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.




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)

CVS Caremark’s Integrated Model Shows Its Strength

I recommended both CVS and ESRX in my post about PBMs here.  In my opinion, the market action on 8/6/2014 for Walgreen (WAG), Rite Aid (RAD) and CVS Caremark (CVS) demonstrated the strength of CVS’s vertically integrated model – i.e combining PBM with retail pharmacy. On that day both WAG and RAD fell off a cliff, while CVS prices remained relatively flat.

  

Why CVS stock held steady as WAG and RAD suffered

WAG crashed not just because of no tax inversion in its Alliance Boots deal, but also because it adjusted guidance downward. Specifically, WAG cited reimbursement rate pressures and generic cost inflation – these happen to be headwinds that RAD is also facing (and discussed extensively in the last earning call). On the other hand, CVS actually came out a few days earlier saying that these headwinds are models and already built into their guidance.

To understand why CVS can better handle the issues that its peers are facing, it’s important to understand what “reimbursement rate pressure” means. First, RAD’s FY1Q15 transcript specific attributed reimbursement rate pressures from PBM’s “MAC” lists and plan mixes (emphasis mine).

“We're always dealing with a competitive reimbursement rate environment. Things that can develop differently than our plans would include just a mix of business amongst and within plans, so migration to narrow networks and business moving between different types of plans can have an impact on reimbursement rates. We also still have certain contracts that are not in a kind of guaranteed rate. We call those MAC contracts. So those can be a little bit more volatile”

And later on:

“…So I'll go back to kind of two basic examples. The first one would be around some contracts, we saw more volatility than we expected. So we might have a contract where on generic drugs, there is a proprietary MAC list that PBM uses. They don't often provide us their proprietary MAC list. And so they have some flexibility to adjust generic drug cost as they go. So sometimes we have a little bit difficulty getting good insight as to how that's going to behave over time…”

“Another situation would be we might have a contract with a PBM where we're in different plans. One is a very narrow plan. One is a medium plan and one is the broad plan. And we might see as we come through into the fiscal year gradually as there's utilization that the PBM has migrated patients from the broad plan, which has the highest reimbursement rate, to either the middle plan or the lowest reimbursement rate plan. And we call that a change in plan mix. And so we saw some of that activity as well. Those things tend to develop over time. “

For background, MAC (Maximum Allowable Cost) contracts basically allow PBMs to arbitrarily define pricing to their benefits. Note that Rite Aid said they’re not even privy to PBM’s MAC lists! Given the lack of transparency I can see how pharmacies would be hurt by this type of contracts. Here are a couple good links on the topic.

Don’t Get Caught By PBMs’ MAC Mousetraps

A CBO paper with good background on drug pricing

Let’s move on to Walgreens. WAG also referred to reimbursement pressure from these MAC prices in its June call:

David Larsen - Leerink Swann & Company: “Hi. With respect to the reimbursement pressure, aren't the generic rates typically set at a max price, and aren't those fixed so that the pressure is really the cost of the generic at the higher inflated rate and the difference between that and the fixed mac price or do those prices actually shift around or are they fixed? Thanks.”

Greg Wasson - President and CEO: “So, every contract is different. But you’re right, it's kind of a general abstraction that’s more or less true, but the thing is that I guess the key thing I alluded to earlier is that the indexes that those are based on don’t always immediately reflect the changes in that inflation, and so that’s the disconnect. But again I think we’re working this from many different angles.”

In the WAG/Alliance Boots call on 8/16/2014, Walgreen also attributed reimbursement rate pressure to Medicare Part D business (“Med-D”). 

“…probably most significant impact was the negotiation and the reimbursement in the fiscal or calendar 2015 Med-D books of business. Those plans have really, really challenged us. We are in preferred positions with Part D plans. We think it's a strategic investment to grow market share with a lucrative senior market. But there were significant margin step-downs in the Med-D contracts beginning in 2015. Combine those two and that's what we're looking at and trying to be realistic as we forecast out the next couple of year

Note that Medicare Part D businesses usually run through a PBM, either because a payer hires a PBM or the PBM directly manages the plan (both Express Scripts and CVS have their own PDP plans). While a big part of Part D reimbursement pressure comes from the government, PBMs/plan sponsors further control prices with preferred pharmacy networks.

So here it is. The reimbursement pressures that hit RAD and WAG, whether it's the MAC contracts and PDP plans, are tied to pressures that PBMs exert on the pharmacies. CVS, on the other hand, runs one of the largest PBMs. Lisa Gill from JPM got to the crux of the issue in WAG’s call:

“And then, kind of a bigger question, as we look into your largest U.S. competitor, they own a PBM, they don't seem to have the same reimbursement pressure that you're having today, any thoughts around perhaps owning a PBM in the future?”

At which point Walgreen basically avoided the question.

Well hedged exposure to increasing drug usage

The above discussion highlights how CVS has a supply chain “hedge” between its PBM and retail pharmacy business. There’s more. CVS is a winner no matter how customers access their drugs and even healthcare services. Its Maintenace Choice and Specialty Connect offerings both provides retail and mail access, while the MinuteClinic shifts services between hospital, clinics, and pharmacies.

So CVS has a portfolio of product and services that makes them channel agnostic (mail order vs retail, PBM vs pharmacy, clinic vs pharmacy or even home service). In another words, a well hedged exposure to increasing drug usage. 

Valuation reasonable but not particularly attractive

CVS trades around $76-78/share (~17.7x 2014E and 15.7x 2015E earnings). Here are the consensus expectations for CVS. Earnings per share are supposed be grow at over 10% CAGR but the underlying revenue and net income are only growing mid-single digits. This is because CVS boosts earnings per share with capital management actions. I think valuation is reasonable as a defensive play, but investors who simply look at EPS growth and argue for a higher multiple are effectively treating share buybacks as free lunch.

 

Sources: 2014 investor day, Bloomberg.

Finally, a word of caution about MinuteClinics. Although the service generates lots of excitement in the market, it is not yet contributing to the bottom line. Minute Clinic is a great idea but Walgreens and Rite-Aid are already copying this. Walmart actually goes even further and tries to offer primary care. I suspect that customers will be the main beneficiaries as opposed to shareholders. Let’s say someone just moved out of the city where they were frequent customer of CVS MinuteClinic. In the weekends are they going to commute into the city just to be a loyal CVS fan?  Or would they go to the nearest Rite-Aid?  I believe the latter. For this reason the rapid expansion of MinuteClinics can turn into an arms race just to maintain competitive positioning. In other words, MinuteClinic can turn out to be maintenance capex as opposed to growth capex.

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.