The health care industry is in the business of saving people’s lives. That is the implicit expectation in commercial and social contracts the industry has with other parties. For the benefit of the services it provides, the industry is afforded a payment that should reward it for the risks and the costs entailed in delivering that benefit. That payment is ultimately a function of demand and supply, which should meet in the long run at the marginal cost of production.
Unique Industry Pricing
In health care, though, it is often unclear where supply meets demand. The level of opaqueness that is pervasive in the industry with respect to pricing, exacerbated by antiquated business models and often-perverse incentives (e.g. gross vs. net pricing, rebates, discounts), only complicates things. The industry operated for decades on a cost-plus model that created duplicative infrastructure for which rents were—and in effect still are—being demanded. It was in the mid 1980s that Medicare, as the largest payer, switched to the Prospective Payment System (PPS), an annual adjustment process by which it would reward incremental reimbursement. The PPS shifted the industry’s focus from building to innovating. There was no incentive to just bulk up on costs and look to get paid for it. Rather, growth was to be had by improving the technologies that were being featured in the products. This created a new dynamic by which technology became the source of pricing power. In every other industry, technology and innovation come in to disrupt business models and lower the marginal cost of production. In health care, we saw 3-4% annual cost increases on the basis of technological advancements. Those were enough to push medical cost growth 2% ahead of GDP growth and overall expenditures to unsustainable levels where they are today (20% of GDP).
Subtle differences exist between health care and other industries when it comes to the demand curve for its services. Our demand curve for health care is perfectly inelastic at both ends of our lives. We will spend whatever it takes to preserve a newborn’s life and also to extend a terminally ill one. Moreover, the greater the benefit of medical products, the more pricing power the industry can exercise. As a result, of the average lifetime health care expenditure (approximate $320,000 for males and $360,000 for females), half is spent in the senior years (55+) and for those who live beyond 85, one third is spent in those remaining years. The oldest group (85+) consumes three times as much health care as those 65-74 and twice as much as those 75-84.
Unsustainable Long-Term Dynamics
With that in mind, the industry’s rational profit-maximizing behavior in the short term created unsustainable dynamics in the long term. Instead of focusing on prevention, the industry has focused on developing technologies that turn life-threatening diseases into chronic ones. With more than two thirds of health care expenditures today going toward managing chronic diseases, these now look like the primary sources of potential savings as the system recalibrates itself toward sustainability. Something will have to give in the coming years to move the demand and supply into market equilibrium, especially in light of the inverted demographics pyramid. New pricing and go-to-market strategies should yield change. If neither does, the industry risks inviting onerous regulation it fears the most.
Anticipating Future Changes
We could be at the point in time when technology, legislation, and market forces start to converge to organically generate the needed change. Spurred by the Affordable Care Act and changes in the payment mechanism for Medicare, the health care industry is starting to develop new business models: enter Accountable Care Organizations (ACOs), private health care exchanges, biosimilars, innovative consumer devices, and new drug pricing strategies. Add to that the increased level of overall consumer involvement, and we finally have a fertile ground for substantive change.
We have tried to position our health care portfolio in recognition of this potential scenario. With primary emphasis on intrinsic value but a view towards growth of normalized earnings power, we buy companies we believe have assets which are currently undervalued relative to their potential. Alere (ALR) is a very good example of that, with its innovative Molecular Diagnostic portfolio. The decision by Abbott (ABT) in February 2016 to purchase ALR for $56/share is, in part, a recognition of that potential. We expect to continue to own ALR indirectly through our shares of ABT, a company we consider to be the best capital allocator in the sector. Taking a cue from ABT Chairman and CEO Miles White is not a bad thing. The company’s decision to focus its business on international geographies, specifically Emerging Markets, is an implicit confirmation of the emergence of some of the aforementioned headwinds in the U.S. market.
Health care expenditures in the United States will receive additional scrutiny in the coming years, with pharmaceutical pricing controversies of the last few quarters a likely harbinger of things to come. Not only are the days of 10% annual January price increases on “me-too” primary care drugs gone, but the new innovative specialty therapies will be priced for the benefits that they provide. For example, Novartis (NVS) recently struck agreements with Cigna and Aetna (AET) on its Heart Failure drug Entresto, such that NVS would provide an upfront discount in exchange for potential savings the drug would provide in the form of lower hospitalization rates. AET has in turn promised some of those savings to win new business on private exchanges and in capitation-based arrangements, the latter of which provide more than half of its portfolio. Further, both AET and Universal American (UAM), both companies we own, have been developing their ACO businesses with a view to provide savings by integrating care across providers and specialties. As the payers integrate more with providers, they will be looking to build out their service portfolios. BioScrip (BIOS), another Diamond Hill holding, is a market leader in home infusion services and a business that we see fitting well in an ACO structure. UnitedHealth Group’s purchase of BIOS competitor AxelaCare highlights that potential. With each of these holdings, we believe we have a good margin of safety to help us wait for the market’s eventual recognition of the long-term opportunity.
Evolution of Business Models
Pharmaceutical and Medical Device companies will continue to innovate and spend on research and development. However, their business models will have to respond to the new realities of the marketplace. Last year saw companies like Sanofi and GlaxoSmithKline (GSK) be forced by payers to provide 20% price concessions on current therapies just to get their newer drugs onto the formularies in diabetes and respiratory, respectively. Similarly, Merck priced its hepatitis C regimen at a 42% gross discount relative to the standard of care to get access and reach. There is good evidence that suggests Pharma’s pricing models will need to recalibrate down even further. Companies continue to price aggressively in relation to the benefit their drugs provide, as measured by the Quality-Adjusted Life Year (QALY) index. Some of the recently launched drugs across therapeutic categories are demanding upward of $150,000—and even multiples of that—for one year of incremental benefit on the QALY scale. Payers are recognizing this and are increasingly focused on demanding price concessions. Hence, alternatives like biosimilars could see faster-than-expected uptake, which would hurt companies like AbbVie (ABBV), one of our short positions. Similarly, investors may be too excited about the prospects of PD-1 and PD-L1 inhibitors and the pricing of combination therapies in oncology. While these new drugs extend people’s lives, they do so at a prohibitively high cost, thus our short position in Bristol-Myers Squibb (BMY), which today sells at higher relative valuation than Pfizer (PFE) did in the second year of Lipitor’s launch.
On the medical device side, we own Medtronic (MDT) and Stryker (SYK), which we see as companies that have recognized the new market reality and have acted decisively to change their business models. By focusing on their services businesses, they can use their scale and breadth to structure contracts that give them the ability to manage customers’ surgery suites, prevent unnecessary readmissions, and share in the generated savings.
Today, we are at a point where health care business models will have to significantly change in order for companies to stay competitive. The industry will need to get more transparent and resourceful in its commercial aspects in order to fulfill its social contract of extending and saving people’s lives.
Notes:
As of February 29, 2016, Diamond Hill owned shares of ALR, ABT, NVS, AET, UAM, BIOS, GSK, PFE, MDT and SYK.
As of February 29, 2016, Diamond Hill held short positions in ABBV and BMY.
© Diamond Hill Capital Management, Inc.
© Diamond Hill Capital Management
