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In: Opinions & Features

10.29.15 | Forbes

By Steve Brozak

To read the entire article on Forbes, please click here.

Valeant Pharmaceuticals is making headlines again as news continues to drip out on its business practices. Recently reports emerged that Valeant, a hedge fund darling, has the option right to acquire a private company called Philidor, a specialty pharmacy that provides it with distribution and marketing services. The unusual structure of the relationship prompted investor questions, causing Valeant’s stock to plummet over 30% in a single trading session last week. With 19.4 million shares as of the fund’s last filing, Bill Ackman’s Pershing Square Capital has a sizable investment in Valeant. As a result Mr. Ackman has announced a conference call that will take place on Friday at 9 a.m. to discuss his position in the company.

There are many ways you could criticize Valeant’s business model, but its relationship with specialty pharmacies that distribute its products is more complicated – and more commonplace – than critics realize. Out of the many people who invest and report on pharmaceutical and biotech companies, few seem to actually understand how drugs get from drug companies to patients. It seems specialty pharmaceuticals are especially misunderstood.

Spec Pharma: 101

One of the best ways I’ve seen specialty pharmacies described is by looking at Coca-Cola. Coca-Cola sends its main ingredients to various third-party manufacturers who then mix the syrup with water, bottle and ship out the product to retailers. The simplest way to describe specialty pharmacies is as background players who contribute to the supply chain for pharmaceutical companies. They are referred to as specialized pharmacies because they hold, handle and distribute drugs that are not easily available at the local pharmacy like CVS Health Corporation and Walgreens Boots Alliance, Inc. In this way, they act as third party extensions of large pharma and biotech company supply chains.

McKesson and AmerisourceBergen are the nation’s largest publicly traded specialty pharmacies, while Express Scripts Holding Company owns specialty pharmacy Accredo Healthcare, a private company. CVS also has a specialty pharmacy division that works with McKesson to provide some of its services. In fact, CVS alone accounts for 15% of McKesson’s specialty pharmaceutical revenues and 27% of Cardinal Health’s specialty pharmaceutical revenues for 2015. In 2014 McKesson’s revenues for pharmaceutical distribution in North America were $124.93 billion. This does not include the additional $4.5 billion from pharmaceutical distribution internationally. AmerisourceBergen’s revenues from pharmaceuticals services totaled $117.38 billion in 2014.

Examples of drugs processed through McKesson or CVS’s specialty pharmaceuticals services division are fertility drugs or biologic drugs for multiple sclerosis and cancer. They are not stocked at traditional corner pharmacies, and because they are often in liquid form they require refrigeration and special handling. When a prescription for one of these drugs is written, a specialty pharmaceutical takes over and either delivers drug to the physician’s office in time for a patient’s next appointment, or directly to a patient through the mail. A specialty pharmacy receives the goods from the drug manufacturer and may conduct some fill and finish work, like mixing drug into saline bags for IV administration or infusion, etc. So they are quite a bit more specialized than the corner pharmacy, and provide the added benefit of a secure channel of critical drugs.

Here are some important aspects between the drug manufacturer and a specialty pharmacy: Specialty pharmacies usually provide their services for multiple drug manufacturers and have several pharmaceutical clients.  They also maintain networks of specialty pharmacy affiliates with whom they barter services and distribution networks, which is risky behavior given the highly regulated nature of this industry.  In exchange for use of their services and distribution networks, pharmaceutical companies usually give their products to specialty pharmacies at a discount. Drug manufacturers usually use multiple specialty pharmaceuticals for the same product to spread risk, create supply chain redundancies, and maintain product integrity. When a drug manufacturer sends its product to a specialty pharmacy, it books it as revenue as the product leaves its facility to the specialty pharmacy. The specialty pharmacy now owns the product and is responsible for delivering the product to the physician or patient.

The Philidor/Valeant relationship is completely different. Philidor’s only client is Valeant, a revelation which allowed many to jump to the conclusion that Valeant was somehow using a shell corporation to its advantage. Further, it was shown that Valeant was using Philidor for claims/co-pay adjudication and interactions with patients. Without a good understanding of the drug company to patient dynamics, many believed this relationship was somehow inappropriate and a conflict of interest, which it actually wasn’t.

The Ackman Defense

If Mr. Ackman intends to defend Valeant on Friday, there are four things he should highlight:

First, the company has been transparent in its accounting methods with its third party vendors and stakeholders. This past Monday, Valeant hosted a conference call during which managementthoroughly detailed its business and accounting methods with Philidor. Valeant stated that it only books revenue once Philidor ships drug to the physician or patient. This is important because Valeant has an option right to acquire the specialty pharmacy and properly handles any potential for conflict of interest.

Second, there are no rules preventing a drug company from owning its own specialty pharmacy. In fact, many drug companies handle the services and functions of a specialty pharmacy internally. While many of the practices of specialty pharmacies (and the tactics of the pharma industry at large) may seem distasteful, they are not necessarily illegal.

Third, the claims/co-pay adjudication process is usually outsourced to third parties, or handled internally by major pharmaceutical companies. They’re usually referred to in a division called “Patient Services” and their goal is to make sure a patient gets on and stays on the company’s drug. Again, while it may seem distasteful or a conflict of interest, the process of claims/co-pay adjudication and trying to manage rebates for drugs is another common practice among pharma.

Fourth, Valeant was probably trying to gain a cost advantage in its various franchises by developing relationships with sole specialty pharmacies with the goal of vertical integration.

Why The Philidor Relationship?

As with most business decisions, it all comes down to cost.

Drug companies usually work with several specialty pharmacies for various reasons, but primarily because they don’t want the logistics headache and regulatory/compliance burdens that come with owning and operating pharmacies, and so prefer to outsource such services. Some drug companies don’t use them at all and handle the specialty pharmaceutical role internally.

Specialty pharmacies claim a network of healthcare insurance plans and their patients they provide drugs to. Sometimes to access these distribution networks, drug companies have to yield and give steep discounts to specialty pharmacies. For instance, Valeant could go to McKesson’s specialty pharmacy division which could boast that it handles prescriptions for 40% of the patients in the US for a certain indication. But if Valeant wants to utilize its distribution channel and handling services, McKesson requires a 15% discount on all of the drug it receives from Valeant, which it would then add to its own profit. Or instead, Valeant could start a partnership with a single specialty pharmaceutical (it seems in this case a constellation of them), for which it is its sole client. This, while unusual, doesn’t appear to be illegal.

What Valeant is most likely doing, and what Mr. Ackman should point out, is vertically integrating a specialty pharmaceutical to cut out the middlemen, keep more money on the table for itself, and command total control over its supply chain. Strategically it makes sense that the company does this since Valeant tends to specialize in acquiring and selling other companies’ older products.

Vertical integration of a specialty pharmacy into Valeant’s operations makes some sense. It has over 500 products that don’t command the types of margins newer, more expensive specialty pharmaceutical drugs command. For instance, Tecfidera, Biogen Inc.’s specialty drug for multiple sclerosis, is the perfect candidate for sale and distribution through a specialty pharmacy – it’s new, unique and, at over $50,000 per year, very expensive. Biogen has more leverage negotiating contracts with specialty pharmacies clamoring to carry the drug. Valeant wouldn’t have the same kind of negotiating power with its drugs, and it shouldn’t be surprising if Valeant decided to build and acquire a specialty pharmacy in order to retain maximum margins on their catalog of products.

The main questions around Valeant and other drug makers shouldn’t be whether or not they have an ownership interest in the specialty pharmacies they work with. It should be how they recognize revenue, whether they recognize it at the time when the drug leaves their facilities or whether they recognize it at the moment it leaves the specialty pharmacy to the end user. Valeant has stated publicly that it recognizes the revenue after its product leaves Philidor’s facilities, which gives greater credence to the idea that Valeant was working to vertically integrate a specialty pharmacy within its operations.

Drug companies still track the performance of their products once in a specialty pharmacy’s hands, and rely on the specialty pharmacy to provide them this data. Usually this data lines up with IMS Health data. Primarily, the big drug companies want to make sure that the first drug a patient takes after getting a prescription actually reaches them. There is a one week period of time between when a drug is prescribed to when it is delivered where an order could get cancelled. Drug companies want to make sure that nothing interferes to make that happen (for instance, a doctor could change his or her mind and order something else for the patient, or the patient could have seen a commercial and request a change in medicine, etc.). Getting the first injection to the patient delivered and starting a patient on drug is critical to the sales cycle. So the processing and handling of product must be incredibly robust and reliable. Most importantly, the handling of data back to the drug manufacturer must be precise. This is where Valeant or Philidor or another third party may have made a mistake and caused a dispute amongst the parties.

There are plenty of arguments for and against Valeant’s overall business and business model. Investors should analyze the quality and performance of Valeant’s acquisitions versus the debt it assumes to acquire the assets. They should be concerned over government scrutiny of its pricing practices. They should also consider the sustainability of its revenue growth. But absent an accounting violation or hard evidence of collusion with a specialty pharmacy, what it seems Valeant was doing was vertically and aggressively integrating an otherwise costly service.