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Health Care Pricing “Juju”

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So far this year both stock portfolios are doing quite well, handily beating the market. The bulk of our success has, of course, been from the companies we chose to buy or hold, but some success has come from what we haven’t bought.

Letting you know the reasoning behind our decisions not to buy a company can sometimes be just as important as discussing the companies we own. Over the past year or so, we’ve looked at various health care companies that appeared to be priced very cheaply. Specifically, we were looking at drug distributors McKesson (MCK), Cardinal Health (CAH), AmerisourceBergen (ABC), and pharmacy benefits manager Express Scripts (ESRX). Ultimately, we decided not to buy any, and it’s a good thing. McKesson (MCK) is down about 45% from its 2015 highs, and PBM Express Scripts (ESRX) is down around 24% from its 2015 highs. Earlier this month, McKesson reported disappointing earnings and forward guidance and dropped some 20%. We tweeted the following.

Health Care Pricing

Here’s what I mean by that tweet and “pricing juju.” Let’s look at a company whose “pricing juju” is easier to understand and one we still may buy.

That company is Priceline (PCLN). The United States hospitality industry is dominated by huge corporate hotel chains and business travelers. Europe is quite different. A majority of hotels in Europe are small boutique hotels, and vacation travelers make up a larger portion of hotel customers. The average European gets about 30 days paid vacation (holidays and time off) while the average private sector worker in the US gets about 16 days off.


Priceline has a pretty simple business model. They’ve spent years cultivating relationships with all the small hotels across Europe, and they provide travelers a one-stop portal to search and book accommodations. Travelers go to Priceline’s websites (booking.com, priceline.com, kayak.com, etc) because that’s where all the hotels are listed. (Priceline also spends a ton of money to appear at the top of Google’s results for travel and lodging.) Hotels in Europe have to integrate with Priceline because that’s where all the customers are going to come from. The value chain then is pretty simple.

Health Care Pricing

As the intermediary connecting travelers and hotels, it makes sense for Priceline to earn a profit, and as an oligopoly with Expedia it makes sense for that profit to be quite high.

The Health Care World

To draw the value chain for the pharmacy distribution and pharmacy benefits management space is quite a bit harder. In an idealized and simplified world, we should see something like the picture below.

Health Care Pricing

When we are sick, we go to see a doctor. The doctor prescribes medication and you or I, the patient, go to a pharmacy to get it. The pharmacy got the medication it has from whichever drug company produces it. Usually, there is a middleman in the form of a drug distribution company that buys inventory from many different pharmaceutical manufacturers and distributes them to the pharmacies.

You can see why each participant in the value chain makes money. Humans are complicated and difficult to fix, so it makes sense for highly trained and highly educated professionals like doctors to be paid well. (Also the supply of doctors is limited by the AMA.) Developing new medications to treat various diseases and ailments is expensive and time consuming, and we can see why pharmaceutical companies should earn a profit. (The size of their profits is a matter for debate.) Getting the medicine from the manufacturer to the end user (the patient) also needs to be done, and again in a capitalist economy worthy of a profit.

Heath care doesn’t happen in a straight line. Instead, the value chain looks something like this:

Health Care Pricing

There is a huge middle industry of pharmacy benefits managers (PBMs), drug distribution companies, and health insurance companies that all have a part in deciding what type of health care you can get, when you can get it, and how much it will cost you.

In the past year, the three major drug distribution companies along with the only public pure-play PBM company earned over $7.5B in profits. The problem is no one really knows who and where this profit is coming from. The drug distribution companies have benefited tremendously from rising pharmaceutical prices, in particular, generics. They buy a bunch of drugs from the manufacturers and hold the inventory. When prices rise, they sell them at a higher profit to pharmacies. PBMs (many health insurance companies have their own captive PBM) supposedly lower prices for consumers. But do they? Take the recent case of Mylan Pharma and the controversy over the price increases for their EpiPen. About half of the price increase went to Mylan itself, while half went to PBMs and insurers.

The system is so convoluted and opaque it’s hard to discern what role each entity plays and what type of profit (if any) each should actually be earning. Many companies have used the lack of transparency to squeeze profits out of whoever is on either side of them in the value chain because no one really has a clear picture of what the entire market looks like.

We stay away from all types of health care companies that fall into that nebulous second health care drawing above. If you don’t know how a company makes money, what value they provide, and what exactly their services are worth, then it’s extremely difficult to determine how much that company is worth. Should those companies be earning $7.5B in profit? Is $5B a fairer number? Maybe they are really doing God’s work and should have a $10B profit pool. I have no idea, so we decided to stay away.

No Company Profiled

No Company Profiled This Month.

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Article by Ben Strubel, Strubel Investment Management


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