R1 RCM (RCM) Has a Long Way to Go Up

R1 RCM (formerly Accretive Health) is a high probability trade with >2:1 upside/downside. The stock is trading at ~$3.3/share and I can easily see this going to $5 if not more. This is an idea that’s been on the radar for years. Here are just a few write-ups that helped along the way.

2014: From Buyside Notes

Also late 2014: write up by Sententia Capital

2016: mentions by Reminiscences of a Stockblogger


So why another write-up? This is now a material position for me and I owe myself a write-up for documentation. Also, given the recent run up, it would be helpful to explain why the stock can go a lot further, as well as provide some valuation ranges.

R1 RCM (formerly Accretive Health) does revenue cycle management for hospitals. I won’t bore you with what that means - that’s covered by the various write-ups I cited above. In any case I’m not enamored by the business. Basically I’m investing in the stock, not the business.

A few years back company had accounting/customer issues which caused delisting. They fixed those problems and just re-listed. The ugly history, customer concentration, combined with (still) ugly accounting and capital structure all combined to discourage investors and create this opportunity. I know that because for the last 3 years every time I looked at the company I thought “yuck” and skipped, until recently the opportunity simply became too good to resist.

Cheap Valuation Relative to High Probability of Delivery Next 3-4 years.

Management has a 2020 plan for free cash flows of $75-105mm by 2020. They expect to be free cash flow positive by 2H17.

Notably, management stated that currently contracted business alone would deliver 90%+ of the low end of that 2020 projection.

Capital structure is messy but not crazy once you work it out. Here are the basics.

• $181mm of cash, but ~16mm of that is “customer float”. So excess cash is about $165mm
• $0 debt. 
• $214mm of Convertible Preferred’s that Pay-In-Kind (PIK) at 8%, convertible at $2.5/share. 
• 60mm shares of warrants convertible at $3.5. 

The best way to value RCM is to roll the capital structure forward to 2020 and factoring in all the dilutions.

• Cash and debt. The company will be cash flow positive by 2H17, so I give them credit for the full $165m cash at 2020, and still no debt.
• Convertible Prefs. $214mm at 8% quarterly compounding get you to ~$295mm by 2020, which at $2.5 conversion price get you about 118mm dilutive shares at 2020.
• Warrants: I used treasury stock method, assuming warrant holders exercise at $3.5/share, and then company buy it back at higher average price of $4/share (just to have some conservatism built in). This gets us 7.5mm dilutive shares.

All in, there should be ~125mm of total dilutive shares from convertible preferreds + warrants, getting to total share count of 239mm by 2020.

So here’s what valuation looks like. Using conservative EV/FCF multiples of 10-12x, RCM should be worth $3.8-$6.0 per share by 2020.




Given today’s stock price of about $3.3, there is no downside, while the mid-point of that valuation range provide almost 60% upside and ~20% IRR

This is almost too good to be true. At what point would I say “I may be wrong, let’s cut out and re-evaluate”? There appears to be some support around $2.4. Using that as a stop loss, downside is about 30%. Compare that to 60% upside that’s a 2:1 reward to risk ratio.

Again, this is a high probability given that currently contracted business delivers 90% of the low end projection. God forbid they actually win new contracts, the shares could go through the roof.

Catalysts

1) The recent listing has brought increased volume and the stock is already trending higher.

2) Company will go through an accounting change 1Q17 to simplify the story.  

Right now the accounting is a mess: GAAP revenue is completely meaningless, so investors have to rely on management’s non-GAAP measures. I remember spending lots of time reconciling GAAP revenue and EBITDA to management's corresponding gross and net "cash generated from customers", and then from that to GAAP cash flow from operations and management's free cash flow measure. It was a super pain in the ass. A simpler GAAP accounting profile would go a long way to remove the “yick” factor and bring in investors.

3) If they win a contract outside of Ascension and Intermountain, that could "prove" their capability and help the story. 

I think they can do it. The company offers a fully outsourced model where they effectively take the risk of cost overrun and reap the rewards of cost savings. I think that makes a lot of sense in today's hospital landscape where margin is tight, and where payers pushing "value based care" are pushing risk into hospitals.

Other notes

Dr. Rizk served as the Chief Executive Officer of Accretive Health, Inc. from July 21, 2014 to May 26, 2016.  It’s likely he left voluntarily because 1) he became CEO of Verisk Health (now Verscend) in Aug 2016, like 3 months later 2) they groomed Flanagan as COO for a while.

Virtus Health

Business and Industry Overview

Virtus Health Ltd (“Virtus”, “VRT”) is a steady dividend grower I found while scanning through Australian stocks.

Virtus operates In Vitro Fertilization (IVF) clinics. Fertility specialists contract with Virtus to use the clinics for IVF and related operations and get a split of the revenue. When a couple gets an IVF at Virtus, they pay the bill initially but gets heavy reimbursement from the federal government (Medicare and EMSN) as well as Private insurance if they have it. As a result, Virtus’ revenue is AUD 10,000-14,000 per IVF cycle but typical out-of-pocket costs for each patient is 1/3-1/2 of the total price.

The Australian assisted reproductive services (ARS) industry is concentrated. The top 3 players Virtus, Monash IVF, and Genea owns over 70% market share and are all privately owned. ARS are mostly provided by private clinics as there are virtually no public sector fertility clinics in Australia. Virtus is the biggest of the three with ~1/3 market share. At the local level VRT is even stronger since it is number one or number two in its geographies.

Why I Like It

There's lots to like about the industry and specifically Virtus. You have a product that is naturally price inelastic (we’re talking about babies here), good market structure, and very long growth runway due to demographics.

The industry structure is a big attraction for me as new entrants will have difficulty recruiting fertility specialists. This is the key to market share gains. But there are only some 300 odds fertility specialists in Australia and they are typically under contract with the big three.

Australia’s low birth rates provide Virtus a long growth runway. Those data were cited extensively in IPO prospectuses so I won’t recite them here.

Acquisitions have been sensible and generally at below 10x earnings. As a result return on incremental capital is solid low-mid teens. Management has been good about returning excess cash in the form of dividends.

My plan to make money with this stock is buy and hold, let the company accrete value over time and receive dividends in the interim. That should give 5-15% IRR over the next few years, maybe even decades.

Risks and Mitigants

What might change my mind? If the key risks turn out worse than expected: government funding risk, lower price competition, and alternative technologies.

By “funding risk” I mean risk that government will reduce reimbursement for IVF, or reduce subsidies for private insurance. Despite the chaos in Australian politics I have actually gotten comfortable here. First, unlike other benefits that add to expenses for the government, an IVF actually creates a future tax payer. 

Second, in the extreme and unlikely case where funding is removed and patients pay 100% out of pocket you're talking about AUD 10,000-14,000 per IVF cycle, a lot of couples would still pay. Keep in mind Australia is one of the wealthiest countries on Earth and typical clients are women in their late 30’s, who tend to be well educated and have sound financial positions (which is often why they delayed starting a family in the first place)

Competition is a bigger worry. Primary Health is in the market with low end $500 or even $0 out of pocket services. There has been some impact on Virtus' lower price, less service clinic but management indicates their full service IVF is still going strong. Industry IVF cycle growth have been higher than normal since Primary Health’s entry, so it would seem that they enlarged the pie by drawing in new customer segments. 

Primary only has two IVF clinics so far and I think scaling up and signing up doctors will be tough. I don’t see why doctors would leave a high priced practice for a low end one.

Longer term tail risks is that an alternative technology emerging to replace IVF. Also if IVF success rates (currently ~25-30% for women in late 30's) improve then people would need less service.

Why Virtus and Not Monash IVF; Catalysts

I prefer Virtus because Monash has business concentration risk with 1/3 of IVF cycle from 5 doctors. It also hasn't really been exposed to competition from Primary Health, which only recently opened a clinic in Melbourne. Yes, Monash IVF does have higher margins mostly due lower employee benefits, but Virtus is not a provider of low cost commodity services and in fact there's something positive to be said about paying your employees well.

“Self-help” earning opportunities are available in the next year or so. The company’s Singapore operations can swing from loss to profit (management indicated this can happen in a couple quarters). One of the Ireland Clinics had some temporary staffing issues in FY1H16 which has been addressed. VRT can also benefit from general ramp up of new facilities and younger doctors as they grow their reputation and attract new clients.

Australian budget comes out in May and we will have more color on the government funding risk then. The technicals are not great - the stock is coming upon a resistance zone at $7.0-7.25. But I’m inclined to ignore that and hold even if it gets there.

I have a 2-3% position right now with average cost basis of $6.56. Virtus trades at 15-16x forward earnings. Accounting earnings tracks cash flows well and leverage is moderate at 2-2.5x EBITDA.

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)

Tenet Healthcare Equity Thesis in Three Words

“Screw the bondholders”, Larry Robbins says.

Ok maybe not in those words.  But at a recent conference, Larry Robbins of Glenview Capital suggested that as Tenet Healthcare (THC), the hospital operator, digest its recent Vanguard acquisition, THC should take advantage of the credit markets to maintain 5x leverage. THC’s debt currently stands at 6x EBITDA (> 70% debt/enterprise value!), but instead of deleveraging, Robbins suggested the company can buy back stock.

Robbins is a power player in healthcare space and supposedly has so much influence on THC management that he actually drove Vanguard deal.

To be fair, THC has other things going for it. Synergies from Vanguard acquisition is one. ObamaCare is another. The company has a sensible strategy of teaming up with reputable non-profit players like the Yale New Haven system. Hospitals industry is ripe for consolidation and THC could be buyers (with more debt?). The conference notes link above noted more. There are concerns about the hospital industry as a whole, and I mentioned some in my HCA write up here, but nothing that can’t be overcome.

Valuation is ok -  ~8.5x EBITDA and 18x 2015 P/E (consensus is expecting some explosive EPS growth). P/E is less relevant here because THC is so highly leveraged (both financial and operating) that any little revenue growth juices earnings disproportionately. By 2016 P/E could easily be under < 15x.

So still, the equity story goes back to leverage. When a company has 6x debt/EBITDA and still want to buy back shares, there ought to be a creditor revolt. But the bond vigilantes are silent. Tenet Healthcare’s 8% senior notes due 8/20 (rated B3/CCC+ by Moody’s/S&P respectively), are yielding a mere 4.4%. What can they do? The Fed started a QE orgy, the ECB is holding the bondholders down, and the BOJ is manning the door. It’s clear that “high yield” bond managers have nowhere else to go.  

Larry Robbins is enjoying this party and he’s inviting all equity investors to join in.

I’m in.­


4/22/2016.  Minor edit as I look back to this very old post. I sold this stock long time ago but this post could be clearer. Added "When a company has 6x debt/EBITDA and still want to buy back shares, there ought to be a creditor revolt. But the bond vigilantes are silent.

HCA’s Organic Growth Prospects

I established a combined 2.5% position in HCA Holdings (HCA) and Tenet Healthcare (THC) last week. I have been eyeing the hospital sector for a while mostly as a hedge against higher medical utilization rates for my managed care positions (now ~7.5% of my portfolio). So when they cratered recently I bought HCA at ~$66 and THC at ~$47.5.

I will focus more on HCA here because that’s the one I might add more to, while THC is more of a trade. Compared to Tenet Healthcare, HCA has better quality hospitals, higher margins, lower leverage and cheaper valuation multiples (at least for 2015E).

Valuations multiples are high by historical standards but still reasonable in absolute terms. HCA trades at 7.5x forward EBITDA and 13x 2015E earnings. The big discrepancy between EV/EBITDA vs P/E numbers hints at the high level of operating and financial leverage. This has several implications. First, it means margins and profitability could be distorted and you have to look further out for “normalized” results. Second, it also means top line growth should be the focus of my analysis.

I will start by putting the company in its industry context, then focus on organic growth.

HCA and Industry Context

HCA is the largest-profit hospital operator in the U.S., with 165 hospitals and 113 freestanding surgery centers. Traditionally physicians are not employees and they bill their services separately, while hospitals make money off bed utilization, medical resources and services, facility charges and other ancillary services. Think of physicians as athletes and hospitals like HCA as stadium operators. HCA has a high quality portfolio - ~70% of the hospitals are in The Joint Commissions list of “Top Performer on Key Quality Measures”, which recognizes top ~37% of U.S. hospitals. Roughly ~45%-50% of revenues came from Florida and Texas facilities. Private equity firms Bain and KKR still have stakes in the company.

The core hospital industry is nothing to get excited about. Volume growth, as represented by same facility admissions growth, fluctuated around -2% to 3% the past decade. As recently as 2013, same store admissions were flat to negative. This is due to a structural trend shifting away from inpatient hospital usage, toward outpatient services and other formats, such as ambulatory surgery centers (“ASC”), specialty hospitals, urgent care centers, diagnostic/imaging centers…etc. Together, these substitutes extend the competitive landscape beyond other hospitals.

This has been going on for years. Hospitals wised up and decided on an “if you can’t beat them, buy them” strategy. Hospitals have been buying ASC, physician groups…etc. Since acquisitions serve to both defend and expand market share, hospitals with strong financial flexibility have clear advantages.

Analyzing Organic Growth

After 2Q14 it became clear that the Affordable Care Act (ACA) is a home run for the hospitals. Same store revenue growth spiked. With Medicaid expansion and insurance exchanges, hospitals got more insured patients, which not only added volume but also lowered bad debt expenses. HCA guided to a strong 2014E revenue and EBITDA growth of 7.5% and 11%.

The question is how much of that growth is organic and sustainable? There will be a day when all the uninsured already have insurance, and ACA as a source of growth goes away. Also, growth by building and buying hospitals cost money. We need to break down revenue growth between ACA, new hospital contributions, true organic/”same store” volume growth, as well as price increases.

This is harder than it sounds and I had to piece together various data points, and made some reasonable assumptions*. I attributed 2014E revenue growth into the various sources (see table below). Volume gains can be broken down as follows:  ~1 % from Obamacare, 1 – 1.5% gain from new facilities, and ~1% organic. Price gains are in terms of net revenue per adjusted admission, which would account for lower bad debt expenses.

This 1% core volume growth is an improvement compared to near 0% in 2013. So it appears that HCA has found a way to mitigate the shift out of hospital into outpatient and free standing facilities. The real organic growth number could be slightly lower as there could be some other sources of growth that’s not sustainable. I can imagine a few below:  

·         Whenever the rules change there will be some distortions of the system. While I have no reason to believe HCA management is anything less than ethical, doctors on the ground could be doing some unnecessary test, exams, or surgeries.

·         Some volumes could be from under-education. As high deductible plans and bronze plans are still relatively new, some people go to hospitals and don’t realize they have to pay. Sooner or later they will learn.

·         As this NY Times article highlighted, buying out physicians groups allow facilities to charge higher price for the exact same service. While legal, this is contentious and could come under challenges.

As outside investors, there is no way we could know or quantify how much these contributed to growth. But it's something to keep in the back of our minds.

Outlook for Next Few Years and Upside

HCA’s top line is in decent shape. An 1% organic volume growth is not much. However, with a moderate 1-2% price increase and new facilities contributing 1-1.5%, HCA can expect 3-5% revenue CAGR in the next few years. EBITDA and earnings should grow faster than that due to operating and financial leverage. This is without further growth from Obamacare so 2015E consensus expectations of 5% revenue and EBITDA growth appear very reasonable.

Ultimately, the success of this company will depend on returns on incremental invested capital. HCA certainly has opportunities here. According to the American Hospital Associations, some 20-30% of hospitals operated at negative margins as of 2012. HCA is a proven consolidator with a track record of improving hospital efficiency. It also has strong capital resources in terms of free cash flows and debt capacity. HCA also just authorized $1bn of stock repurchase program. 

As with all things healthcare, the key risk is reimbursement changes.

* We have some useful data points. HCA said 4% out of the expected 11% EBITDA growth came from ACA. This is consistent what other hospitals have said (roughly 1/3 of their gains came from ACA). We also have % growth vs same store growth %, which allows us to back into contribution from new facilities. The remaining is same store organic growth. Finally, we also know what proportion of revenue comes from price versus volume, since HCA give us equivalent admissions and revenue per equivalent admission.

* Back of the envelope way:  Total volume growth is 3.3%. Assume ~1/3 new admissions are from ACA (just pro-rate as EBITDA growth contribution) that means ~1% came from ACA.  SS admission of 2% minus 1% from ACA leaves ~ only 1% organic/“same store” volume growth.

Management Turnovers at Pharmacyclics (PCYC)

So someone told me about this company with a wonder drug. She loves the product but got this weird feeling about management. Maybe it’s the way management interacted with each other on the latest earning call, or the way they answered analyst questions. She could not put a finger on what it is.

She also told me they just got a new chief commercial officer but the chief medical officer (CMO) just left. So naturally I googled the CMO’ name. Multiple names popped up. Digging deeper here’s the summary timeline I found:

·         Dr. Ahmed Hamdy - appointed CMO March 2009

·         Eric E. Hedrick - interim CMO sometime around 2011

·         Lori Anne Kunkel - appointed Dec 2011; departed July 2013

·         Jesse Seton McGreivy  - departed Aug 2014

So you have 4 CMO’s in 5 years.  When a company’s CFO or Chief Accounting officer leaves, you worry there’s something wrong with the numbers. But how about when a biotech’s CMOs keeps leaving?  Do you worry that the product is fake?  Is it even possible to fake your way through FDA approval?

More research. What is wrong with Pharmacyclics, Why would top executives keep leaving?

·         Nothing positive in CaféPharma. Let’s just say this is a highly entertaining board. You got threads  named “Pharma-stall-ics”, “Pharmasucklycs”, and “Pharmafuckyclics”.. .etc. Definitely some employee relationship issues here. There are also widespread mentions of wrongful termination suits.

·         A post on investor hub paints an unflattering picture of COO, and mentions former CMO Lori Kunkel.
·         Bloomberg  article. Lots of insinuation here when the article talked about Duggan’s association with fraudster Slatkin. The article spent almost no time on what Duggan did at Intuitive Surgical (which would have added to Duggan’s credibility).

Obviously all of the above could be written by people with agendas. The fact though, remains that you got 4 CMOs in 5 years at a biotech. I doubt CMOs leave due to “work life balance” issues because these are overachievers and probably workaholics to begin with. It’s also hard to explain this as CMOs asking for big pay raises because well, you should pay them.

I get the sense that this tight clique of Duggan, Zanganeh, and Erdtmann calls all the shots. Given the rampant turnovers and the colors above, I can only infer that at best that the top management are unpleasant dictators, at worst there’s something unethical going on.

But, they have an awesome product!

Does all this matter when you got a hot product like Imbruvica?  In general, when do management matter the most?

First, if this is a fraud then obviously all bets are off. Again, is it even possible to fake your way through FDA approval? Granted that EVP of Corporate Affairs Ramses Erdtmann is a Scientology Operating Thetan VIII, which according to Wikipedia gives him the power to "control others from a distance" and "create illusions perceivable by others", the probability of a fraud getting through FDA has to be pretty small.

Second.  If it’s not a fraud but top management are major tyrants, does that matter? I think it depends on context:

o   If the company’s valuation depends on the ability to keep innovating and create demand (think Apple and Steve Jobs), then management competence matters a lot, but management likability not as much (again Steve Jobs was known to be a bit of a dictator).

o   If this is a mature / growing company trading on say 15-20x earnings, management have to optimize revenue, control cost…etc. Clearly management matters a lot more.

o   In PCYC’s case though, the company is trading on vast market potential of a single product, Imbruvica. The patient demand already exists. The product is already there, theres no more innovation that’s needed. The science either works or it doesn’t, and there’s nothing management can do about it.

Ultimately, this comes down to how PCYC fits into your investment style. If you’re allocating to numerous small positions with catalysts for quick pops, then management matters less. If you’re trying to find that rare company that's built to last, then I'd say this is not the situation for you.


**** Updated 10/2/2014 (originally posted on Seeking Alpha Instablog)***

I normally don't like to dwell on management too much. In fact in my blog post here I concluded that management turns at PCYC can arguably be a secondary consideration depending on your investment style.

Then I learned that the drugs are made in China. Why would you do this? So you have a biopharma who keeps losing medical/science personnel; core executives couldn't answer questions about IMS data in their own presentations (and get yelled at by the Morgan Stanley analyst). And oh, by the way the drugs are made China.

I don't have the guts to outright short this company given strong reviews about Imbruvica, but at some point the red flags pile up and I stop looking further.

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.

Week ending 8/1/2014: OCN, HLSS, and managed care

I have been all over the place the past 3 weeks due to the earning season and because I’m trying to expand my circle of competence. Here I will comment on OCN, HLSS, and managed care.

Ocwen (OCN)

Lawsky probes Erbey

Fundamentally, earnings (and expenses) actually came in better than I projected. 1Q14 already saw big expense increases so I’m not sure why the market was surprised by that. Still no news on the WellsFargo MSR transfer but that’s actually not too material to the long term thesis.

What is this “long term thesis” then? As in any business: 1) sustainable volume and 2) price/margins. In my Seeking Alpha article earlier this year, I envisioned a scenario where banks get in the habit of transferring delinquent loans to handful of special servicers (OCN/NSM/WAC). The development of a consistent “flow” mechanism is what drives sustainable value in my “normalized” scenario. The second thing is this “delinquent flow” needs to provide a sufficient margin – this will be a function of industry structure. In the 2Q14 call management explicitly referred to this vision as well.

The problem is getting a steady flow of delinquent loan business requires better customer service, reputation, compliance, and generally business goodwill. Frankly, as a shareholder I have been frustrated with the lack of progress here. The customer service topic deserves its own article so I won’t get into that here. But suffice to say improving service will require higher cost (at least in the short term).

I think the stock market is being short sighted here. Institutional shareholders should be holding management accountable for better customer service and compliance, even at the expense of lower margins. Only then can OCN achieve its vision and upside.

Note 1: At 26.7 per share this is a bargain! Now, investing in OCN requires some faith on how the entire industry is going to change. No matter how much sense this idea of delinquency flow transactions seems to make, the industry is just not there yet, so there’s definitely an element of speculation.

Note 2:  OCN talked about exercising their clean up calls, which coincidentally is the name of this blog. I need to dig deeper here but I would think the value of those calls are already priced in when they paid for the MSRs. 

Home Loan Servicing Solutions (HLSS)

This has very much moved in sync with OCN, which makes me wonder if the market understands what the company does. HLSS is a liquidating asset by nature so the best way is to model cash flows in a runoff scenario, assume it hit 0 one day and calculate the IRR. In my analysis I got a nice single digit IRR. Yes, additional MSR transfers from Ocwen can provide some bonus but I’d be surprised if many institutional investors counted on that to begin with. I also don’t get the high short interest in this name (short interest 8% of float and 16 days to cover). At this price shorts are paying out 8-9% in dividend yield, clearly there are better ways to short mortgage servicers (assuming that’s what shorts are trying to do)?

The biggest risk here is management getting adventurous with non-traditional assets. The latest creativity came from reperforming loans (RPL) where HLSS takes a small amount of credit risk. This is still a small portion of the overall portfolio but will likely increase as OCN exercise its clean up calls. Until then, the vast majority of HLSS’s assets still consist of servicing advances which have zero credit risk and very low interest rate risk.

Managed Care companies

Managed care organizations (“MCO”) stocks took a real beating last week despite solid earnings and guidance outlooks. The pressure actually started building a week earlier when WellCare slashed its guidance by half (on Florida MMA, negative reserve development and other charges). On 7/29/2014, Aetna beat consensus earnings but its commercial medical loss ratio (MLR) came in at 80.6%. Apparently this is worse than expected (market expected MLR to improve yoy instead of deteriorate) and managed care stocks tanked.

The market is worried about utilization trend deteriorating, given the strong numbers seen in hospital volumes and prescription drug trends. Wellcare’s guidance cut and AET’s higher commercial loss ratio were seen as a potential inflection point. The sentiment on managed care got so negative that when Wellpoint reported the next day with a “beat and raise” plus solid loss ratio, its stock fell more than 4% before recovering!

Does this make sense? My problem with the increased utilization theory is this: even if there is increased utilization and higher costs, why wouldn’t MCOs build that into the next round of price increases? Longer term profitability does not depend on cost trends, but rather pricing power, which is in turn based on industry structure, availability of industry capital and competitive rivalry, none of which have seen observable changes. Yes re-pricing to higher cost trends will suffer from lags that could impact the next year, leading to lower guidance and EPS estimates. But for investors with long time horizon, higher cost trends should not be a worry.

I also heard that empirical/historical data shows that we’re at a point in the economic recovery cycle where cost trend accelerates. Well if the pattern is so well known, does this not in fact help managed care companies argue for higher prices?

Gilead Sciences, Inc. (GILD) – Can the Hep-C market size justify Sovaldi’s implied valuation? A plausibility check

As the maker of Sovaldi, Gilead’s 2Q14 net income grew an explosive earnings 376% yoy. Yet it is trading at 10x 2015E earnings, what’s the catch?

I see bloggers and even professional analysts projecting earnings for Gilead then apply a single multiple to the entire company’s earning. This approach has two problems. First, as Sovaldi now constitute over 50% of product sales, it’s better to value it separately. Second, it ignores Sovaldi’s unique ability to cure patients and decrease its own target market size. In other word, Sovaldi is a melting ice cube, thus has to be valued with a different multiple.

The approach

Ideally I would project out Sovaldi earnings versus other parts of Gilead; value them separately, then add up the 2 parts. Before committing the time however, I’d like a shorter plausibility check. Here I will do the reverse. First, value GILD ex-Sovaldi; second, back out Sovaldi’s implicit market valuation; third, check this again the Hepatitis-C market size to see if that valuation is reasonable. This approach saves me from having to forecast whether revenue and earnings should be up 400% vs 300% (or 200% for that matter).

1) Ex-Sovaldi valuation & implied Sovaldi price per share

Gilead’s management is kind enough to give us assumptions for 2014E excluding Sovaldi, so projecting the ex-Solvadi income statement is relatively easy.

Management’s assumptions are below including and excluding Sovaldi:

With ex-Sovaldi EPS going from ~$2 to $2.7 per share the next 2 years, apply a 20-18x multiple would get roughly $40-55 per share for the non-Sovaldi business.

2) Implied Sovaldi valuation and years to break even (at current cure rate)

With GILD trading ~$91 per share, this would imply the market is valuing Sovaldi at $35-50. Sovaldi is expected to contribute $5.9 per share of gross profit for 2014 ($10bn 2014E sales and ~95% gross margin), so the current price requires 5-9 years of 2014E like gross profits.

Is the Hep C market big enough to last 5-9 years before Sovaldi and its competitors cure everyone? Keep in mind the analysis so far eases the hurdle for Sovaldi: 1) the payback period is probably longer because we assumed Sovaldi gross margin falls right to the bottom line. In reality some cost is incurred by Sovaldi. 2) the EPS numbers shown above assumes $8bn of share buyback per year, this boosts the ex-Sovaldi valuation and lowers the Sovaldi break even.

3) HepC market size

A simple market size analysis below shows that at a current annual cure rate of 139k patients, the market can support 6-11 years at the current pace of Sovaldi monetization. The management case assumptions below mostly came from p31-33 of 2Q14 presentation slides. I got the annual cure rate of 139k patient as follows:  for the first 2 quarter of 2014, total Sovaldi patients and revenue were 80k and $5.75bn, respectively. So $10bn of expected 2014E revenue scales to about 139k patients.

At the surface, this should easily be able to accommodate the 5-9 years of sustainability implied by the stock price. Keep in mind though, this is assuming the following:

               i.            No price cuts. Regulators and PBMs have been making some noises here. However, their sabre rattling is based on some really high patient assumptions. CVS for example, cited 3mm of eligible patients versus my forecast of 390 -800k U.S. patients under care above. If we ever get to 3mm patients getting treated then clearly there needs to be a steep cut in Sovaldi prices. But then again, if that’s what regulators and PBMs are using to justify the price cuts then we’re not anywhere near that.

             ii.            GILD takes 100 %mkt share. In reality Merck and Abbvie are both about to come out with their own HepC products. Merck is more of a threat to take market share but ABBV can cut prices in its desperation to drives sales and recoup its investments.

           iii.            Same pricing and margin outside of US.  This is unrealistic as gross margins will likely be lower in Europe due to some of the single payer systems there. GILD is getting about $60,000 in Europe for a course of therapy with Sovaldi.

           iv.            Same volume & pricing mix across all genotypes. There could be some shift here and I may need to break it down further.  For example which genotype is more profitable?  And do those get treated earlier or later

             v.            No discount for time value of money. This is less material

With the above negative factors (and gun to my head), I’d guess the HepC market supports 7-8 yrs of current monetization. So GILD’s stock price at least passed the plausibility check. The market is pretty efficient after all.

So now what - do I suck it up and do that long form detailed model? Just because something is plausible doesn’t mean it’s worthwhile.  What’s the upside?

Counter-argument & other factors

·         Maybe ex Sovaldi GILD is worth more. Stribild is a blockbuster in its own right and has been growing >100%.  20x multiple may actually be too low for the non-Sovaldi business.

·         Market size could turn out much larger. Diagnosed rate and treatment rate assumptions can make huge differences. I already adjusted management assumptions upward in my base case. What does a realistic upside case look like? 

·         Other countries outside of US/EU5/JP.  Other parts of Europe, China, India and others won't be very profitable but they are still worth something.

·         Sovaldi revenue will likely ramp up from its current 2014E levels. This is irrelevant because faster cure rate just shifts revenue forward. Remember the HepC market size is finite no matter how fast your ramp up. In real life faster sales gets you some benefit because a back ended revenue is exposed to competition and price cuts. On the other hand, faster cure rate also lowers the market size because now you have fewer patients to infect others (taking away that already low new patient growth rate of 1-3%).