Thursday, June 26, 2014

Investing In Pharmacy Benefit Managers (PBM)

Recommendation:  Buy ESRX and CVS

PBMs as the best way to benefit from healthcare trends

Several trends are due to hit the healthcare sector in the next decade. 1) Aging population means rising usage of drugs. 2) Obamacare expands population access to healthcare. 3) New specialty drugs improve effectiveness but raises costs exponentially. 4) The government system is already operating with strained budget, and will have to increasingly rely on private sectors to fund healthcare expenses and keep them under control.

Among parts of the healthcare value chain, PBMs are the best way to invest in these industry trends. Managed Care Organizations (MCO) gets increased volume from expanded healthcare and aging population, but they would be victims of higher drug prices.  Pharmaceutical manufacturers as a group will benefit, but the industry is notoriously hard to pick winners and losers. Wholesalers/distributors have the least little influence in the choice of drugs and thus little leverage over other parts of the supply chain. Providers (hospitals, nursing homes, clinics) are possible winners but those tend to be capital intensive (and labor intensive).

PBMs benefit from these trends by working on behalf payers (government, employers, and MCOs) to keep drugs expenses under control.  They effectively use their size to negotiate better pricing with pharmaceutical manufacturers and pharmacies, while capturing a skim of drug costs in the process.

Is PBM an attractive business:  Growth and return

First, some very high level numbers to put this in perspective. Total U.S. healthcare spend is estimated to be ~$3T in 2013 & 2014E, and PBMs represented a $283bn market (by revenue, per CVS presentation 2013), with EBITDA margin in the low/mid-single digits. Thus we can see that PBM as a group captures a relatively small, but important part of overall healthcare spend. Due to some of the secular trends discussed earlier, total healthcare spend can hit $4.5T in 2020E (around 18-19% of GDP), or mid-single digits CAGR. 

PBMs will participate in that overall growth, but also have some of their own levers to increase earnings:  1) higher mix of specialty drugs (prices of which are growing 15-20% per year).  2) Increase mail order volume which lowers cost (estimated current penetration rate in 20-35% range).  3) Higher mix of generics which have higher margin vs branded drugs (currently hover around 80%’s but could peak in the mid-high 80%s). 

The subsector itself has high return on capital as there are very little capital needs (for example ESRX’s capex runs only 5-6% of EBITDA). Return on incremental capital can technically be infinite due to negative working capital (they get paid by customers before they pay pharmacies). Industry structure is conducive to keeping that high return on capital, as the top 4 (Express Scripts, CVS, OptumRx, and Catamaran) controls more than 70% of the market.

The aforementioned low/mid-single digit EBITDA margin is one way to think about value capture, but not such a good way to think about PBM economics. Whenever someone buys a drug at the pharmacies, PBMs earn a spread between what payers pay them and what they pay in turn pharmacies. There’s no risk of being stuck with the inventory due to inadequate demand. Thus a more relevant way to think about economics is to look at gross margin as the real revenue, and remember this is a spread x volume type of business. However, GAAP forces PBM to account for drug costs as COGS and pass that through revenue. So revenue is artificially high and margin percentage artificially low.

Value Drivers  

·         # of claims
·         EBITDA per claim, which is a function of
o    Mix of specialty drugs volume & price inflation (strong here)
o    Generic penetration (still improving but tailed off)
o    Mix of home delivery  (stabilizing)
o    Bargaining power vs other parts of supply chain (slightly worse than before due to consolidation of pharmacies & effect from exchanges)
o    Ability to keep SG&A under control

Choosing between the players

The top 4 are ESRX, CVS, OptumRX, and Catamarn.  They each have their own unique business models:

·         Express Scripts (ESRX). The largest PBM with probably the strongest mail order pharmacy business. ESRX also own specialty pharmacy and distributor (Accredo and CuraScript).  The company caught some public attention in 2011-2012 when they took on Walgreens, the largest pharmacy in the US, in a pricing dispute. ESRX redirected its customers away from Walgreens and WAG’s sales dived. While not particularly great for publicity, the dispute demonstrated the pricing power of ESRX, as WAG eventually turned around and accept a deal with ESRX.
·         CVS (CVS). A vertical integration between retail pharmacy and PBM (with retail pharmacy contributing about 2/3 of EBIT). CVS has multiple touch point with payers and consumers. Consumers have the flexibility of getting their drugs through mail order or picking them up at a CVS store. I particularly like their initiative with MinuteClinic. Although < 1% of revenue right now, the number of MinuteClinics will double in 3 years and offer their payer clients a way to not just lower drug cost but even overall medical costs.  CVS has wisely showed a consistent brand message by stopping sales of cigarettes.

·         Catamaran (CTRX). CTRX started out as an IT systems provider and grew through consolidation of smaller PBMs.  In the near term CTRX has opportunity to consolidate smaller PBM clients that already use its systems.  Its angle is flexibility to customers by offering its services on a-la-cart basis. CTRX is also careful to avoid competing with MCO’s by not directly taking part in Medicare Part D business (unlike ESRX and CVS).
·         OptumRX is a part of the largest MCO, United Healthcare, and a relatively small part.  So this is not a good option if one is looking for PBM exposure

One can make a strong investment case for each of the players above. Catamaran has the highest growth upside; ESRX has sheer scale, bargaining power, and financial flexibility; CVS is the safest option with its multiple touch point to the healthcare system, but probably the least upside because the retail operation is capital intensive, and also because the pharmacy and PBM segment somewhat offset each other.  I would save the details for individual stock write-ups.  

ESRX/CVS/Catamaran will all get you nice exposure to PBMs so it’s really a matter of going through each one in detail, and finding a reasonable valuation. In separate write-ups I will show that ESRX and CVS are both reasonably valued. Catamaran is somewhat speculative as consensus already builds in 20% EPS growth in 2015E.  Even though it does have the best growth prospect (and perhaps a buyout candidate), I really have no basis to say EPS would grow say, 30% as opposed to 20%.

Appendix:  PBM Risk & assessment of drivers 

·         Longer term biggest risk is from payers.  Either complete disintermediation or payers bargain to pay less.  Worry about payer consolidation.  
o    (-) Long precedence for payers doing it themselves.  UNH does.  WLP has talked about "optionality" with its "renting" to ESRX. Somewhat offsetting this risk is the fact that large contracts tend to have lower margins.
o    (+) Payers have little incentive as drug cost is only a small portion and PBMs skim a small % of total drug value (5-8% EBITDA margin % of sales)
o    (+) PBM can lower cost with mail business and specialty pharma.  Payers would have to build this up.  MCO’s can go to pharmacies like CVS directly but CVS has conflicting incentives to actually raise cost
o    (+) Payers use PBMs as the “bad cop” to other parts of the supply chain
·         Pharmacies are teaming up with distributors to increase their bargaining power
o    CVS:  JV with Cardinal
o    WAG:  teams with Alliance Boots and ABC
o    RAD:  teams with McKesson
·         Competition: Nice industry structure with top 3 >  60% of market share
o    (+ )Competitors have differentiated models. A positive for ESRX & CTRX is that for some payers, CVS (pharmacy) & UNH (a rival payer) represent conflict of interest, even if those 2 can legitimately lead to lower cost
o    (-) Larger contracts have lower margins. This is indicative of some price competition to win big payer’s business
·         Shifting distribution models
o    (-) Exchange environment means some employer clients will be shifting to MCOs.  This consolidates more power to MCO side as they get a higher % of payer responsibility (vs employer & government). Payer consolidation can lead to lower margin for PBMs
o    Some PBMs will lose direct access to employer clients, as health plans on some exchanges use a “carved-in” approach where customers choose an MCO and PBMs are bundled along… so PBM no longer contract with employer payers directly. An example is some employers have move retirees from group insurance to Medicare exchanges -   with Medicare Advantage the drug benefit is bundled
·         Backlash from consumers and regulators.

o    This is a little like the mortgage servicers. PBMs play the bad cop and restrict pharmacy network and formulary. They bear the risk angering consumers and the big pharmas. Doctors don’t like them either as PBMs will increasingly require more documentation and even challenge what doctors are doing.