The Business Of
Healthcare | CVS Health | How Do They Make Money?
Morning All!
So yesterday, we started Part 2 of The Business Of Healthcare. And our focus this week is on CVS Health. As we now know, CVS Health doesn’t just operate the largest retail pharmacy chain in the world. But they’re also a pharmacy benefit manager (PBM). And as if that wasn’t enough already… CVS actually have a health insurance division too! I’ll tell you in a moment why we won’t cover that part this week!
The chart below shows us that whilst retail pharmacy made up 29% of CVS Health’s 2022 revenues. The main revenue generator is actually the PBM segment, which brought in an astonishing $169bn in revenue!
Now, this week, we’re going to focus on the retail pharmacy and PBM segments. Because next week we’ll actually be diving into the biggest health insurer in the world - UnitedHealth. So, let’s leave the health insurer stuff for then!
Alrighty, without further ado, we know where CVS Health makes their money. Let’s see how they go about doing it!
More Pharmacies = More Prescription Sales!
Okay, let’s start with CVS’s pharmacy chain. Yesterday we noted that CVS Pharmacy has over 9,500 locations! And these 9,500 locations made a whopping $109bn in revenue last year! About 75% of this revenue comes from ‘typical pharmacy’ sales - unwell people buying their drugs (prescription). And the other 25% comes from people buying wellness products (e.g. Aveeno’s moisturising cream) and OTC drugs.
But let’s dive a bit deeper into the typical pharmacy sales. These revenues have grown from $57bn in 2010 to $107bn in 2022. And a question to ask is - what’s really driving this? Are more people getting sick every year and so buying more drugs from CVS pharmacies? Is the price of drugs going up?
Well, as the chart below shows - it is absolutely the first answer! The blue bars show that the number of prescriptions bought at CVS grew at ~7% CAGR from 723m (2010) to 1.6 billion (2022). But interestingly, the average price/prescription has dropped over that same period from $59 to $49.
So, what’s going on here? Well, the reason >2x more prescriptions are being filled at CVS in 2022 vs 2010 isn’t because 2x more people are falling sick. It’s because CVS have been buying more and more pharmacies! We’ll dive into this more on Thursday when we talk about acquisitions. But think about it, if you have 1 pharmacy that fills out 100 prescriptions. You’re obviously going to fill out more than 100 prescriptions if you buy another pharmacy!
Okay, so then what about price? Because some of you may be thinking - ‘hold on, last week we saw AbbVie raising the price of Humira by 10% a year! So surely drug prices are going up?! Are CVS being super generous and lowering the prices of their drugs?!’ And the answer is not exactly. The reason for this fall in average price is because a higher proportion of the drugs sold at CVS pharmacies are generic drugs! And as we saw last week, generic drugs are much cheaper than the original, patent-protected drugs!
But why’s this happened? Why are CVS pharmacies selling more generic drugs? Well, interestingly - it’s because CVS pharmacies make a higher margin selling generic drugs than patent-protected (branded) drugs. Why? Well, it’s all to do with bargaining power. And we’ll talk more about this margin dynamic tomorrow! But for now, what’s been driving CVS’s pharmacy revenues? Buying more pharmacies!
Discounts + Spread Pricing = $$$
Okay, so now let’s move on to the segment that makes CVS Health most of its revenue - pharmacy benefit management. And as we saw yesterday, a pharmacy benefit manager (PBM) like CVS Caremark has nothing really to do with the flow of drugs. It’s all about the flow of money. Hopefully you remember this graphic below which explained how PBMs negotiate discounts from drug manufacturers. To help reduce medical costs for insurers and individual members.
Okay, so we hopefully know what PBMs do now. If you’re still a little confused - understandably! - check out this simple video. But now, let’s look at how these companies make money! Because if they’re just passing discounts on, where’s their revenue coming from?
Well, the thing to note here is that, yes - PBMs pass the discounts on to health insurers. But they don’t pass on all of the discount! They keep some of that discount, and that bit they keep is their revenue! Let’s look at an example below. So, say Pfizer has a drug that they price at $100. And CVS Caremark are able to negotiate a 30% discount ($30) from Pfizer. CVS Caremark may pass on $25 of that to the health insurers. And keep $5 of the $30 for themselves as revenue!
This method of keeping some of the discount is the first main way PBMs like CVS Caremark make their revenue. But there’s one other major (and controversial) way CVS Caremark makes money - and that’s spread pricing.
So, let’s use this Pfizer $100 drug example again. Now, the pharmacy (Walgreens in our example) doesn’t care about the discount negotiations that happened between the drug manufacturer and PBM. They still want to get paid their $100! And so, the PBM (CVS Caremark) will pay the pharmacy (Walgreens) the $100. But PBM will charge the health insurer a higher amount! In the chart below, we can see that CVS Caremark pay the pharmacy $100 but then charges United Healthcare $105! And what does this mean? It means that again, CVS Caremark pocket $5 as their own revenue!
So, who are the winners and losers from PBMs being around? Well, health insurers are happy. Because they pay $80 ($105 - $25) instead of $100. Pharmacies still get paid their $100 so they don’t really care about the negotiations. Drug manufacturers lose out, because although they’ll sell their drug for $100 to wholesalers (who’ll then sell them to pharmacies). They lose $30 of this in discounts to the PBM. And then, we have the PBM. And the PBM is the real winner in all of this. Because they’ve made a decent amount of revenue from just being a middleman!
Now, the industry is pretty secretive about how much PBMs take from the discount or through spread pricing. But as we can see from the chart below, CVS’s overall PBM business has been doing pretty impressively over the last 15 years! Growing from $35bn in 2007 to $169bn in 2022.
However, this growth may not continue quite as strongly in the future! Because politicians in the US are currently trying to pass a law which bans spread pricing from PBMs! But what have people got against spread pricing? Well, as we saw in our example above, people don’t like that health insurers are paying $105 for a drug that costs $100. After all, the purpose of PBMs was to lower cost for insurers and individuals, not profit from them! We’ll touch on this more in Friday’s email!
A Consistent, Consistent Business
Okay, so to wrap up, what has this all meant for CVS’s total revenues? Well, the chart below paints us an incredible picture. CVS Health’s revenues have grown remarkably consistently over the last 2 decades, growing at ~14% CAGR. With the company having negative growth in only one year - 2010!
Now, a lot of this has growth been fuelled by CVS’s acquisition strategy. So to fully understand revenue growth for CVS Health, we’ll have to wait till Thursday. When we’ll dive into the acquisitions CVS has made. Why they’ve made them. And just how important they’ve been for this company’s growth… and survival!
4th Jul 2023
And that’s a wrap! Tomorrow, we’ll crack on with looking at CVS Health’s margins. To see whether the drug giant has been able to convert their revenues into profits!
Have a fabulous day!
The Business Of Team