Valuation of Specialty Pharmacies

The specialty pharmacy marketplace in the US has experienced rapid growth in recent years. The number of specialty pharmacies operating in the US has more than doubled since 2015. US expenditures for specialty drugs have also nearly doubled from $83 billion in 2013 to $157 billion in 2017. Combined with spending on orphan drugs, total US expenditures on specialty pharmaceuticals is now nearly equal the amount spent on traditional medications.^[1],[2]

The substantial growth in expenditures and specialty pharmacy entities has been driven by a growing demand for medications to treat specific disease states. This niche market formation has also been enabled by advancements in drug manufacturing and patient-friendly methods of administering treatment for these focused populations.

The previous years of rapid growth in the specialty pharmacy market is now slowing, and the industry is nearing maturity.  Pharmacy benefits managers (“PBMs”) and insurers are thus positioning themselves to dominate dispensing channels through consolidation and leverage, often through their specialty pharmacy operations.

Nevertheless, the market remains financially lucrative and burgeoning therapies are spurring hyper growth among some specialty pharmacy markets. By nature, specialty pharmacies are highly unique; however, below is a brief discussion on several risks facing most specialty pharmacies from a valuation perspective.

Exogenous Risks in the Specialty Pharmacy Market

Consolidation and Litigation

As PBMs gain economies of scale and leverage, they are directly impacting profitability for specialty pharmacies. Litigation and controversy surrounding direct and indirect remuneration (“DIR”) fees is continuing in several states. This is creating uncertainty as to whether political or legal pressure will affect DIR fees and pharmacies’ ability to compete going forward, particularly in battleground states such as Ohio.

Downward Reimbursement Trends

Downward reimbursement trends and auto-rejections of claims are also affecting independent specialty pharmacy profitability.  PBMs and large insurers can compete intensely on cost to consumers, putting pressure on independent operators. Due to the heterogeneous nature of many specialty claims, specialty pharmacies constantly face a threat of claim auto-rejection and difficulty collecting. Specialty pharmacies must be diligent and obtain significant expertise when submitting claims in order to reduce this risk and maximize both the likelihood and amount of reimbursement.

Product Obsolescence

As larger and better-capitalized entities have begun to enter the specialty pharmacy market in greater volume, so do their R&D dollars.  New medical discoveries and rapid technological innovation can cause loss of market share for current technologies.  Many specialty pharmacies focus on a single disease state and are thus exceedingly exposed to this risk. 

Increasing Regulatory Pressure

The specialty pharmacy industry is also becoming the target of increased regulatory scrutiny.  For example, federal law enforcement has been focused on compounding pharmacies (a subset of specialty pharmacies) as an area of potential abuse.  Since these compound pharmaceuticals are not subject to the same FDA regulations as retail pharmaceuticals, and because these drugs receive on average higher reimbursement, cases of fraud have been pursued by authorities in increasing numbers. Cases include allegations (and convictions) of fake or unnecessary prescriptions, enrolling patients in auto-refill plans without consent, writing prescriptions without seeing the patient, and large physician kickbacks.^[3]

Internal Risks to Specialty Pharmacies

Cash Flow

A specialty pharmacy produces/sells drugs for niche patient populations for which it can take weeks or months for payers to approve and reimburse the pharmacy.  Furthermore, inventory turnover can be high for a pharmacy when local supply for a certain drug is limited.  As such, timing floats for reimbursement and inventory purchasing can pose cash flow issues and increase the amount of cash on hand required for operations.

Physician Relationship Development

Relationships with physician and non-physician providers are a key driver of success for specialty pharmacies. Traditional retail pharmacies tend to focus more on convenience and accessibility for the customer.  For example, the creation of automated drug kiosks, positioning of retail pharmacies on busy street corners, and mobile phone applications allowing patients to fill prescriptions on the go are implemented with the customer in mind.

In contrast, for specialty pharmacies, relationships with local providers are paramount. Specialty pharmacies must work diligently to build strong, reliable relationships with referring providers to establish a stable stream of business. The advantage that specialty pharmacies may have is that many focus on a niche disease state and thus may be one of a very few choices for patients. This can simplify the effort of fostering relationships with local physicians.

Specialty pharmacies must also pay close attention to their sales teams and marketing efforts.  Many pharmacies contract with third-party sales teams, which may lead to sales teams who are undertrained, have misaligned incentives which can greatly damage reputation, or even expose the pharmacy to fraudulent marketing practices.

From A Valuation Perspective

As with any enterprise, valuators must consider all three approaches of business valuation: the asset-based, income-based, and market-based approaches. 

In our experience, the asset-based approach is not typically relied upon when valuing specialty pharmacies expected to generate significant future cash flows. Although transaction activity is occurring, many of the crucial details surrounding these transactions are not available. Therefore, we most commonly rely upon the income-based approach.

In our view, many of the exogenous risks mentioned above are most appropriately incorporated into the company-specific component cost of capital, or discount rate. Such risks are not properly captured in other common risk premia (nor the risk-free rate). These risks are also extremely difficult to directly quantify in a projection, unless detailed information is available. In those cases, some risks may be directly incorporated into a discounted cash flow analysis.

To address cash flow risk, we generally project a high net working capital requirement to capture the additional cash and receivables necessary to operate within the specialty pharmacy marketplace. All else equal, a higher net working capital requirement decreases free cash flow — the cash available to owners (and debtholders potentially) — thus decreasing the value of the enterprise.

In summary, the specialty pharmacy market is one with both attractive margin prospects and substantial risk.  While growth prospects may be declining for some niches, others may still be experiencing hyper-growth in the near-term. Like the industry itself, the valuation of specialty pharmacies requires case-by-case consideration. Therefore, there is indeed no standard formula applicable to all industry participants.

^[1] Acentrus Specialty, Specialty Pharmacy by the Numbers, accessed October 15, 2019, www.actrusrx.com.

^[2] Drug Topics, Specialty Pharmacies On the Rise, accessed October 15, 2019, www.drugtopics.com.

^[3] Food and Drug Law Institute, Those Involved in Compound Pharmaceuticals Beware: Law Enforcement Is Focused on You, accessed October 15, 2019, www.fdli.org.