Amazon made a big step forward in its healthcare ambitions last week, with the $1 billion acquisition of PillPack.
The acquisition ends years of will-it-or-won't-it speculation about Amazon's intentions in pharmaceuticals. This sudden shift is similar to Amazon's other recent major acquisition of Whole Foods. While the cost this time is an order of magnitude smaller, the impact on the competition was similar. Walgreens and CVS dropped nearly 10% on the day the deal was announced, and all told some $13 billion in market cap was wiped out from companies in the pharmacy sector - a phenomenon that grocery stores know all too well.
So why did Amazon buy PillPack? A big motivating factor is that PillPack possesses pharmacy licenses in all 50 states. In a highly regulated industry, this kind of head start can save a lot of money and time. Additionally, PillPack's business model gives Amazon recurring deliveries and recurring revenue, giving the company an opportunity to cross sell the rest of its products to these customers.
Beyond that, the PillPack acquisition is a curious one for Amazon. PillPack specializes in providing monthly supplies of pills for chronic-disease patients. Pharmaceutical consumers, and chronic-disease patients in particular, tend to skew older than Amazon's typical Prime customer base. And while Amazon may have giant ambitions in healthcare, PillPack gives it a mere fraction of a percent in market share, and no clear path to the kind of dominance we've come to expect.
Amazon's Consolidation Conundrum
The challenge for Amazon lies in the way U.S. consumers get their pills. While many people get prescription drug plans along with their insurance, those plans are often not actually managed by the insurer. Instead they're run by companies called pharmacy benefit managers (or PBM's for short). PBM's effectively manage your prescription drug plans much the same way your insurer manages your primary care.
So what's wrong with PBM's for Amazon? Well, PBM's are extremely consolidated. Collectively, PBM's managed some 80% of drug benefits in the U.S. in 2017. And just three companies controlled in excess of 70 percent of the market.
These companies, Express Scripts, CVS Caremark and OptumRX have worked with PillPack in the past, but they will be wary of Amazon's entrance into their industry.
This consolidation poses a problem for Amazon's usual path to dominance in a new industry. Here's how Amazon's strategy usually works. Its linear ecommerce business typically seeds the market by focusing on high volume items.
The next step for Amazon is to then open up the industry to its third-party marketplace. This pattern has played out in one vertical after another, from books to consumer electronics to, most recently, B2B distribution.
The linear business provides initial volume and baseline revenue, and the platform business brings scale, product breadth, defensibility and increased margins.
In pharmaceuticals Amazon's wedge would be generic drugs, which often have several manufacturers who primarily compete on price. Generics still only make up about a third of global pharmaceutical sales, but their sales are growing three times faster than branded drugs, giving Amazon a clear opportunity to capitalize on that growth.
However, given the consolidation of PBM's, who effectively serve as a middleman between the customer and manufacturers or distributors, it's not clear whether Amazon's typical marketplace model would work in pharmaceuticals. One answer might be for Amazon to become a PBM itself. It could then vertically integrate throughout the whole supply chain, from distribution down to consumer sales, by opening pharmacies in each of the nearly 500 Whole Foods stores it has in the U.S. as of last year. This would give Amazon a clear path to owning the customer relationship.
But even then, Amazon would likely struggle to gain significant market share, as the big three PBM's could effectively cut Amazon off from much of the existing market. And, marketplaces typically struggle to scale in such consolidated markets. This is not to say Amazon couldn't establish itself as a fourth large PBM. But this would take many years and a huge investment on Amazon's part, and it would involve building out a lower-margin linear business without a clear path to platform dominance.