Last year I noticed an article on @WSJ about a possible change to the treatment of rebates from drug manufacturers attributable to government accounts of pharmacy benefit managers (PBM). I posted about it on Twitter when I saw it, as I have been interested in the apparent influence of this source of revenue within the overall operations of insurers. I decided to invest a little time this weekend into this by reviewing the most recent 10Q from UnitedHealth Group ($UNH) to seek out some details.
I am particularly curious about the reliance by UnitedHealth on the treatment of drug manufacturer rebates on its earnings, and how its subsidiary, Optum, fits into the story. I find the entire topic interesting. I came across a May 2019 report by CBO here. Very interesting.
So, the Trump administration announces changes to outlook on drug plans and major health insurer market caps pop by 5-12%. Interesting.
— Jens Thorsen (@jensholger78) July 12, 2019
#employeebenefits #stoploss #pbm #rebates https://t.co/hkOS3Mbjxa
Background
Prior to delving into some analysis, I looked for some background on the history and current operations of United Health Group, also known as UHC, which trades on NYSE as UNH. According to Mergent Intellect:
“UnitedHealth Group traces its roots back to Dr. Paul Ellwood, the health-policy guru who coined the term “health maintenance organization,” or HMO, in the 1960s and helped entrepreneur Richard Burke found the company in 1977. Then United HealthCare Corporation, the company acquired Charter Med Incorporated, a company formed by a group of physicians and other health care professionals who wanted to expand health coverage options for consumers. In 1984, United HealthCare Corporation became a publicly-traded company and in 1998, was renamed UnitedHealth Group.”
“UnitedHealth Group is a leading US health insurer offering a variety of plans and services to group and individual customers nationwide. Its UnitedHealthcare health benefits segment manages health maintenance organization (HMO), preferred provider organization (PPO), and point-of-service (POS) plans, as well as Medicare, Medicaid, state-funded, and supplemental vision and dental options. In addition, UnitedHealth’s Optum health services units – OptumHealth, OptumInsight, and OptumRx – provide wellness and care management programs, financial services, information technology solutions, and pharmacy benefit management (PBM) services to individuals and the health care industry.”
Within the esteemed community of insurance professionals, United is known as the “U” in the large health insurers, oftentimes referred as a group as BUCA (i.e. Blue Cross, United, Cigna, and Aetna).
Financial Review
I invested some time today into a review of recent UNH financial statements. In particular, I reviewed the current 10Q and its accompanying press release, and, focusing upon the income statement and some footnotes, I created the following analysis:
| (in USD millions) | March 31, 2020 | December 31, 2019 | Change |
| Revenue | |||
| Premiums | $ 50,640 | $ 47,513 | 6.58% |
| Products | $ 8,431 | $ 8,072 | 4.45% |
| Services | $ 4,985 | $ 4,318 | 15.45% |
| Investment and other income | $ 365 | $ 405 | -9.88% |
| Total revenues | $ 64,421 | $ 60,308 | 6.82% |
| Operating costs | |||
| Medical costs | $ 41,000 | $ 38,939 | 5.29% |
| Operating costs | $ 10,015 | $ 8,517 | 17.59% |
| Costs of products sold | $ 7,687 | $ 7,381 | 4.15% |
| Dep. and amort. | $ 723 | $ 639 | 13.15% |
| Total operating costs | $ 59,425 | $ 55,476 | 7.12% |
| EBIT | $ 4,996 | $ 4,832 | 3.39% |
| Interest expense | $ (437) | $ (400) | 9.25% |
| EBT | $ 4,559 | $ 4,432 | 2.87% |
| Tax expense | $ (1,094) | $ (875) | 25.03% |
| Net Earnings | $ 3,465 | $ 3,557 | -2.59% |
| Earnings attributable to noncontrolling interests | $ (83) | $ (90) | -7.78% |
| Earnings attributable to UHG common shareholders | $ 3,382 | $ 3,467 | -2.45% |
| Source: UNH Form 10Q |
This preliminary review did not really respond to the question about the impact of Optum on the results of United Health Group, much less the contribution of aspects of Optum’s operations. However, some additional reading of the press release on page 4 leads to the following additional data:
| (in USD millions) | March 31, 2020 | December 31, 2019 | Change |
| Revenue | |||
| UnitedHealthcare | $ 51,068 | $ 48,896 | 4.44% |
| Optum | $ 32,839 | $ 26,360 | 24.58% |
| OptumHealth | $ 9,192 | $ 6,713 | 36.93% |
| OptumInsight | $ 2,494 | $ 2,189 | 13.93% |
| OptumRx | $ 21,557 | $ 17,817 | 20.99% |
| Optum eliminations | $ (404) | $ (359) | 12.53% |
| Eliminations | $ (19,486) | $ (14,948) | 30.36% |
| Total consolidated revenues | $ 64,421 | $ 60,308 | 6.82% |
| Earnings from operations | |||
| United Healthcare | $ 2,888 | $ 2,954 | -2.23% |
| Optum | $ 2,108 | $ 1,878 | 12.25% |
| OptumHealth | $ 712 | $ 626 | 13.74% |
| OptumInsight | $ 536 | $ 432 | 24.07% |
| OptumRx | $ 860 | $ 820 | 4.88% |
| Total consolidated earnings from operations | $ 4,996 | $ 4,832 | 3.39% |
| OptumRx | |||
| Quarterly adjusted scripts (in millions) | 339 | 333 | 1.80% |
| Contribution to consolidated revenue | |||
| Estimated United Healthcare eliminations | $ (19,082) | $ (14,589) | 30.80% |
| Estimated United Healthcare net contribution to revenue | $ 31,986 | $ 34,307 | -6.77% |
| Estimated Optum net contribution to revenue | $ 32,435 | $ 26,001 | 24.75% |
So, over a period of this quarter, the contribution of Optum’s pharmacy benefit services division, OptumRx, accounted for 17% of UnitedHealth’s operating earnings: $860 during the Q1, 2020 and $820 during Q4, 2019. Furthermore, as a percentage of total revenue (net of eliminations) the total contribution by Optum to UHC revenue is 50%. Not unsubstantial, especially when considering OptumRx contributes 66% of Optum’s total revenue!
This analysis still does not respond directly to my questions about the influence of rebates on UnitedHealth’s earnings. I found the following chart on page 14 of the recent 10Q filing, which raised some additional questions:
Nearly 100% of “product revenues” for Optum provided to unaffiliated customers during the 3 months ending 3/31/2020 came from OptumRx. I could not find a useful discussion of how manufacturer rebates are incorporated here, but I did find a reference on the prior year’s 10K:
The Company’s cost of products sold includes the cost of pharmaceuticals dispensed to unaffiliated customers either directly at its home delivery and specialty pharmacy locations, or indirectly through its nationwide network of participating pharmacies. Rebates attributable to non-affiliated clients are accrued as rebates receivable and a reduction of cost of products sold, with a corresponding payable for the amounts of the rebates to be remitted to those non-affiliated clients in accordance with their contracts and recorded in the Consolidated Statements of Operations as a reduction of product revenue. Cost of products sold also includes the cost of personnel to support the Company’s transaction processing services, system sales, maintenance and professional services.
United Health 2019 SEC Form 10K, Page 57
I wonder what the magnitude of the rebate dollars were for this period: in aggregate, as well as by affiliated and unaffiliated segments. I have not found a clear disclosure of those values. I looked for some basis by which to estimate this and came across are variety of interesting sources: the following very interesting study by Milliman under contract by AHIP (specific to Medicare Part D), the following very interesting article at KFF (specific to Medicaid). Also, the following chart from Statista.
The challenge in making estimates of these rebates is, depending on where you get data, there is a lot of potential bias; For example, as stated in this report by the Center for American Progress, “[t]here is no one price for a drug: Medicare, Medicaid, and different private payers all pay different amounts for the same product, and depending on a patient’s source of insurance, the patient’s share of the drug cost will also differ.” Then, you might find evidence from a source, such as this report from AARP, but then you have to consider the profile of the group (in this case older with possibly higher utilization of more expensive drugs within the category), and consider if the basket referenced at $6,800 per year is really a reliable proxy for average cost across the health care system, overall.
So, I created a framework below based upon prescription count and total cost. (Once I publish this, I will go ask some independent experts to take a look at my math and assumptions.) Perhaps approximately 134 million prescriptions run under OptumRx during 2019 were subject to a meaningful rebate. Alternatively, perhaps 85% of the total $96 billion run under OptumRx was subject to a meaningful rebate. Based upon some very rough assumptions, I develop the following calculations:
| Item | Value | Source | Comments |
| Total 2019 prescriptions | 1,340,000,000 | 2019 10K, P38 | This is disclosed |
| Brand prescription, as a % | 10% | Estimate | |
| Brand prescriptions | 134,000,000 | “ | |
| Average brand cost per script | $600 | “ | |
| Total brand costs | $80,400,000,000 | “ | |
| Average rebate, as a % | 20% | “ | |
| Average rebate per rx | $120 | “ | |
| Total rebates | $16,080,000,000 | “ | |
| Percentage “passed through” | 80% | “ | This is a total guess |
| Illustrative rebate retained by Optum | $3,216,000,000 | “ | |
| Total costs during 2019 for OptumRx | $96,000,000,000 | 2019 10K, P9 | This is disclosed |
| Total brand costs, as a % | 85% | Estimate | |
| Total brand costs | $81,600,000,000 | “ | |
| Average rebate, as a % | 20% | “ | |
| Total rebates | $16,320,000,000 | “ | |
| Percentage “passed through” | 80% | “ | This is a total guess |
| Illustrative rebate retained by Optum | $3,264,000,000 | “ |
So, I estimate that there was roughly $3 billion retained by UnitedHealth after “pass through” agreements to various parties. This seems to me to be, from an order of magnitude perspective, reasonable based upon the price move that was reported in the @WSJ article originally referenced. I include some figures below.
| Item | Value | Source | Comments |
| UNH Shares outstanding | 964,000,000 | https://www.macrotrends.net/stocks/charts/UNH/unitedhealth-group/shares-outstanding | Quarter ending 6/30/2019 |
| Prior stock price | $247.48 | WSJ article referenced from July 11, 2019 | |
| Change in stock price | $13.68 | WSJ article referenced from July 11, 2019 | |
| Change in market cap | $13,187,520,000 | ||
| ERP | 5.67% | http://pages.stern.nyu.edu/~adamodar/ | Damodaran’s data |
| RF Rate | 2.0% | ||
| Levered Equity Beta | 0.75 | Yahoo Finance | Based upon 5/31/2020 |
| Estimated WACC | 7% | https://finbox.com/NYSE:UNH/explorer/wacc | |
| Inferred improvement to annual FCF based upon move in stock price | $923,126,400 | FCF improvement / WACC = Change to market value of equity |
I wonder if a call into investor relations would lead to a clear disclosure of manufacturer rebates paid to OptumRx, subsequently passed through to non-affiliated customers, passed through to customers of affiliates, passed through to affiliates, and not passed through at all. I am curious, but imagine this will remain an academic curiosity, as the time is 4:36pm on Sunday, May 31, 2020 and I am going to start my grill!
Post-script: Following a request for input that I posted on Twitter, I had a connection made to Adam Fein, Ph.D. He has a very clear and relatively comprehensive flow-chart for the pharmacy business included below. He also has a website that addresses some of the topics from this blogpost here.
Furthermore, at this link, Dr. Fein has an OpEd published in the Wall Street Journal that addresses some of the issues with the ecosystem for prescription drugs. Specifically:
The payments are massive. Last year manufacturers paid $166 billion in rebates and discounts, amounting to a 40% reduction in prices for off-brand drugs. Certain essential drugs like insulin sell at even deeper discounts. PBMs are able to demand these big rebates from drugmakers because a small number of them handle most of the drug purchases for America’s insurers. As a consequence, sale prices for brand-name drugs increased only 1.5% last year. That marks the fourth consecutive year that net drug prices have grown by low single-digit amounts. “Big Pharma” companies such as Johnson & Johnson, Merck and Novartis have disclosed that their drugs’ prices actually declined last year after rebates and discounts were accounted for. Critics have accused PBMs of pocketing the discounts, decreasing drug manufacturers’ revenue without any benefit to consumers. In fact, PBMs pass the bulk of the rebates to the health plans they represent. Plans are then able to offset part of the cost of nondrug treatments, and reduce their premiums. This article appeared in the February 4, 2019, print edition of The Wall Street Journal.
Yes, this issue continues to be quite interesting!