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2-28-2019

At the end of 2018, I touched on Health care as a sector to watch in 2019, coming off the ‘unconstitutional’ ruling of Obamacare. This email is a deeper dive, as I feel (perhaps naively) the industry is mostly a black box to outsiders like you and me. Speaking as a financial professional, over the last 30 years, the finance industry has become incredibly commoditized and understood. This could very well be the prognosis for the health care industry. As always, none of this is considered investing advice – but I do think you need to be familiar with these details prior to making health care investments. The attached piece from Ernst and Young is a terrific illustration of industry challenges.

 

I’ll begin with a quick personal story.

 
While my father (“Happy”) aged in his 50’s, he was diagnosed with severe rheumatoid arthritis. Should be no surprise that he was prescribed monthly HUMIRA shots that cost an arm and a leg; luckily Happy had Blue Cross Blue Shield 100% covered by the construction company he worked for. These shots continued for many years, leading to insurance reimbursements in the hundreds of thousands of dollars (around $6,600 per month at this time). If you didn’t know, Humira is owned by Abbvie, and accounts for about 65% of Abbvie’s total revenue (2018). More on those details later.
 
In March 2017, when Happy approached retirement, he was then diagnosed with cancer, metastasizing from his lungs through to his spine. For the subsequent 8 months, he was prescribed Keytruda (cancer immunotherapy), bi-weekly painkillers and spent more and more time in hospitals. Each time he visited the hospital, he would describe it as another $10,000 into the system. In fact, at $12,500 per dose, Keytruda represents about 15% of Merck’s total revenue (2018). 
 
Looking at the hundreds of thousand in medical bills Happy racked up in just those 8 months, his insurance company could have employed a dozen people for a year. And Happy is only one person fighting cancer in the world. Interestingly, both Rheumatoid Arthritis and Cancer have largely unknown causes, creating a guaranteed market for the drugs, including Happy. Although Happy didn’t pay directly, our society mostly did, leading me to wonder how long insurance companies can support social healthcare in light of the changes in 4Q 2018. One thing I will say, he would tell me that he felt like a king in that hospital – the money bought him the feeling of control and power in his final month which can’t be priced.
 
Below, I discuss Healthcare as an economic component and reasons for potential growth deceleration. In part 2, I will discuss Healthcare in terms of business fundamentals and also reasons for potential growth acceleration.
 
Let’s start with some economic numbers. Healthcare as a GDP segment represented 18% in 2017, a 50% overall increase from 12% in 1998 (cms.gov). This leads to two conclusions. First, while healthcare has been growing more than average GDP (5.4% in 2017), other segments have been lagging. Administrative and Information services were the only segment growing faster, at 6.8% and 6.6% respectively and accounting for about 11.2% and 7.1% of GDP, respectively. 
 
Second, the technology driving the accelerated growth in the healthcare segment should be more additive than that of other GDP segments. Utilities, which declined 1.1% in 2017, is somewhat of an oligopoly, with less competition and therefore less need for innovation. But is the accelerated growth truly a result of innovation, but of aging or healthcare-related inflation? Will other segments like utilities begin to outperform healthcare, forcing a reversion to the mean? While I won’t speculate on improvements in other segments, I believe an ‘aging effect’ may be determined:
 
Medicare/Medicaid costed over $1.5 Trillion to the government in 2017 (Kaiser Foundation) as % of total spending over years change, with $700 Million related to Medicare. This figure is an increase of 165% from 2007 and is expected to double from now to 2028. Because medicare costs over the same period (’07-’17) have increased about 140%, the 25% difference is the best evidence of aging as a source of industry growth and is an underwriting loss to the government. These figures illuminate the both the importance of responsible medicare premium underwriting as well as the importance of government programs to healthcare: $1.5 Trillion is about 60% of the total healthcare industry (US census). 
 
It appears based on Census information that aging definitely contributed significantly to GDP growth. In part 2, I will cover technological advancements and potentials.
 
Since 1965, CMS has overseen medicare increases, effectively making the government the largest underwriter for arguably the entire healthcare industry. Underwriting healthcare is a herculean task that is fraught with conflicts of interest, just as GE, Unum or Genworth, whose underwriting in the 90’s has crippled going concern prospects (great read). Thus, if CMS has difficulty increasing premiums enough to keep up with aging, there will be more underwriting losses or claim denials, causing industry slow downs. However, on the bright side these government programs have facilitated private business growth and technological innovation, which is the largely the goal of a government ‘for the people’.
 
However, there are serious risks to consider that could cause that the growth party to end. Despite what many folks think, healthcare is largely a system fueled by societies around the world (i.e. socialistic). As healthcare companies sell more services and products for more money, the healthy increasingly pay more for the sick. The rich in health subsidize the poor. Yet on December 14, 2018, the US became more capitalistic, by not levying a tax on folks that don’t buy insurance. This leads the healthy to leave the system, which leaves everyone still in the system to spread the premiums lost by that healthy person. This is what would happen if young people no longer paid into FICA/Social Security and OASDI was only funded by elderly. So is society and universal health care the answer?
 
Part of the difficulty behind international scale is, in fact, the universal health care programs found in many other countries. If universal health care were eliminated, governments would no longer subsidize hospital operations, meaning private business would control the health care space, and more efficient, capital rich private firms would outperform. This is a popular discussion among analysts, as the subsidies granted for Universal healthcare is potentially misappropriated , but I cannot speculate there. America has done well in industry where the private firm and its entrepreneurs are rewarded with market share, rather than being shunned in favor of public programs. My point here is not political, but illustrative – moving away from Obamacare would likely cause more private innovation. Unconstitutionality is to be seen.
 
However, because of this, there must be regulatory intervention to control private firms, and there is. Large Lawsuits are commonplace in the industry, as companies protect revenues. For years we considered investing in Corcept (CORT) and its drug, Korlym. A lawsuit with Teva has clouded investment prospects, causing legislative risk. Any investment in manufacturers or drug lessors has inordinate legislative risk. The key is to block generics/knock offs with strong patents. Therefore, in order to truly make an educated investment in manufacturers, one must verify patent strength more than anything else. If Humira suddenly faced a cheaper, FDA-approved substitute, Abbvie’s revenue could drop 65% or more, throwing numbers off.. 
  • Sales EOY 2018 total $32 Billion, losing Humira results in $21 Billion less revenue, leaving $11 Billion
  • Debt is EOY 2018 total $36.6 Billion, with interest expense of $1.35 Billion
  • Dividend is currently $6.5 Billion.
  • Market Cap currently is $121 Billion…  
 Clearly, without Humira, Abbvie has trouble paying dividend and servicing debt after expensing operations. The heavily inflated market cap would likely reduce more than 65%. However, this is only illustrative of worst case since patent law is strong in the USA.
 
Perhaps the biggest issue in the healthcare supply chain is Rebating to Pharmacy Benefit Managers (“PBM”). Courts around the world have wondered?, who is the customer of the PBM, is there a fiduciary requirement to provide value to retail customers?, as well as what were the negotiated terms of agreements? A PBM serves three parties – manufacturers, insurers, and retail customers. In theory the PBM serves as a negotiator between insurers and manufacturers for the customer’s benefit. This has been big business for CVS, Express Scripts, Wallgreens, Rite-Aid, ad other PBMs, but in light of Amazon’s acquisition of Pillpack and the Philidor scandal, business is slowing. This leads us to industry consolidation.
 
From the PBM perspective: Manufacturers – Let me have access to your customers and I will give you a rebate on business. Insurers – negotiate to give my insurance customers the lowest prices so I generate better underwriting results. Customers – Keep my premiums down and give me valuable care. Four parties with opaque negotiations that are being further scrutinized now by courts. PBM’s get net revenue from all three parties without any disclosure to the customer. The famous consolidations between Aetna/CVA and Cigna/Express Scripts shows that insurers want to ‘cut out the middle man’. 
 
To most investors, this is a method of controlling costs by bringing PBMs in house and capturing the fees paid for negotiating on the insurer’s behalf. However, The PBM business is much higher margin than insurance, especially in light of higher drug costs and aging (causing difficulty in underwriting). So, if PBMs call the shots, patients may be directed by their insurers toward drug treatments that generate the highest profit margins and the largest rebates. They might pay more in drugs and insurance premiums while receiving low value health care. 
 
For these reasons, investors really need to know the risks of investing in PBMs (and insurers) before making a bet. Risks will increasingly include premium affordability and defensiveness of negotiated agreements between all four parties. In finance, people can simply ask and know what an intermediary receives on most transactions, but if a retail customer asks the margin on drugs CVS makes, the answer will be impossible. Ideally, customers can buy direct and not pay the PBM margin.
 
Business has boomed for decades in healthcare faster than almost every other business segment domestically. It is very likely that there will be a reversion to the mean for healthcare based on what I discussed above, but we will dive further in part 2. 

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