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.