Healthcare

We expect 3.0% (nominal) y/y growth in US health services demand during 2Q13, the product of 1.6% growth in unit demand, and 1.4% price growth. Unit demand growth remains very slow; the projected 1.6% rate is essentially equal tothe inherent rate of demand growth (1.5%) attributable to population growth and aging alone, and well below our long-term expectation of 2.8%

We expect nominal pricing to decelerate 50 bps during the quarter, from 1.9% to 1.4%; this is a direct consequence of the 2% decline in Medicare payments brought about by the ‘fiscal cliff’ sequester. Dental is the only major health subsector that appears largely insulated from sequester effects

Independent of our quarterly growth rate models, we handicap the odds of a trend break, i.e. a significant acceleration or deceleration in demand. The trend-break model still indicates near zero probability – <2% – of accelerating demand in 2Q13

Our models correctly anticipated that the downward trend in unit demand would persist during 1Q13 – however the fall was even more dramatic than our pessimistic view. This is directionally consistent with company reported results from the quarter – where surprises to the downside of sell-side analyst revenue consensus estimates far exceeded positive surprises

We continue to believe that demand is weak primarily because of low employment, which translates into a smaller percentage of households having the benefit of the most generous source (employer-sponsored) of health coverage. Employment gains, expansion of Medicaid eligibility, and the initiation of state health insurance exchanges all are likely to expand the availability of health coverage in the relatively near-term

We recommend a pro-US / pro-cyclical tilt to healthcare portfolios; this translates into overweight positions for Hospitals, select Non-Rx Consumables (especially more US-focused names such as CFN and OMI), and select Dental names (emphasize more US-focused names with product lines that include higher-mix items, such as XRAY and PDCO). We recommend underweight positions in Large-cap Pharmaceuticals (on US real pricing power concerns), drug trades (Retail, Wholesale, PBM)(on the loss of AWP pricing, and risks of PBM disintermediation), and Research Tools / Services (implied revenue growth exceeds R&D spending growth)

For our full research notes, please visit our published research site

The Center for Medicare and Medicaid Services’ (CMS) final rule replacing average wholesale price (AWP) as a basis for reimbursing pharmacies for generic drugs dispensed to Medicaid beneficiaries will be published this August. The rule will be effective as early as this September, but no later than December of 2014. Our best guess is that the rule takes effect in either January or June of 2014

To process Medicaid prescriptions, pharmacies nationwide will have to include the AWP alternatives (average manufacturer price or ‘AMP’; and/or national average drug acquisition cost or ‘NADAC’) in their information systems – thus making AMP and NADAC available for commercial (e.g. employer-sponsored) drug benefit contracts

AWP bears no consistent relationship to pharmacies’ costs of acquiring generics; two government studies cited herein show that AWP-based reimbursement tends to exceed true acquisition cost by roughly 400 pct. AMP and NADAC both are closely related to true acquisition costs; these same studies show AMP-based pharmacy reimbursement exceeds true acquisition cost by only about 35 pct

We’re convinced commercial plan sponsors will insist on AMP or NADAC as reimbursement benchmarks once these are available in pharmacy information systems, that this will reduce generic dispensing margins throughout the drug trades (PBMs, retail, wholesale), and that PBMs will be most negatively affected

A common counter-thesis is that PBMs will simply shift to the new benchmark but price at a level that maintains to total gross margin. We believe this is unlikely for several reasons, primary among these being the tendency of AMP or NADAC to eliminate much of what makes newly launched generics so particularly profitable

Because AWP is not tied to acquisition costs, as acquisition costs fall in the first months and quarters following the new generic’s launch, pharmacy margins rise (the AWP-based reimbursement remains constant, even while the cost of the generic to pharmacies is falling). AMP and NADAC are tied to acquisition costs, thus as the cost of a generic to pharmacies falls (as it tends to do dramatically early in the new generic’s life), the AMP or NADAC based pharmacy payment also falls, narrowing the opportunity for outsized generic margins in the months and quarters following launch of a new generic

For our full research notes, please visit our published research site

We expect 2.9% (nominal) y/y growth in US health services demand during 2Q13, the product of 1.5% growth in unit demand, and 1.4% price growth. Unit demand growth remains very slow; the projected 1.4% rate is below the inherent rate of demand growth (1.5%) attributable to population growth and aging alone, and well below our long-term expectation of 2.8%

We expect nominal pricing to decelerate 50 bps, from 1.9% to 1.4%; this is a direct consequence of the 2% decline in Medicare payment rates brought about by the ‘fiscal cliff’ sequester. Dental services are significantly less affected by the sequester, and appear able to maintain steady price growth of roughly 3.7%

Independent of our quarterly growth rate models, we handicap the odds of a trend break, i.e. a significant acceleration or deceleration in demand. The trend-break model indicates near zero probability – <2% – of accelerating demand in 2Q13

Our models correctly anticipated that the downward trend in unit demand would persist during 1Q13 – however the fall was even more dramatic than our pessimistic view. This is directionally consistent with company reported results from the quarter – where surprises to the downside of sell-side analyst revenue consensus estimates far exceeded positive surprises

We believe demand is weak primarily because of low employment, which translates into a smaller percentage of households having the benefit of the most generous source (employer-sponsored) of health coverage. Employment gains, expansion of Medicaid eligibility, and the initiation of state health insurance exchanges all are likely to expand the availability of health coverage in the relatively near-term

We recommend a pro-US / pro-cyclical tilt to healthcare portfolios; this translates into overweight positions for Hospitals, select Non-Rx Consumables (especially more US-focused names such as CFN and OMI), and select Dental names (emphasize more US-focused names with product lines that include higher-mix items, such as XRAY and PDCO). We recommend underweight positions in Large-cap Pharmaceuticals (on US real pricing power concerns), drug trades (Retail, Wholesale, PBM)(on the loss of AWP pricing, and risks of PBM disintermediation), and Research Tools / Services (implied revenue growth exceeds R&D spending growth)

For our full research notes, please visit our published research site

For most households, the marginal costs of acquiring health coverage on an exchange are within shouting distance of the annual cost of a new car (Exhibit 1); and, the odds of health costs (if uninsured) exceeding costs of coverage (if insured) are less than 50 pct (Exhibit 3). Among subsidy-eligible households, in many cases net premium costs are higher for younger (and presumably healthier) than for older (and presumably sicker) beneficiaries with similar incomes (Exhibit 4). It follows that many households – especially younger and healthier – may choose not to purchase coverage

Assuming households that do purchase coverage do so optimally, +/- 80 pct of households would buy the cheapest (Bronze) coverage and the remainder (+/- 20 pct) the most expensive (Platinum) coverage. By purchasing the cheapest plan, healthy households (the 80 pct on Bronze) minimize their payment of excess premiums (premiums above their costs of care), and thus minimize the extent to which they subsidize households (the 20 pct on Platinum) whose medical costs exceed premiums paid

Small employers with younger and healthier employees can almost certainly save by self-funding, i.e. by avoiding the exchanges entirely. Stop-loss policies to self-funding employers can be priced to reflect a specific employer’s health risks, where fully-insured policies on the public exchanges cannot. This is likely to result in small group exchanges consisting of significantly worse-than-average health risks

We believe that the Affordable Care Act’s (ACA’s) provisions for limiting adverse selection are too weak (e.g. penalties for being uninsured are too low), or even counter-productive (higher effective premiums for younger than for older subsidy-eligible beneficiaries at a given level of income). The Act’s provisions for risk sharing are relatively strong; however these only serve to ensure equivalent relative exposure to unsustainably high absolute risks

Conclusion: Enrollment in individual and small group exchanges will be much less than originally (and perhaps even currently) expected; sellers of alternatives to full risk policies (ASO services, medical stop-loss insurance) in the small group markets will see accelerating demand; and, additional legislation and/or regulatory rule-making (i.e. further reforms) may be necessary soon after the exchanges begin operating

Cigna (CI) is a notable beneficiary of rising demand for ASO services and medical stop-loss in the small group market. Health Net (HNT) and Aetna (AET) are relatively exposed to small group risk, and stand to lose from a shift by employers (with healthier workers) to self-funding. AET’s acquisition of Coventry, completed last week, increases their exposure

Risks to other insurers have less to do with adverse selection (you can see it coming and price for it; and, the ACA ensures the risks are more or less equally shared), and more to do with the high likelihood that adverse selection forces new – and potentially adverse – legislation and/or rule-making

For our full research notes, please visit our published research site.

PFE announced direct to consumer sales of Viagra; orders placed on Viagra.com will require a legitimate US prescription, and will be filled by CVS

Viagra is a perennial favorite of drug counterfeiters. The National Association of Boards of Pharmacy (NABP) counts more than 10,000 online pharmacies dispensing to US customers but operating outside of state and/or federal regulatory compliance; more than 8,000 of these will either issue prescriptions or dispense prescription products without one. Thus patients too embarrassed to ask for a prescription, and/or those with off-label plans, can avoid physicians

Beyond being shy and/or misbehaving, men are cheap. Years ago when Levitra and Cialis ended Viagra’s ED monopoly, we asked men to ‘build’ an optimal ED drug by allocating 100 points among their preferred drug attributes, with more points given to the more important features. Men gave as many points to low price as to speed of onset, and twice as many points to low price as to duration of effect. Price matters – a lot

The typical Viagra Rx is $160 – $190 at retail (6 to 7 pills at about $27 each). Viagra is not covered by Part D, so not many men over 65 have coverage. A little more than two-thirds of commercial plans cover ED treatments, but most require co-payments well above the prevailing tier-2 $30 for ‘preferred’ brands. Counterfeits are available for $1 to $3 / pill – cheaper than the best co-pay

For all of these reasons ‘online pharmacies’ will remain attractive to men who are cheap, shy, or misbehaving. PFE’s online service can only cater to men with legitimate prescriptions that are willing to pay either retail, or their applicable co-pay. Notably, most commercial drug benefits will not pay for drugs received by mail, unless the prescription is filled by the payor’s own mail order operation. Thus outside of CVS (who administers PFE’s program) there may be many men with drug benefits that cover Viagra, but that will not cover prescriptions sourced from Viagra.com

Thus on net, the marginal utility of Viagra.com is that it serves men who are: 1) sufficiently self-confident to talk to their doctors (and thus get legitimate US prescriptions); 2) willing to pay either retail or their share of retail; 3) if covered, belong to a commercial plan that will cover a mail Rx dispensed out of network; AND, either: 4) too shy to have the Rx filled at retail; and/or who prefer the convenience of Viagra.com over any mail alternative their plan may offer. The initiative makes total sense – but offers very little answer to men’s motives for buying counterfeits – so the counterfeits will continue

For our full research notes, please visit our published research site

Affordable Care Act (ACA) provisions stand to increase smaller (≤ 100 employee) employers’ premium costs by 20 percent or more in 2014, before accounting for medical trend (+/- 6 pct)

The ACA provisions driving the premium increase for smaller employers (e.g. community rating, minimum essential benefits, excise tax on premiums) can be entirely avoided by shifting from fully-insured coverage to self-funding – self-funded plans are exempt from these ACA provisions.

We show that because of ACA, the average small employers’ cost of self-funding is on par with, or cheaper than, continuing with fully-insured coverage. For employers with healthier than average employees, self-funding may be far cheaper than fully-insured coverage; stop-loss premiums paid by self-funding employers can still vary according to the health of employees, where fully-insured premiums cannot

As an added motive, employers no longer face the risk of sharp increases in stop-loss premiums in a year following large self-funded claims – because they now have the option of reverting to the exchange for fully-insured, community-rated coverage if and when their employees’ claims rise

Roughly 40 pct of fully-insured commercial lives are sponsored by employers with ≤ 100 employees (Exhibit 4, pg. 4); we expect many of these lives will shift to self-funded plans. CVH is most negatively affected with more than 10 pct of members in small group risk plans; CI is least negatively affected with less than 0.1 pct of members in small group risk (Exhibit 5, pg. 5)
CI and UNH are best positioned to benefit from expansion of self-funding among smaller employers; both have relatively large shares of the ASO (administrative services only) service market for smaller employers (Exhibit 6, pg. 6), as well as the market for medical stop-loss insurance (Exhibit 7, pg. 7)

Taking all moving parts into account (decline in fully-insured, rise in ASO and stop-loss) CI is by far the best positioned and is a clear beneficiary (no meaningful small group risk exposure; strong presence in ASO and stop-loss); CVH is by far the least well positioned and stands to be negatively affected (relatively large exposure in small group risk; little or no exposure in ASO or medical stop-loss)

For our full research notes, please visit our published research site.

We expect 3.7% (nominal) y/y growth in US health services demand during 1Q13, the product of 1.9% growth in unit demand, and 1.8% price growth; unchanged from the 3.7% actual growth rate in 4Q12. Unit demand growth remains very slow; the projected 1.9% rate is only marginally higher than the rate of health services unit demand growth (1.5 %) attributable to demographics (population growth and aging) alone, and well below our long-term expectation of 2.8%

Pricing also remains suppressed – 1Q13 will be the ninth straight quarter of price growth below 2%, more than twice as long as the last such period in 1997-1998

We estimate that flu effects drove a +/- 1% unit demand increase in 4Q12, and raised health services unit demand by +/- 1.5% in 1Q13. Large apparent flu effects continue to indicate that underlying ‘non-flu’ unit demand growth is well below the 1.5% demographic rate

We believe demand is weak primarily because of low employment, which translates into a smaller percentage of households having the benefit of the most generous source (employer-sponsored) of health coverage. Employment gains, expansion of Medicaid eligibility, and the initiation of state health insurance exchanges all are likely to expand the availability of health coverage in the relatively near-term

We recommend a pro-US / pro-cyclical tilt to healthcare portfolios; this translates into overweight positions for Hospitals, select Non-Rx Consumables (especially more US-focused names such as CFN and OMI), and select Dental names (emphasize more US-focused names with product lines that include higher-mix items, such as XRAY and PDCO). We recommend underweight positions in Large-cap Pharmaceuticals (on US real pricing power concerns), drug trades (Retail, Wholesale, PBM)(on the loss of AWP pricing, and risks of PBM disintermediation), and Research Tools / Services (implied revenue growth exceeds R&D spending growth)

Independent of our quarterly growth rate model, we handicap the odds of a trend break, i.e. a significant acceleration or deceleration in demand. The trend-break model indicates a very low probability – 11% – of accelerating demand in 1Q13

For our full research notes, please visit our published research site.

We solve for the share price value of research pipelines by subtracting the NPV of approved and near-to-market products from companies’ enterprise values. We then estimate the relative volume and quality of future products in these pipelines using quality-adjusted patent data

By comparing pipeline market values to patent-based estimates of pipeline contents, we identify companies with apparently over- or undervalued pipelines

In November of 2012 we ranked the ten largest (by mcap) drug / biotech companies according to pipeline value. The five companies identified as having undervalued pipelines all outperformed their peers (avg. outperformance 5.7 pct); three of the five companies identified as having overvalued pipelines underperformed peers (avg. underperformance 6.1 pct) (Exhibit 1)

This note updates and expands these indices to the 22 largest (mcap) drug and biotech companies. Our results imply long or overweight positions in BMY and ABBV, and short or underweight positions in PFE and NVS

Separately, we offer two indices of R&D productivity; among the larger companies LLY, NVS, and PFE have been the least productive; BMY, NVO, and ABBV have been the most productive

For our full research notes, please visit our published research site.

We believe commercial health insurance markets will shift toward an exchange-based format for employees of all income ranges and employers of all sizes, and that this transition will occur for most employees within three to five years

Rather than choosing from one or two relatively generous plans from a single (often national) issuer, the typical employee will have the choice of both less generous and more generous levels of coverage from multiple issuers, many of whom are likely to be local

This implies smaller average contract values (we believe employees will choose plans with average AVs of 65, a 21 pct decline from the current average of 82), share gains by local insurers at the expense of large national underwriters, and rising MLRs as each beneficiary is now both ‘in range’ of more underwriters, and more willing to switch plans each year based on price

The larger commercial HMOs (e.g. CI, AET, UNH, WLP) are most negatively affected; falling average contract values and rising average MLRs being compounded by a loss of share to local insurers. Because of these risks we now favor the smaller Medicaid-predominant HMOs (e.g. CNC, MGLN, MOH, WCG)

Where they exist, integrated health networks (IHNs) may have better reputations and generally do have cost advantages relative to other local issuers, and are likely to see large share gains. Being newly empowered to choose among multiple issuers, beneficiaries will demand revolutionary improvements in customer service from all health insurers

Pharmacy benefit managers (PBMs) are likely to see a shrinking market for pharmacy benefit carve-outs sold to large national accounts. Issuers of comprehensive exchange-based health plans are likely to outsource administration of pharmacy benefits to PBMs, but at ‘third party administrator’ margins below those in PBMs’ direct-to-employer relationships. Being less reliant on large employer-based national accounts, we believe CTRX is far less negatively affected than ESRX

Hospitals are negatively affected by the decline in average actuarial values, particularly as this affects collections. A beneficiary receiving care under an 82AV plan (the current ESI average) pays (out-of-pocket) $0.18 per dollar of care received, and hospitals’ collection rate on the beneficiary’s portion of the obligation is +/- 40pct over 90 days. The same beneficiary receiving care under a 65AV plan is responsible out-of-pocket for $0.35 per dollar of care received, and collection rates on this larger beneficiary obligation are likely to fall from the current level

Non-Rx Consumables companies (e.g. CFN and OMI in particular because of US focus, and also BDX, BCR, COV) offer exposure to rising per-capita utilization as coverage expands, without direct or even significant exposure to Hospitals’ pricing and collection pressures; accordingly we favor these names over Hospitals

For our full research notes, please visit our published research site.

Walgreens (WAG) and AmerisourceBergen (ABC) yesterday announced a 10-year agreement in which:

• ABC handles US brand and generic wholesale distribution operations for WAG;
• ABC participates in global purchasing using the aggregated buying power of ABC, WAG, and Alliance Boots; and,
• ABC participates in an expanded portfolio of manufacturer services

WAG and Alliance Boots have been granted warrants for up to 16pct of ABC equity, thus at least to some degree ABC used its equity to buy its way into a distribution agreement. By extension, this implies that the economic returns to ABC for being in the agreement must be well above the typical returns one would expect from a ‘normal’ distribution arrangement between a large US-based wholesaler and a large US-based warehousing chain pharmacy. This looks like a very high hurdle. There are three opportunities for ABC to create value in excess of ‘normal’, corresponding to the three elements of the deal in the bullet points above. And, there is a downside risk to ABC, or at least a practical limit to how far the WAG alliance can go – ABC is highly dependent on sales to US independent pharmacies, who are naturally wary of WAG…

For more information / full-text please see our published research archive