Veterans Administration (VA) began to offer drugs to veterans on a mail order basis. Instead of paying a co-payment for a 30 day supply and picking up the drugs in a pharmacy, veterans got a 90-day supply through the mail. In 1983 Marty Wygod, an investment banker, started Medco with the idea of spreading this mail order concept to companies and HMOs. This did not sit well with the CVSs of the world because PBMs could buy drugs at a discount from the drug companies and ship them directly to the patient -- bypassing the wholesalers and drug stores altogether -- and passing the savings on to the companies, HMOs and patients. Medco also worked with companies and HMOs to find the cheapest drug that worked for a particular disease.

Merck's 2,200 person sales force with their trips to Bermuda was of no avail when it came to persuading HMOs to stock Merck's drugs. For example, in 1992 Medco negotiated a deal with Bristol Myers Squibb Co.'s (NYSE: BMY) to distribute its cholesterol drug Pravachol which slammed sales of Merck's cholesterol reducing drugs. In the next year, Merck's cholesterol drug sales rose a mere 2% while Bristol's spiked 205%.

Merck had heard rumors that Bristol was planning to buy Medco -- extending its power over Merck -- so Merck jumped at Medco. Unfortunately, Merck did not add value to Medco -- leaving it to operate independently and never merging the information flows that would have given Merck the ability to develop better and cheaper drugs. Merck also angered its retail pharmacy customers by buying one of their competitors -- causing them to substitute $400 million worth of Merck drugs for a competitors'. And Merck got into regulatory trouble when Medco failed to disclose its Merck connection when setting up drug formularies in 17 states -- leading to a $1.9 million settlement.