Analysing the Threat of Pharmacy Benefit Manager Reform

Overview:

• Over the past several years, increased regulatory scrutiny has generated concern about whether pharmacy benefit manager (PBM) reform presents an existential threat to the current PBM model.
• Our scenario analysis, which looks at the impact of various proposed legislation on the big three PBMs, suggests that PBM earnings are unlikely to be significantly disrupted.
• We believe PBMs' ability to evolve their models to adapt to the prevailing macro environment is often misunderstood. We see transparent PBM models as the next evolution.

The TD Cowen Insight

Increased regulatory scrutiny has spurred concerns whether PBM reform presents a threat to the existing PBM model. Our analysis suggests various proposals are unlikely to significantly impact earnings. What may be underappreciated is the value of PBM services and PBMs' ability to adapt to market dynamics. We see specialty and biosimilars driving PBM growth above long-term (LT) targets over the next several years.

Our Thesis

With increased scrutiny on the PBM industry and its practices reflected in multiple PBM reform proposals by multiple regulatory bodies, many have begun to wonder whether current efforts of reform represent a structural threat to the PBM model as it currently stands. While admittedly there has never been a time when so many proposed actions have been levied against the PBM industry, and it's probably fair to say the industry has lost control of the narrative, our analysis of the various proposals suggests that we are unlikely to see any significant disruption to the PBM's operations of three big PBMs. We believe the most likely form of PBM reform that is likely to be enacted is that which is included in the reconciliation bill (prohibits spread pricing in Medicaid and delinks remuneration & increases transparency requirements in Medicare Part D), both of which we don't expect to have a meaningful impact on PBM profitability.

However, we do see changes coming to the PBM business model. As plan sponsors struggle to manage rising pharmacy trend (largely brought on by specialty), we have seen a push towards greater transparency into the pharmacy benefit, and we see more transparent PBM business models emerging and gaining traction. In response, large PBMs have begun to introduce early iterations of transparent models, and we believe the market will continue to push the large PBMs in the direction of increased transparency. For future iterations, we believe it's possible to see sponsors look to break up the pharmacy benefit whereby it contracts with different vendors to create structural transparency, with PBMs more willing to provide either standalone specialty pharmacy or pharmacy benefit administrative services.

What is often underappreciated is that PBMs provide many valuable services to employers and plan sponsors, and the discussion around rebates and transparency is more directly a question of how to price those services. Also underappreciated is the PBMs' ability to evolve their business models over time to adapt to the prevailing macro environment, and we believe the move to greater transparency is just the next evolution of the business that the large PBMs will be able to navigate. We note that over multiple decades, PBMs have adapted their model seeing growth driven by different drivers over time including from retail spread, rebates, mail-order generics and, currently, specialty pharmacy. Right now, we see the rise in specialty pharmacy and biosimilars representing meaningful longer-term secular tailwinds for PBMs that present the opportunity for them to see growth above LT targets.

What Is Proprietary

We developed a detailed flow of funds chart that dissects the various components of the pharma drug chain as well as providing detail into the various profit streams of PBMs. We also developed a PBM Reform Scenario Analysis that estimates the ultimate impact from each of the notable PBM reform items brought forth by Congress, the Federal Trade Commission (FTC) and Executive Branch.

Financial and Industry Model Implications

Our PBM reform analysis suggests that most of the proposed bills would drive adjusted (adj.) earnings per share (EPS) impact to our 2026 adj. EPS estimates of less than (1%) for all PBMs. The proposal with the biggest potential impact to adj. EPS is "Delinking for both direct AND indirect fees". Importantly, we note that the delinking proposal included in the reconciliation bill would be much less impactful as we estimate.

Part D delinking would drive a less than 1% impact to adj. EPS. Unsurprisingly, we believe the proposed legislation that would likely have the biggest impact to adj. operating income would be if companies are required to divest either specialty pharmacy or core PBM functions, to which we think companies would choose to divest PBM services and retain the specialty pharmacy businesses. While this would have an impact adj. operating earnings, we think the net impact would be a significant unlock of value, as proceeds from selling PBM services could be used to repurchase a meaningful amount of its shares. More importantly in this scenario, the overall businesses would have a higher exposure to the specialty pharmacy and thus see the companies, command higher valuations.

What To Watch

• The outcome of the Trump Administration's Executive Order, which tasks the Secretary of Labor with drafting transparency proposals into the direct and indirect remuneration received by PBMs;
• Pace and status in which states implement their own PBM reform laws;
• Outcomes of the FTC Lawsuit, which is currently expected to begin evidentiary hearings in early 2026;
• Pace of specialty pharmacy growth;
• Biosimilar introductions to gauge PBMs' ability to drive adoption through their wholly owned private-label businesses.