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3-17-2019

This is a continuation of a prior email sent early March…. None of the following is investment advice. Here, I continue the regulatory discussion, and I cover both cautions in healthcare and opportunities.
As though executives at the world’s largest healthcare benefit provider read my prior email, this week, Unitedhealth Group Inc. (UNH) took a bold step toward a fiduciary-like responsibility for its Optum Rx Subsidiary. Optum Rx is currently the 3rd largest Pharmacy Benefits Manager (PBM) if you didn’t know. According to WSJ, UNH will now redirect rebates it receives from drugmakers right back to the plan clients that use the drugs, making the drugs effectively cheaper. Due to the variety and opaqueness of such agreements, we know not how much consumers will benefit. However, in the long term this move opens the flood gates for more scrutiny and minimization of costs to consumers. Righteously, this all reminds me of taxation without representation or the transformation of Europe from the Feudal system. 
 
Of everything I have read on the debate, I feel this was the most valiant (excuse the pun) possible step toward the future of healthcare. Why? If the rest of the market adopts this policy, there will be an immense first-mover advantage to UNH logistically, technologically, and administratively. The risk is that UNH will be left out in the cold and other PBMs (i.e. CVS, Express Scripts) continue to collect the rebates, out-earning UNH. Regulation is a foul, loathsome beast out to destroy the margins of PBMs everywhere to make them work in the benefit of end-users. One thing is for sure – the UNH move nods to regulatory pressure and will likely have widespread effects on the entire healthcare industry as end users are empowered.
 
Medicare and Medicaid encompass nearly 60% of all healthcare spending, making them about 11% of total GDP spending. Imagine what effect UNH’s move could have if a similar proposal passed for Medicare? Controlling these costs could add significantly to America’s bottom line: consumers pay the same premiums, while the reimbursements from the USA’s accounts back to the healthcare industry would be much lower. For a refresher, Americans pay into Medicare and Medicaid, which then collects into trust accounts (overseen by CMS), which finally reimburses hospitals, drug retailers, and Pharmacy Benefit Managers (PBMs). Similar to the private markets, the costs in these arrangements are largely out of control and unregulated. Again, estimating the financial benefit of a remedy is impossible.
 
Clearly, healthcare as an investment has outperformed most other segments, but let’s look at fundamentals. Looking at XLV, a healthcare index fund, the return over the past 10 years is almost 300%; equating to an average return yearly of 13% without consideration of the dividend (currently 1.5%). Can this streak continue?
 
The business end of healthcare is historically defensive – people always get care/drugs in good and bad times, making care a normal good. Case in point – the industry had 35% less downside in ’08 than the general market. At that time, the healthcare industry was ‘booming’ as nearly 10,000 so-called baby-boomers per day began to retire, more than in any other era. 
 
Today, we see companies consolidating using record amounts of debt, creating more industry related risk. I was hard-pressed to find any US company in healthcare without both debt and goodwill less than 10% of assets at any market capitalization – I am still looking. The psychology behind this management, of course is in some respects the same as a gambler – if I can make more money than I pay in interest (debt) or premium paid in acquisitions (goodwill), these are responsible decisions. Thus, investing in healthcare requires heavy scrutiny of solvency and cash flow ratios. 
 
Additionally, SGA expenses over time and R&D expenses have risen on average over time, as percentages of revenue. Margin expansions to curtail the ballooning of costs often does come from synergistic consolidations, however. So to make a comment here may be misguided, though watching operating margins is always a best practice for investors. 
 
Many hospital systems are tax-exempt, to allow the systems to more easily build better infrastructures for helping patients in the best ways possible. This tax status attracts entrepreneurs to the space and breeds innovation/capitalistic tendencies. For that reason, combined with the defensive nature of healthcare, there will always be a crowd of investors for the industry, including myself. 
 
In fact, tax-exempt hospitals are eligible for Charitable donations. As an investment advisor, I recommend charitable giving to clients from time to time for large personal tax deductions. These gifts are often ‘unrestricted’ and are used to increase surplus (profits) of the hospitals. Gifts are yet another reason for the defensiveness of the healthcare industry, and I am a huge fan of them. Personally, I endeavor toward this type of giving – one day I could have a part of a hospital named for my family – imagine that!
 
Back to business.. 
 
As discussed in Part 1, Abbvie has done well capitalizing on Humira, just as many other manufacturers have capitalized on flagships. Despite what I thought years ago, the largest ‘healthcare’ companies like JNJ, Pfizer, Novartis, etc. make majority of revenues not with health care, but with selling pharmaceuticals at incredible margins. So, marketable drugs are often the largest assets on balance sheets, listed as patents, Intangibles, and in some cases goodwill.. So.. What methodology do companies use to put value on their largest assets? Who is the arbiter to check adherence to industry methodologies? The answers are shocking – there are no methodologies and there are no arbiters. This means there are $100’s of billions in ‘assets’ that may be mispriced, for better or worse. If these gargantuan intangible assets are impaired, there will be loses on income statements, causing significant cash outflows and drops in net earnings. Another issue to consider is the effect of insurance premiums to these increasingly high per-use drug costs. People will pay for the drugs until they can’t, similar in many respects to housing prices in ’07 – people could not afford the houses they were buying, leading to drops in house prices. 
 
Yet another set of reasons to be cautious: first we have the PBMs renegotiating agreements, record amounts of industry debt/goodwill, and now we have the potential for price checks on drugs.
 
In San Diego, I am always shocked to talk to elders at my La Jolla Church about their strategy for buying drugs. The ‘Strategy’ sometimes even involves driving to Mexico to buy the same price for up to 90% less. Unthinkable. Matter of fact, Kaiser estimates that 19 Million (~8% of population) imports drugs to save money, on average around 56% savings. 
 
Prime example is Nexium (a top drug of AstraZeneca). in 2017, Nexium was dropped by the military formulary in part due to its incredible cost versus generic alternatives. The result has been a nearly 60% reduction in US Nexium revenues. Compared to Europe, Nexium is about 450% more expensive in the US. This statistic leads me to believe that drug prics must come down eventually, since 1) the per capita incomes comparisons of Europe and US do not warrant this much of a cost difference in any drug and 2) drugs with high prices in America will eventually face some form of austerity. I suppose an entrepreneur in Europe could make a good living exporting drugs to America if it were feasible..
 
Having said all of that, what we need to analyze is this question: is healthcare priced to perfection, or are there more gains coming?
 
There are a few reasons to believe the party is just getting started. Raising prices on drugs clearly facilitates revenue expansion, and economic reports in the US have been good as of late. People can and are paying for more expensive drugs and care. As long as incomes continue rising, so can healthcare costs. 
 
But what about margin expansion and cost reductions? More well-known innovations in the cost reductions category are more on the patient care side of health care rather than on the manufacturing side. Popular innovations include Internet of Medical Things (IoMT), diagnostics innovations (genome), AI (applications, robotics, EMR). Of course, scaling internationally and entering new markets is the preferred way to keep the growth alive for the health care sector as well as reduce costs by aggregating lower income economies. An area that needs improvement is waste minimization, though this is true almost in any industry.
 
First, IoMT and one of its benefactors, Intuitive Surgical (ISRG). ISRG is a brainchild of legendary Dr. Frederic Moll in the late 1990’s. ISRG designs, installs, and maintains machines that handle complicated surgeries with 80 different FDA-approved machines and minimally invasive techniques. ISRG revenues exceed $3 Billion, of which ~75% is annually recurring. Internationally, ISRG has installed nearly 5000 “da Vinci” units costing over $1 Million on average. With the da VInci, hospitals have reductions in in-patient costs from faster recoveries, faster surgeries, trade in sales (upgrades), repairs (20% of revenues), and of course new blades 60% of revenues). 
 
However, IoMT is the reason a machine like da Vinci will probably continue to grow for years to come in the medical community. With IoMT, da Vinci machines log each and every surgery internationally, producing troves of data. Anyone privy to the data will begin to learn more about the maladies causing surgeries, what the best practices are to operate on them (without human error), what areas of the world have different diseases, how to further reduce human payroll costs, etc. At this time, privacy policies disallow aggregation of such sensitive data by third parties, as such data are accessed only via hospital EMRs. By having machines produce the surgeries, ISRG (for example), generates its own data without divulging personal EMR information that could be intercepted. 
 
This is the IoMT opportunity that is just beginning. Clearly, everyone can win in this scenario – patients have better experiences, private companies like ISRG capitalize, and hospitals with the machines have more patients for higher ticket items. 
 
The issues, however, are that smaller hospitals really cannot compete with hospitals that have the machines, and that there isn’t any competition for da Vinci yet. Hospitals will need to roll up into larger systems to get access to the machines, or take on adverse capital structures for financing the machines. 
 
Robotic surgery is en vogue across the healthcare industry, not only for the incredible ‘razor-and-blade’ business model, but also for the troves of data that can be learned from. Auris Health was recently bought by Johnson and Johnson; Mazor Robotics was bought by Medtronic, Mako was bought by Stryker, TransEnterix and other smaller independent robot makers are on the path for FDA regulation of techniques and machines.
 
Diagnostics has also been a hot topic int he healthcare space. The cost of genomic sequencing has come down from $100 Million to now less than $1000 according to NIH. Because of this (among other innovations), money has poured into corollaries of the life-sciences market. The largest benefactor, arguably, is Illumina (ILMN) here in San Diego.
 
If you have heard of ’23 and Me’ or Grail Cancer research, you know about Illumina. Like ISRG, ILMN has a ‘Razor-and-Blade’ business model, selling its sequencing machines for 6 figures and then charging around $1,000 on average per run. Again, such ARR’s embolden a defensive non-cyclical business model; can you imagine this practice to end in a downturn or at all? Such is why, at $45 Billion market cap, ILMN trades at almost 14 times its revenue, similar to pricing for a monopoly….
 
Because ISRG’s machines will continue to reduce ‘days in hospital’ and ILMN has empowered mankind to uncover infinite data about permutations of disease through DNA sequencing, are we better off financially? As I discussed in part one, most of the companies in the healthcare sector have a disconnect – they are innovating amazing products across the board from machines to drugs, but the costs have made ubiquitous benefit increasingly difficult. Times are good, and we would need an Extinction-Level-Event to drive Humira’s cost down (for instance) to a scale that behooves society over capitalism. Even so, the holy grail question is – what will drive costs down and knowledge up in healthcare? 
 
Clients own UNH, JNJ, ISRG, ILMN, and XLV.
 
 
 
Even so, the holy grail question is – what will drive costs down and knowledge up? 
 
Clients own UNH, JNJ, ISRG, ILMN, and XLV.

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