In the current bull market, it is becoming harder to identify value orientated stocks. Valuations are being stretched and I anticipate a broader market correction sometime in the near future. However, some of the healthcare stocks look particularly beaten down. There has been plenty of political commentary weighing on the healthcare industry.
The Whitehouse recently launched a new website directed at informing the public on how the Affordable Care Act is failing. Anthem and other large health care insurers that participate in the Affordable Care Act have been pulling out of some states like Ohio and Indiana.
We all have heard the politicians attacking the ever-increasing drug prices. In fact many of the pharmaceutical companies have pledged to be more transparent to the public regarding drug prices. A few have even pledged to keep price increases under 10%. This is still much higher than the CPI. See the image.
Image source: Thomson Reuters
Could there be opportunity for the DIY investor? I’m not sure, but I started looking at two industries with oligopolies.
The pharmaceutical distribution business in the United States is an oligopoly. There are three key players in this market
- Amerisource Bergen
- Cardinal Health
All of these companies have been launching closer relationships with their retail pharmacy customers. McKesson recently launched a joint venture with Wall-Mart to distribute generic drugs. Walgreen’s entered into a long-term agreement with Amerisource Bergen and now owns over 20% of ABC’s outstanding shares. Needless to say, there has been tremendous competition over drug distribution and margins appear to be getting thinner on generics.
A few quarters ago, the valuations of all three companies imploded after comments from the CEO of McKesson cut guidance due to drug pricing scrutiny. Sometime shortly after, Seth Klarman of Baupost and the writer of the definitive book on value investing called Margin of Safety, added all three of these companies to his portfolio. Later he added Express Scripts. What does he see in this industry that others are missing?
Since McKesson cut guidance they still earned record revenue’s of $192 billion, landing them 5th of the fortune 500. Until there is a better way to distribute drugs to our ever aging population, it is my opinion that these three companies will find a way to keep their dominant market share in the distribution market. However, Amazon has an ambitious plan to enter the market and we are keeping an eye on Amazon’s developments as they have been completely destroying other industries like retail.
Pharmacy Benefits Manager (PBM)
A pharmacy benefits manager is essentially a middle man who sits between healthcare plan administrators, like medicare part D, and the drug manufacturers themselves. They negotiate discounts and rebates on behalf of the plans they support. The PBM industry, like the distribution business, is dominated by three companies who have over 70% of the market:
- Express Scripts
- CVS Health
- United Health
These companies are also under political duress with a fair share of scrutiny as independent operators. The government and healthcare insurers want them to be more transparent over the drug price negotiation. This transparency also lead to the well publicized lawsuit of Anthem filing suit against Express Scripts. Anthem was Express Scripts largest customer and ESRX may lose them as a customer going forward which could lower their earnings potential going forward.
Also, there are rumors that Amazon could become a competitor in this area as well.
Are these companies adding value by negotiating better prices or are they root cause of the price increase? Notorious short seller Jim Chanos believes they are not adding value. Please see the interview. In fact he believes they are in charge of increasing drug prices and has a short position thesis on Express Scripts.
Uncertainty, Risk and Valuation
All of the uncertainty is driving the profitability and valuation of these companies down. There are plenty of uncertainties and risks related to the future of the healthcare market and the current business models of each of the industries we discussed here. We have no idea how this will play out. However, similar political rhetoric was used back when Obama was campaigning for his first election and things still turned out very well for these companies.
In our opinion these companies valuation hold a decent margin of safety at these levels and in full disclosure we are currently holding Express Scripts and McKesson at the time of writing this as we continue to monitor the situation.
What do you think about the state of healthcare and drug distribution? Is it too early to tell? What are you favorite healthcare stocks?