Thursday, November 26, 2015

Reasons for Declining Medicare Part D Reimbursement - and What They Mean for Healthcare Stocks

In its 3Q15 earning call, CVS explained that its margins declined due to higher proportion of lower margin Medicare and Medicaid business. Here I want to focus on Medicare, and specifically Medicare Part D (the drug portion), which obviously have big impacts for the PBMs (CVS, ESRX), pharmacies (WBA, RAD), and the rest of pharmaceutical supply chain from distributors to drug manufacturers. 

Pharmacies like WBC have been talking about drug reimbursement pressure for a while. Much of that stems of their weaker bargaining position relative to PBM and payers. But what has not been discussed enough is that Medicare Part D revenue per member has deteriorated several years in a row.

Reimbursement Pressure Starts at Health Plans and Propagate Through Supply Chain

There are lots of online articles on drug costs to the enrollee, but figuring out what the government pays health insurance companies is not straight forward. Fortunately, chapter 6 of this Medpac report has a detailed explanation of how Part D reimbursement works, and even an example of how plans bid. From the same report (shown below) is Medpac’s measure of government outlay in Part D plans.

How much is the government paying health insurers

From this chart it’s clear that “expected reinsurance” has been steadily increasing, while “base premium” and “direct subsidy” have been steadily decreasing. A quick note about how this works. “Direct subsidy” is what government pay to health plans directly. “Base premium” is what enrollees pay. “Expected reinsurance” is what government reimburse the plans after drug costs exceed some catastrophic threshold. 

Since reinsurance is used to cover catastrophic drug costs, what the plans really get is direct subsidy and base premium, or what CMS calls the “National Average Monthly Bid Amount”. This is a good proxy of a health plan’s revenue, from which it needs to cover drug costs (below the catastrophic threshold) and administration costs, with the remainder going to plan profit *. The table below show that the average bid amount has been declining steadily, which led to reimbursement pressures throughout the entire drug value chain. For 2016, the industry will see another steep drop of 7.6%.

Reasons for the Decline

Why is this happening? First, what is not an adequate is the argument that health plans are not actually seeing reimbursement pressure, because the overall bid amount including reinsurance has actually been increasing. From the plan’s perspective, reinsurance just compensates for extraordinary costs and does not add to the bottom line. As for the base elements, even the MedPac report cited above - which alleges that sponsors use clever bidding strategies to maximize profits - the example given (page 163, table 6-11) clearly shows that gaming the bid system would lead to higher, not lower bid amounts (Case 3 in the example is what the plans have been doing. Based on actual claim experience the direct subsidy and beneficiary share should have totaled $46.50, but the plan bid totaled $60.00 those items).

So the way to reconcile a) ever higher reinsurance payments with b) ever lower bid amounts is that government and private sectors are both sharing the pain of higher drug costs. The government has been taking on more catastrophic risks, while private sector focused on efficient day to day administration. In this way both utilize their comparative advantage.

So the fact that bids amount have been lower every year is not about plans ripping off the government, but due to genuine industry competition. There are various explanations:
  • The “National Average Monthly Bid Amount” is weighted by enrollees. So as low cost plans win over more enrollees the weighted average would be dragged down.
  • The larger plans have been aggressive as scale allows them to lower operating expenses and push through formulary changes. 
  • Generic conversion have lowered regular drug cost, while government took on the tail risk of the Sovaldi/Harvonis of the world.
  • Medicare Advantage plans with drug benefits (MA-PD plans) can bid lower as the Part D is small portion of overall revenue (Part D bid amount will be $64.66/month in 2016E, while Part C benchmarks are easily $750-800/month)

Investment Implications

The above drivers are not about to go away soon, so this trend of lower bids and worse economics for entire drug value chain could continue for a while. In the longer term though, large players like CVS and UnitedHealth might actually benefit as lower margins drive out smaller competitors. In terms of ability to withstanding constant Part D reimbursement pressure, I would rank the various players from best to worst as follows.
  • Managed care companies. (UNH, AET, HUM) Medicare Part D in general is a smaller part of their business. If the Aetna/Humana merger goes through, the combined entity will be a major player in MA-PD plans and can continue to push bids lower to take market share.
  • Standalone PDP / PBMs (CVS and ESRX). Both CVS and ESRX are large players in the standalone PDP space. They are at a disadvantage relative to managed care companies but have been able to exert strong bargaining power over the rest of the supply chain.
  • Pharmacies (WBA, RAD) and drug distributors (MCK, ABC, CAH). These have weak bargaining power. The pharmacies in particular have been beaten up by PBMs. Their only hope is more consolidation as in the Walgreens Rite Aid deal. The major pharmacies and drug distributors have also teamed up to get more market power.
All the industry participants above have low margins. The managed care companies even have legal caps on their profitability. So going forward the big costs savings will have to come out of the drug manufacturers, specifically the specialty drug companies. The specialty drug companies are a totally different game. On the one hand they are prime targets for price cuts. On the other hand it’s hard to cut prices without political action, and even if price cuts go through these manufacturers have some fat margins anyways.

I am holding on to my UNH and AET shares despite the political rhetorics sure to come in 2016. I particularly like the idea of a combined AET/HUM dominating the growing Medicare business. CVS is a tough call as it a well-run company but its pharmacy business will likely bear reimbursement pressure for years to come.

* Notes: Some analyst reports calculate plan revenue as average bid amount + enrollee premium. That is incorrect, as the enrollee’s base premium is calculated as a percentage of the National Average Monthly Bid Amount, which implies the latter is inclusive of enrollee premiums)

Monday, November 16, 2015

Gold Call Options

I bought a small amount of GLD call options today.

I got into the June $115 call for $1.59. I think this is a much better way to gain exposure than going outright long. With GLD trading at $103.5, maximum loss on this trade is only 1.5% of the long exposure obtained. I'm also long USD (currently against NZD and EUR), so some gold will help in case the Fed hike thesis falls apart.

Gold has been beaten down to multi-year lows and I can understand why. The Fed can't stop talking about raising rates. Inflation is no where in sight. Marginal costs for gold producers keep declining over the years, and will get lower if the US dollar strengthens. Jewelry demand, roughly 50% of total demand, will likely be weak in a low growth environment. Finally, after a massive build up over the past decade, ETFs has been decreasing their gold holdings the last couple years.

So why a long position? These call options are a low risk, high reward way to go contrarian on the consensus view that Fed will raise rates in December.

First take a step back. Gold has four functions: 1) as a safe haven/physical currency, 2) inflation hedge, 3) jewelry, 4) industrial use. Right now the only reason for anyone to own gold is the first one - gold as a currency. This is really the flip side of US dollar strength, which has everything to do with market's expectations of a rate hike.


It wasn't that long ago (just September!) that the Fed failed to raise rates and cited risks in China and low inflation. Every other day some Fed officials (Lacker, Bullard, Lockart, Brainard...etc) took their turn going rogue on media and gave contradictory statements.

Now, just a couple months later, everyone is supposed to have suddenly fell in line and agree to raise rates? That hardly seems credible to me.

Last year's experience made clear a few things about the Yellen Fed regime. First, the Fed takes into consideration a lot more than its dual mandate of inflation and unemployment. Some of these unstated factors include general market stability, US dollar strength, and yes - China. Second, the Yellen Fed does not like to surprise the market, so October's hawkish Fed statements was just a way for Yellen to raise expectations of a December hike in the market. Put another way, October's Fed statement was just to keep their options open. Finally, we learned that it doesn't take much for the Fed to delay that rate hike -- perhaps permanently.

Given the lessons above, and all it takes is a weak inflation number, a couple bad numbers out of China, or another market meltdown to lower the probability of the December hike.

As for gold, market expectations about the rate hike is what matters. If any of the above happens, the call option will likely be a winner. There's also very little downside. Depending on how macro data comes out, I might increase this option position.