Archive for March, 2010
Protected: March 28, 2010 Three Reform Realities That Aren’t Priced In
March 16, 2010 Initiating Coverage – TMT: The Only Constant is Change – Sector & Sovereign Research, LLC
We advocate an aggressive stance in TMT, with a focus on stocks positioned to take advantage of major paradigm shifts driven by innovations in smartphones, IP video, 4G, LED lighting, telepresence and cloud computing. We note that Apple, Cisco and particularly, Google have positioned themselves advantageously across multiple opportunities, with Nokia, Qualcomm, Broadcomm, ARM, Ericsson, Netflix, NewsCorp, Cree, Veeco, Polycom, Salesforce.com, and Amazon also well stationed. We also favor emerging companies with proprietary advantage in key new technologies, as well as new business models that are levering technology to attack traditional markets. We are skeptical as to the potential for companies in sub-sectors without IPR-based competitive barriers – e.g. telecom, cable, television networks, manufacturing, distribution and many semiconductor categories – to sustain above average returns.
TMT currently trades at a modest premium to its 5 year average vs. the S&P500. On the whole TMT has performed only slightly better than the market over the past 12 months, but this is misleading, as the very poor relative performance of cable, telcos and to a lesser extent, semiconductors pulled down the average. TMT sector analysts are expecting 23% EPS growth for 2010, well ahead of full market expectations, but, in our opinion, achievable, given potential for margin expansion on cost reductions and revenue growth. On a subsector basis, semiconductors and hardware may have the most difficult time meeting expectations while software, tech services, mobile devices, and internet stocks face a lower bar.
New disruptive technologies are moving from conception to commercialization, assisted by the improvements in semiconductor speed, size and power draw predicted by Moore’s Law. History suggests that the adoption of new technical paradigms can occur swiftly and comprehensively, catalyzing enormous growth for companies that can catch the wave. We believe that future users will access most applications and content via wireless internet connections with powerful search/navigation tools and that the opportunity to profit from content aggregation and regulated oligopolies will be severely compromised. We also anticipate dramatic reductions in the cost of LED lighting that presage the end of the 135 year run for the incandescent light bulb. We expect enterprise technology use to become even more web-centric, as telepresence displaces business travel and cloud computing breaks reliance on in-house data centers.
The trajectory of technological change is governed by formal and informal standards processes, subject to industry politics, government regulation and policy, and customer adoption which may favor some market participants to the detriment of others. Size and incumbency can help, but more often hinder companies seeking to gain advantage. Many of the best TMT investments in history were the direct result of winning this crucial game, often against well established competitors. The benefits of standards are typically robust and long-lasting, at risk only to new disruptive innovation and thus, new standards obviating them.
The concentration of value along TMT value chains is also changing. Manufacturing and distribution have largely ceased to be a competitive factor, while increased competition has and will continue to pressure margins for network operators of all ilks. The weakening of “gate keepers” should allow owners of unique proprietary intellectual property and content to reap even greater benefit in the future.
To view this entire report and to see other available research see “Prior Research”
PBM Gross Margins – This Looks Like the End of the Cycle
Since 2001, PBM gross profit per claim has grown three times faster than average drug prices, and 1.25 times faster than drug retail mark-ups
As with drug retail, during this period PBMs benefitted from drug price inflation and an increasingly generic product mix. Unlike drug retail, PBMs shared in increasingly generous manufacturer rebates; and, PBMs gained at drug retail’s expense by driving retail mark-ups and dispensing fees downward
PBMs’ gross margin (GM) gains came predominantly after 2005; since this point the 3 major PBMs’ GMs have been of roughly similar magnitudes and have grown at roughly similar rates, characteristic of a cooperative oligopoly. Industry structure also is consistent with oligopoly; the 3 majors have roughly 50 percent share of US Rx’s; the next full-service / non-captive PBM has roughly 3 percent
MHS and CVS saw slight declines in GM – and attendant shifting of clients – in 2009. It is reasonably clear that the PBM competitive dynamic since 2005 has been one of (implicitly, not explicitly) cooperative oligopoly; the question of whether MHS v. CVS action in ’09 signals a near-term shift to price competition is a coin-toss. Looking out to the mid-term, we see a return to price competition as
highly likely, as we expect business conditions to deteriorate for PBMs
The traditional (and current) PBM model relies on large volumes of highly interchangeable products, written by large numbers of prescribers and consumed by large numbers of patients. Share shifting in this context is a clinically sterile (drug choice matters little), brute force process of converting very large volumes of moderately priced prescriptions at a very rapid pace – something PBMs do better than their plan sponsors (HMOs and employers)
As the market shifts from these traditional, highly interchangeable products to more specialized products, whether to use a product and which product to use becomes a slower moving, more clinically complex and higher dollar per-decision game – something health insurers do better than PBMs
We suspect that PBMs cannot shift from traditional products to specialty products quickly enough to preserve GMs (75 percent of sales attributable to highly interchangeable products will lose patent by 2014) nor do we believe PBMs offer the same value proposition in specialty care (particularly to HMOs) that they have with more traditional products. Add to this the likelihood that the cooperative pricing dynamic crumbles, and we see considerable odds of considerable mid-term GM pressure
In the very near term, PBMs may benefit from deeper manufacturer rebates if Congress chooses to expand Medicaid – either as part of large scale reforms, or as a separate initiative
We believe that large scale reforms will not pass, but whether the Speaker holds a vote on large scale reforms is potentially meaningful to informed trading of PBMs in the near-term. If the Speaker holds a vote that fails, Congress is unlikely to attempt a smaller reform package, meaning no Medicaid expansion and no attendant benefit to PBM GMs. Conversely, if the Speaker declines to vote on large
scale reforms, we see reasonable odds that Congress passes a modest reform package that expands Medicaid, with a one-time near-term benefit to PBM GMs
Beyond the near-term matter of Medicaid expansion, we see more downside than upside in the PBM business model, as both fundamentals and competition conspire to narrow margins. Drug retailers are more levered to the GM benefits of an increasingly generic product mix; and, being free of PBM’s risks, strike us as a far better way to play this trend