GoodRx's S-1, How PBMs Work, Another Telemedicine integration

This is how you get 40% EBITDA margins

Sep 10, 2020

I’ve wanted to dig into GoodRx for a while. Now that they’ve filed an S-1, I’m well past due to write them up.

In this issue:

How PBMs work, and how they dominate their value chain
Gaps in the pharmaceutical value chain for cash pay / uninsured patients
How GoodRx makes money, and the keys+threats to their high margins
Why should GoodRx pursue telehealth if it lowers their margins?

Pharmacy Benefit Management for Fun and Profit

Before we get to GoodRx, let’s first understand the value chain that they operate in, in particular the role of the PBM. (If you already know this, or just don’t care, feel free to skip to the next section!)

Here’s how I picture the market for insured patients:

PBMs sit right in the middle, which is notable because they do not manufacture, distribute, dispense, prescribe, or bear risk for the costs of drugs. Instead, they make money off of the people who do those things, aggregating demand on one side of the market, and using that demand to set the terms of their relationships with suppliers.

PBMs originated as claims processors for insurance companies. Prescription claims are both tedious and numerous, so it made sense for insurance companies to outsource this function to a third party that could do it more efficiently. (Modularity! Although PBMs have since begun re-integrating with payers).

In practice, this means PBMs are highly concentrated, do a lot of purchasing, and know more about drug prices than anyone else. They use that advantage to generate revenue as intermediaries between insurance companies and pharmacies. (And also other sources of revenue, such as from drug companies, which we’ll ignore for now.)

Specifically, PBMs maintain a ‘network’ of retail pharmacies that are willing to accept the (low) prices on offer, much in the way an insurer maintains a network of doctors. Unless pharmacies join these networks, their customers won’t have drugs covered by insurance and will go elsewhere.

When an insured patient buys a drug from a pharmacy, the pharmacy bills the PBM for it. The PBM pays the pharmacy, then turns around and bills the insurance plans a higher amount, making money on the difference, or spread. In some cases, the PBMs might not use a spread but will charge the pharmacy a network fee per transaction.

Cash Pay Patients are Under-Served

That’s for insured patients. Things look different for cash pay patients, where all of the stakeholders are under-served:

Cash pay patients pay full list price for their drugs in cash, and those list prices are much higher than the PBMs’ negotiated prices. Furthermore, patients don’t have a good way to shop around and compare prices across pharmacies. Pharmacies don’t publish their retail prices on their website, at least not in a consumer-centric way (most patients have insurance, so shopping around is moot). And even if they did, there’s no price comparison site for drugs like those that exist for, say, flights and hotels.
Pharmacies profit from cash pay patients, but high list prices for cash pay mean that many such patients leave their prescriptions unfilled, rather than paid for. And pharmacies can’t lower these prices without eroding their position in the much larger insured segment.
PBMs represent insurance companies, so don’t have a way to make money off of cash pay patients. If they could find a way to take a cut of the cash pay business, it would be a growth opportunity.
Physicians who are treating uninsured patients want to prescribe drugs that the patients can afford (and adhere to), but they don’t know which drugs are affordable.

Enter GoodRx, the hero of our tale.

GoodRx brings PBM pricing to uninsured patients

GoodRx solves all of those unmet needs at once, simply by presenting the PBM’s prices to the patient in the form of a coupon.

Patients avoid the ultra-high cash pay prices (GoodRx says their prices average 70% less), and can shop around for the very best deal.
The PBM can now collect their transaction fee from the pharmacy, sending part of that fee back to GoodRx.
The pharmacy doesn’t come out great, but will accept the coupon in order to make the sale, plus it’s already agreed to the price anyway among insured patients.

I want to connect GoodRx’s operation back to a concept I previously wrote about, framing One Medical’s business model is a form of arbitrage:

One Medical’s business can be thought of as aggregating private pay customers, and then selling them to health plans at a markup via their partnership program.

GoodRx operates on a similar principle: uninsured patients are valuable for PBMs, but hard to access. GoodRx offers a value-added service to those patients, which means patients use GoodRx as their first stop in shopping for drugs. PBMs then pay GoodRx to access those patients.

Flipping that around, GoodRx first acquires the patient, then monetizes it by ‘selling’ it to the PBM. Buy low, sell high.

The great thing about an arbitrage business is how little it costs: GoodRx spends nothing on direct unit or labor expenses. Their ‘Cost of Sales’ line item comes down to odds and ends like AWS fees, and so the margins that they generate are excellent. In that sense, it’s a more powerful approach than One Medical’s, which must build out a costly footprint of tastefully decorated storefronts to attract patients.

High margins, though, are a bit like blood in the water: they attract a lot of sharks. How durable will GoodRx’s margins turn out to be in the long run? There are two threats that concern me the most.

Margin Threat #1: Scalable Customer Acquisition

If you think of GoodRx as arbitrage of patients as described above, then customer acquisition really should be considered a direct cost for analysis purposes. A retail business buys widgets and sells them at a markup, and records the price they pay for each widget under ‘Cost of Goods Sold.’ GoodRx buys patients and sells them to PBMs at a markup, so operationally, their customer acquisition cost is equivalent to COGS, even though it doesn’t show up that way on the income statement.

The problem with acquiring patients cheaply is that, eventually, costs start to increase. The first customers to find your product are the ones that really need it, they’re the segment where you have the best product-market fit. As you scale, it takes more advertising dollars to acquire a marginal customer, even as you must also invest to build your brand.

Furthermore, the best places to look for new patients tend to be places like Facebook and Google. You can buy low because you have a nice app, but Google can buy lower because their search engine is one of the greatest products of all time. So, Google captures more of the value. This is part of what has happened to Dollar Shave Club and the online travel agencies.

I think GoodRx has found a way around that trap in the form of…doctors. Doctors don’t generate any value for GoodRx directly, but are critical as a marketing channel. A patient that hears about GoodRx from their doctor is not just aware, but getting a valuable endorsement from a trusted source. GoodRx knows this (pg 119 of the S-1):

…approximately 17% of our website visitors are healthcare professionals. Our NPS score among healthcare professionals who use our platform was 86 as of February 2020, and over 2 million prescribers have a patient who has used GoodRx. We are able to integrate our pricing information and GoodRx codes directly into EHR systems, enabling healthcare professionals to provide prices from our platform directly to their patients at the point of prescribing, including via EHR-sent text messages and emails.

See also, under ‘Marketing’ (pg 126):

We have also built GoodRx Pro, an app designed specifically for healthcare professionals to facilitate electronic prescriptions. This app is integrated with our prescription offering to enable physicians to quickly find the form, dosage and quantity of medication that they intend to prescribe and seamlessly send pricing that is available on GoodRx to their patients.

This is just beautiful. Somewhere, a marketing team figured out how important doctors are in driving adoption, even though the doctors produce no value for GoodRx directly. This insight was elevated to a product team, which created an entirely separate app devoted to exploiting it.

Selling through doctors is difficult. Pharma companies mobilize enormous sales forces to do it, a brute force approach that pays off because their reps carry bags full of multi-billion dollar drugs. GoodRx can’t afford that, but they get a good result by building an app that adds real value to the doctors, which translates directly into customers. Even if the doctors don’t have the app, GoodRx is right there in the EHR, which by the way is happy to offer GoodRx’s data because it adds value to their own systems.

Finally, note that the ‘Pro’ app is a fixed cost, not a direct cost—it will enable GoodRx to scale their customer acquisition much more effectively than a sales force, or relying too much on Google ads.

Margin Threat #2: Competition

In financial disclosures, companies love to play up their competition because (a) the point is to warn investors about risk and (b) they don’t want to get regulated. GoodRx says this about competitive threats:

Within the prescriptions market, our competition is fragmented and consists of competitors that are smaller than us in scale. There can be no assurance that competitors will not develop and market similar offerings to ours…

‘Fragmented’ is another way of saying that there are a lot of competitors emerging. Indeed, a Google search for “cheap prescriptions near me” yields a massive ad load from competitors like WellRx, RxSaver, etc. If any of these become large, it gives PBMs a better BATNA, patients another choice, and lowers switching costs for both, certainly reducing GoodRx’s margins. Common ways to stave off competition include economies of scale, network effects, switching costs, branding, etc.; are any of those in play?

There might be a scale effect in the sense that generating more patients allows better terms with PBMs, which enables lower costs, which enables lower prices, which loop around to attract even more demand. Combined with a head start on the experience curve and a head start in brand building, that might produce a semi-durable advantage. Certainly GoodRx has done a fine job of executing thus far.

On the flip side, switching costs are low for both patients and PBMs. Margins are high enough that even an inefficient upstart could absorb lower margins and still earn an attractive profit. There are relatively few barriers to entry. To maintain a dominant position, GoodRx will need more tricks…like telehealth?

Why telehealth?

Over 90% of GoodRx’s 2019 revenue came from the core prescription product that we’ve discussed above, and a bit more comes from selling ad units on their app. The rest comes from:

Hey Doctor, a telemedicine provider that they acquired last year
GoodRx Telehealth Marketplace, which launched this year

That’s two bets on telemedicine just 11 months apart, which is striking because of the lower margins in telehealth. As Kevin O’Leary hilariously notes:

I find it funny that GoodRx has to call out its telehealth platform HeyDoctor in the risk factors section of the S-1 because the margins are so much worse than the core business. “Our business model is so good that if we’re too successful in the telehealth space it’s going to be bad for us financially”. What a flex.

And yet…it’s a fair warning! You have a core business that is growing quickly and extremely profitable. Do your newest investors really want to fork over their capital when you spend it on a less profitable telehealth business instead?

Aside from the obvious synergies around cross selling, I’ll offer two angles:

The LTV/CAC angle. GoodRx invests a lot in patient acquisition (building good apps, advertising). Once a patient hits their website, though, it’s time to monetize.
One monetization tactic involves collecting a fee on the patient’s prescription—this is GoodRx’s core product—and telehealth will be a second tactic. Many GoodRx users are sick and will need convenient doctor visits. As long as the margins in telehealth are positive, then adding a second monetization tactic will increase the lifetime value (LTV) of each patient. In addition, more users will find the platform organically, so cusomter acquisition costs (CAC) go down. Taken together, this means the LTV / CAC ratio should improve dramatically with each additional tactic.
To be clear, LTV / CAC is not a perfect metric, since it says nothing about customer volume. Consider an alternative use for the funds spent on telehealth: GoodRx could drive more volume AND margin by spending its cash buying more customers for its high margin business. But that’s only a short-term win.
Telehealth might produce lower margins but it juices the unit economics of the business for the future, where each new customer is monetized in multiple ways and is stickier. That in turn justifies higher marketing spend, and allows GoodRx to be profitable at higher volumes.
In my view, GoodRx correctly takes the long view by investing in a low margin opportunity.
The Telehealth-as-a-complement angle. I wrote in June that one possible outcome of the telehealth industry is heavy consolidation, given that there are economies of scale, and geographic distribution constraints that have been removed. This would be a poor outcome for GoodRx, since doctor visits are a powerful complement to their business (visible in their Q2 numbers, which are down as the pandemic halts doctor visits). Products become more valuable when their complements are commoditized.
To understand the risk, picture a powerful, centralized telehealth provider. This hypothetical company would be in a great position to offer its own prescription discount solution, because the doctors it employed would all use it. Alternatively, it could contract with GoodRx, but capture much of the profit through the terms of that contract. GoodRx therefore wants to foster healthy competition among telehealth providers, and owning a piece of the action (HeyDoctor) or running a marketplace, help do exactly that.

Conclusions

GoodRx’s high margins are grabbing all of the headlines. A profitable startup, in 2020! But unit economics at the patient level are a better way to assess GoodRx’s prospects than just margins.

Unfortunately, the unit economics can’t fully be derived from information in the S-1. Regardless, a bet on GoodRx must include a point of view on their ability to continue bringing in customers cheaply, and account for the various ways those customers can be monetized. Further, it must consider the potential impact of competitors that are already chasing those very same margins.

Structurally, GoodRx is making things a little better for uninsured patients - in that way, it complements Sesame. I’m going to explore the implications of a market that caters to uninsured patients in an upcoming essay.

The Caseload