"There are actually businesses you will find a few times in a lifetime where any manager could raise the return enormously just by raising prices-and yet they haven't done it. So they have huge untapped pricing power that they're not using. That is the ultimate no-brainer"
-Charlie Munger (Poor Charlie's Almanack)
Pricing power is one of the most desirable characteristics of a business. It enables managers to raise prices to not only keep up with inflation of input costs, but it also enables managers to drive revenue and profit increases in excess of inflation. While a price raise in most businesses results in a loss of demand, a price raise in a business with pricing power only minimally impacts demand or not at all. But pricing power isn't a characteristic that exists on its own. Pricing power is typically derived from some or many other characteristics of the business or the industry in which it operates. These other characteristics that drive pricing power are typically competitive advantages that a business possesses like a strong, reputable brand name, owning proprietary patents, or benefitting from a customer base with high switching costs to a competitor product.
The topic of pricing power has been top of mind for me for some time as I see more and more press about pharmaceutical companies coming under fire for hiking prices of their drugs with little or no competition. When you're the only game in town, you can price that game at a hefty premium. Sure, companies like Disney, Coca-Cola and See's Candy have some untapped pricing power from the unique experience or strong brand equity as Munger goes on to elaborate, but life saving drugs are the ultimate extreme of pricing power - they mean the difference between life and death for their consumers and as a result command nearly unlimited pricing power.
If you're not familiar with the recent controversy surrounding Mylan and the EpiPen, here is an article and the summary version. Basically, Mylan purchased the rights to EpiPen from Merck in 2007 and went on to hike the price of the drug/injector from ~$100 in 2007 to ~$600 in 2016 - a nearly 500% increase in about 9 years. Most of that increase has occurred in the last few years and the most recent increase led to consumer outrage as a larger part of the burden begins to fall on consumers with the increasing prevalence of high deductible health insurance plans.
What's most interesting to me is that the EpiPen isn't some fancy new drug with massive investments in R&D that need to be recouped. Rather EpiPen is a simple injecting device that provides a quick way to inject someone experiencing an allergic reaction with epinephrine- a drug that's been around since the early 1900's and is not protected by any patents. While the drug is no longer under patent, Mylan owns patents around the design of the medical device (injector), which apparently is more effective than competitor injector devices. As a result, Mylan commands about 85% share of the market for epinephrine injectors in the US.
But we've heard this story before. Turing Pharmaceuticals and its controversial CEO (to put it kindly) similarly came under fire (and a congressional investigation) when it hiked the price of Daraprim- a little known and low volume drug used to treat malaria and HIV patients- nearly 50x overnight. Another company- Valeant based its entire business model on acquiring drugs with little or no competition and hiking prices to the highest price that the market would bear. And a lot of sophisticated investors including Bill Ackman and the very well respected Sequoia Fund bought into this strategy and thesis eventual leading to major losses.
This raises a few interesting questions for me. First, how have these pharma companies sustained such sky high price hikes? Sure this makes sense when a company patents a new drug like a treatment for Hep C in the case of Gilead. But it doesn't make as much sense when thinking through some of the examples above. Taking the example of the EpiPen, it seems nearly impossible in today's day and age of free markets and generic competition, that Mylan could raise the price of the EpiPen so high, when it delivers a mainstream drug invented in the early 1900's that is not under any form of patent protection. The answer as with most companies that demonstrate strong pricing power goes back to competitive advantages. Mylan has been able to raise the price of the EpiPen because it benefits from some key competitive advantages (that don't include a patent on the drug). Putting aside the morality of such egregious price hikes (we'll get to that), Mylan benefits from many competitive advantages that enabled it to command pricing power for a commodity drug. Some other industries can stand to learn from how Mylan has been able to command such strong pricing power for a commodity product (the approach on the other hand might need a touch of humanity and morality- as I said, we'll get to that):
- Strong brand name: EpiPen (as with Band-Aid or Kleenex) is brand name that defines the category. There are some generic competitors but Mylan has invested considerable marketing dollars to build awareness specifically for the EpiPen brand and ensure that EpiPen is prescribed by name by doctors.
- High barriers to entry: The FDA has high hurdles for generic competitors and has rejected some competitor products (like one from Teva) from coming to market. It is this lack of competition has provided the window for Mylan to hike prices. Furthermore, Mylan has aggressively lobbied the FDA and other key figures to reject competitor products for their supposed lack of safety. Whether that is true, we can't opine.
- Proprietary manufacturing process/technological advantage: To Mylan's credit, they have perfected a manufacturing process that other companies have been challenged with. Sanofi and Amedra (which made AUVI-Q and Twinject) have been forced to recall their products from market due to device/dosing issues. The only competitor in the US (Adrenaclick by Impax Labs) has supply issues because they have not yet figured out how to automate their manufacturing process
- High switching costs- 2 ways: 1) An anaphylactic allergic reaction requires quick and immediate action. In tense, quickly evolving situations like this, it is critical that the person administering the drug knows how to use the device. There are slight differences between the various devices on market and there is a potential learning curve for alternative devices. Thus, there is value in stocking the device that more people are trained on and are likely to know how to use- the EpiPen. The resources that Mylan has invested in training a broad swath of the population on using the EpiPen are paying dividends in this regard. 2) An EpiPen is classified as both a drug and medical device by the FDA. As a result of this classification, pharmacists in 29 states can't simply switch a generic epi injector for an EpiPen the way they could with medications that do not require a device, such as antibiotics. This ensures that an EpiPen prescription remains a branded EpiPen prescription and not a generic epinephrine injector prescription.
Mylan is sitting in a sweet spot as this confluence of competitive advantages has enabled it to garner a significant price premium for its product. I am convinced though that this pricing power will be short lived. The spotlight that the pricing controversy has created along with the high profits that Mylan is earning is likely to attract new competition and put pressure on the FDA to approve competitor products.
My second question is a question I ask myself often- WWMD - What would Munger do? What would Munger do if he was running one of these pharma companies? As in the quote above, Munger has on several occasions talked about exploiting untapped pricing power where it exists but he also recently referred to Valeant as "a sewer" at the Berkshire annual meeting. So what's the disconnect. These pharma companies have in some ways followed the capitalistic playbook that Munger laid out on more than one occasion. These companies have capitalized on their untapped pricing power and nearly inelastic demand for their drugs by consistently raising prices. "It's the ultimate no-brainer," says Munger. If I have to conjecture, I think that Munger would have also increased prices for some of these drugs to tap some of the latent pricing power. However, I am convinced that he would not have been as aggressive and egregious in his approach, but rather tempered and responsible. In the long term, the short term profits captured by these egregious price hikes will inevitably be tempered by the spotlight on these companies and the inevitable entrance of competitors as result.
I'm not a public policy expect or an ethics professor so I don't feel qualified to comment on the morality of these massive price hikes on life saving drugs. However, I do believe that there are adverse business consequences for companies that are perceived to be immoral actors, especially in the healthcare industry. See what happened to both the CEO of Turing and Valeant - they got canned! These adverse consequences include scrutiny from Congress (whether it's grandstanding, I'll let you decide) and government bodies like the FDA. Thus there is business rationale to exercising some degree of restraint when it comes to price increases. Also there is a necessity to justify such pricing actions proactively rather then reactively as opposed to the common response of, "because we could". Restraint, morality and reasonable, justifiable increases make for long term success and keep companies from being demonized as villains.
I am convinced that these lopsided economics for drug companies cannot last- which is part of the rationale for implementing more reasonable price increases. The spotlight that egregious price hikes attract also attract innovation and competition that is ultimately bad for the long term pricing power. In the case of Daraprim, CVS found a workaround to create its own generic version that doesn't need FDA approval. Something similar will happen with the EpiPen, although it may take a bit of time.
Afternote: After writing this post, I saw that Mylan announced that it would introduce a generic version of the EpiPen (the same exact product without EpiPen written on it) at half the cost - $300 - within a few weeks. From a pricing strategy standpoint, this seems like a smart move. It quells some of the furor around the price hikes, while also discouraging some potential new competitors from entering the market. While it does cannibalize their existing branded product, Mylan is essentially cannibalizing itself before a new competitor does. Furthermore, it severely debilitates new entrants in the market by lowering to a price point where consumers/doctors might be willing to pay a smaller premium to buy the solution that they know and trust. Would you rather buy a life saving injector from a new company for $200 or a life saving injector from the company that makes the trusted EpiPen for $300?
After afternote: After having some technical difficulties with getting this post live, Imprimis Pharmaceuticals (a compounder - different from a traditional pharmaceutical company) announced it was launching a $100 version of the Epipen. Also the US House of Representatives Oversight Committee launched an investigation into Mylan over price gouging.