From the Mouths of Babes
The industry in question was not pharma, but the $1.5 billion infant formula industry. Until the 1980s, infant formula was a high-growth, high-profit business for companies such as Bristol-Myers Squibb (through its Mead Johnson division), Abbott Laboratories (through its Ross Products division), and American Home Products (now Wyeth).
But then, in 1983, the US federal government launched the Special Supplemental Nutrition Program for Women, Infants, and Children (WIC), and within a few years the business underwent a remarkable change for the worse. The program began as a way to offer free formula, paid for by federal and state funds, to the poorest 20 percent of new mothers. Within 10 years, nearly half of US customers—some two million of the four million babies born annually—were receiving their formula gratis. Through rebates and contract negotiations, the financial burden of the subsidy, meanwhile, shifted in large part onto the shoulders of the infant formula manufacturers.
From 1992 to 1994, BMS, Abbott, and Wyeth saw their US profits level off, decline, and even disappear. By 1994, Wyeth, for all intents and purposes, had withdrawn from bidding for WIC contracts, and it subsequently exited the US market in 1996. For several years thereafter, Ross and Mead Johnson fought a costly war for brand share in a series of state-by-state, winner-take-all battles for market access, ultimately squeezing profitability out of the fastest-growing and highest-consumption segment of the market.
Why does this story matter to the pharma industry? Because there is good reason to think the dynamic that drove the profits out of infant formula is about to be repeated—this time in the pharmaceutical market—thanks to the Medicare drug benefit. Superficially, the markets and the programs may seem not to have much in common. But the underlying market logic is strikingly similar, as pharma may learn.
An Industry Evolves For nearly 50 years, the infant formula industry evolved slowly, with few innovations either in products or marketing/sales models. The introduction of WIC, however, led to customer, regulatory, and competitive actions that quickly rewrote the rules for success. The process took place as a sequence of six steps:
Rebates rise. The executives who worked for infant formula companies in the late 1980s will tell you that WIC rebates started rather innocently and that the initial "offers" to state WIC administrators were of no consequence. The first bids for rebates to state programs were more or less voluntary(5 cents-10 cents per can) and, in the beginning, all three manufacturers continued to compete within these states using traditional selling and sampling methods. As enrollments rose and use increased among the subsidized segment, the states, starting with Tennessee and Oregon, began to solicit single-source bids. The industry did not respond until 1988, when Florida successfully negotiated a sole-source contract from Wyeth, thus changing the rules of the game forever.
During the next five years, more than 30 states or groups of states followed suit. The rebates increased dramatically to more than $1 for a can of concentrate that retailed for $2.25—more than 70 percent of the contribution margin. The rebate dollars flowing back to the state agencies were used to expand enrollment. This, in turn, led to generally higher rebates, giving rise to an increasingly vicious cycle. The infant formula executives did not realize it at the time, but they had made the fatal mistake of "feeding the gremlins."
Price competition emerges. Aggressive price competition was a natural consequence of tightened access, high contribution margins, and the unbalanced stakes in a zero-sum game. The destabilizing player was Wyeth. With significantly less share than either Ross or Mead Johnson, Wyeth could easily triple its total market share (for combined cash and "rebated" segments) in any state. Winners and losers in the game could be easily predicted.
Until Wyeth exited the business, the auctioning of access to the WIC market led to round after round of price cuts. And even after only two competitors remained, the seemingly naked competition for share continued to drive prices down. Because WIC contracts typically lasted for three years, it was a long and painful process before prices began to stabilize, most likely because all profits had been bid away. Between 1990 and 1996, estimates are that the net contribution margin per can of formula for the winning bid for a major WIC contract declined by nearly 80 percent, and in some cases vanished entirely.
New pricing models applied. As the WIC program grew, calculating the true sales and profit impact of a won or lost contract required a new level of complexity. Especially important was the "spillover" of winning or losing a WIC bid. Spillover took two forms: Direct spillover occurred when a WIC enrollee purchased more formula than her free allotment. Indirect spillover was measured through the contract's effect on retail shelf space, out-of-stocks, promotional inclusion by retailers, and even physician "prescribing." (When pediatricians did not know if a new mother was eligible for WIC, they often recommended the formula on the WIC contract at the margin.) Ross, Mead Johnson, and Wyeth each developed their own spillover models that allowed them to calculate the direct and indirect contribution of a three-year contract in a given state."
State-based planning models. WIC's influence on the infant formula business was felt more quickly and deeply in some states than others. By 1993, more than 70 percent of the infants in Tennessee and Mississippi received WIC subsidies; the equivalent figure in Virginia, New Jersey, Michigan, and Illinois was 40 percent. Because of spillover, the value of marketing to the non-WIC, non-rebated segment of the market differed dramatically depending on whether the company or its competitor had the WIC contract in a given state. By the early 1990s, it became clear that a one-size-fits-all resource plan (sales reps, sampling, and couponing) no longer made sense.
Initially, all three competitors reduced their discretionary spending on a state-by-state basis and attempted to maintain their sales forces at historical levels. However, as they looked at the prospect of being "off contract" in a state like California for a three-year period, they downsized sales forces selectively and moved representatives from one state to another. Ultimately, the annual planning and resource allocation process for Abbott and Mead Johnson had to move from a single national plan based on total volume to state-based marketing, sales, and compensation plans that incorporated an understanding of the various segments and contract status.
Industry cost structure rationalized. By the mid-1990s, Wyeth had exited the US market, and Ross and Mead Johnson had seen their profits from the US market decline. A new competitor, Nestle/Carnation, which used a lower-cost direct-to-consumer business model, had successfully entered the market. Although gross sales of infant formula increased each year through price and volume growth, net sales flattened and actually declined in some years.
Lessons for Pharma The pharmaceutical industry should look at the evolution of the infant formula business to anticipate the customer, government, and competitor dynamics that are likely to emerge as a result of the new Medicare drug benefit, as well as the actions that managed care companies and state governments could take to leverage their market power. Moreover, managers should look to the changes in business models and processes that evolved in infant formula as a precursor of what is likely to occur in their own industry. The evolution and decline is likely to repeat itself in the same sequence of steps.
First, participation in subsidies will increase as consumers, public health organizations, and state agencies learn to optimize the system. Although the specific regulations have yet to be written, the Medicare Modernization Act (MMA) has aims similar to those of WIC and includes a deeper federal subsidy for the lowest income segment of the market. Currently, the Part D benefit includes no deductible, threshold, or gap in coverage for Medicare beneficiaries with an annual household income under $12,490. Beneficiaries with incomes up to 150 percent of that figure will receive subsidies in the form of sliding-scale premiums and lower deductibles and co-pays. They will also not be subject to the coverage gap between $2,250 and $5,100, in which the patient pays all costs.
Current estimates by the Kaiser Family Foundation are that approximately 6.3 million of the 40 million Medicare beneficiaries will qualify for the greatest subsidy and an additional 7.5 million will have income and assets low enough to qualify for reduced premiums, co-pays, and deductibles. Will this subsidized segment expand as participants learn the rules of the game? How long will it be before state agencies, private "drug purchasing counselors," and the infor- mal network of retirees figure out how to game the system to get their drugs at little or no cost? The odds makers would favor highly motivated seniors with a lot of free time, over government bureaucrats and gatekeepers.
The structure of the Medicare drug benefit will give MCOs powerful leverage in extracting such concessions. Today, the co-pay difference between a third-tier and second-tier product (typically $180 per drug per year) can shift as much as 25 points of market share in a therapeutic class. Medicare Part D patients will be exposed to substantial out of pocket costs: monthly premiums, the $250 deductible, 25 percent co-pays. In all, beneficiaries will pay as much as $1,170 for the first $2,250 (and $4,520 of the first $5,600) of drugs they purchase in a year.
A somewhat hidden dimension of the current legislation provides that the federal government will serve as the insurer of last resort. This fallback coverage—and a stabilization fund—is available when only one prescription drug plan (PDP) is available, or in the very likely case that a PDP goes out of business. This arrangement will also become a catchall for any group or individuals that cannot or will not enroll in the Medicare Part D through a PDP. These could include current Medigap customers who are terminated by the indemnity insurers, rural customers, and large groups of retirees whose employers are unable to find a PDP to cover their obligations. In almost every consumer insurance business, the "uninsurable risk pool" becomes a dumping ground for the unprofitable customer. That's likely to happen here as well.
Finally, the state governments, which would appear to be losing bargaining power, may, as they did in the WIC program, exert their influence to squeeze prices. The Medicare drug program gives the federal government responsibility for the "dual-eligible" patients who qualify for both Medicare and Medicaid. But the transfer of responsibility will cost the states bargaining power, and the financial savings it provides are likely to be small or wholly illusory. The states will still pay 90 percent of the cost of serving dual-eligible patients. And costs are certain to rise, if only because the states already receive deeper discounts from drug companies (around 15 percent) compared with the 8 percent the private providers who will administer the program are expected to receive. It is possible that states will end up paying more out of pocket for dual-eligibles than they currently do. It is therefore easy to project a scenario in which the states respond with some form of supplemental rebate requirement for dual-eligibles.
State success in extracting price concessions with either the fallback group or the dual-eligibles could lead to an even more frightening scenario in which the subsidized low-income senior segment would be bundled with other non-Medicare enrollees to squeeze higher rebates and discounts from manufacturers. It is an easy step for states to go down the "Maine RxPlus" path in which low-income "under-65" eligibles could be bundled with the uninsured who would fall below 150 percent of the poverty level.
When contracting with state governments and managed care organizations, pharma executives must think about the potentially irreversible effects of their actions. A small supplemental rebate for low-income Medicare enrollees may be the first step down the slippery slope.
The industry may have already have seen a glimpse of the future in 1998 when Pacificare solicited therapeutic class "capitation" proposals from manufacturers. At that time, many pharma companies studied the "request for proposal" and declined to participate. Perhaps they saw utilization risk or the possibility of exceeding "best price" as too great. Or perhaps they saw the slippery slope that would follow this first step. Will Pacificare or the state of Florida be able to change the rules again? Category capitation and utilization risk-sharing proposals are very likely to be seen again in 2005. In certain therapeutic classes, third- and fourth-place competitors will certainly have the incentives to discount deeply in exchange for taking on price and utilization risk.
Soon, new pricing and segmentation models will emerge. Before 2006 arrives, pharma companies will need to develop an understanding of how spillover and carry-over effects (retention of chronic patients) of their product discounting and couponing will affect their Medicare cohort. They will also have to use far more complex customer segmentation. Patient and physician responses to pricing and promotion will differ not only by therapeutic class but also by co-morbidity status and previous payer history. Patients who take three or more chronic medications (and are thus exposed to the coverage gap) will behave differently from those who have no chronic prescriptions. Patients who come into Part D or managed care after losing generous drug coverage (and there will be many) can be expected to behave quite differently from those who have always paid cash for their drugs.
In any event, traditional models trading off discounting and share will be insufficient. Companies calculating the potential payoffs from winning or losing a bid must incorporate this new complexity or risk losing their bids on a consistent basis.
Cost Structure Shifts As these changes take place, planning and resource allocation models will shift from maximizing national volume to optimizing state-based profit margin. Pharma companies have already acknowledged differences in geographic markets, principally because of managed care penetration and reduced physician access. But even though they know the single national model is becoming obsolete, they have opted to retain the simplicity of mirrored territory alignments, uniform sample allocations, and standardized performance measures.
Differences in the underlying distribution of Medicare beneficiaries, the expected future growth rate of Medicare enrollment, payer history, and the influence of state government agencies all vary significantly. The Medicare drug benefit will push the relevance of a national planning and resource allocation model past the tipping point.
As a result of all those changes, cost rationalization will be required for pharma companies to sustain their US earnings. To stay profitable, they will have to streamline their sales operations, followed by marketing and other customer-focused areas. Ultimately, the Medicare benefit could lead to a fundamental restructuring of US pharmaceutical operations.
Learn From Experience In hindsight, the infant formula companies can now see that the WIC program and the competitive dynamics it set in motion changed the economics of their business forever. Had they known the endgame, they might have restructured more aggressively. However, like a terminally ill patient, their business models and strategies had to go through Kubler-Ross' five stages of dying—denial, anger, bargaining, depression, and acceptance—before a new strategy (and cost structure) could be put in place.
It would be easy to dismiss the idea that what has evolved in the infant formula business as a result of WIC will happen to pharma as the Medicare drug benefit is implemented. There are many differences between a medically promoted consumer product and prescription pharmaceuticals. It is also easy to believe that pharma company executives are better prepared to deal with bidding and contracting for Medicare enrollees, based on their experiences with managed care and pharmacy benefit management companies.
However, dismissal of the infant formula industry's history as prologue is not that easy. Ross, Mead Johnson, and Wyeth were much smaller, less global, and more cost conscious than today's pharma companies. Their managers largely came from the pharma industry, and they ultimately reported to strong and competent pharma CEOs. These managers simply had never seen anything like the WIC program, nor did they know how best to respond to it.
Today's pharma executives can look to the infant formula experience, anticipate many of the responses by managed care, state governments, and competitor companies, and, by applying these lessons, avoid many of the pitfalls associated with such a fundamental change.
Supply Chain Strategy: Managing risk and opportunity in a changing global landscape