The Market Appears to Misprice Risks to Healthcare Earnings from the Budget Control Act

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Richard Evans / Scott Hinds

203.901.1631 /.1632

richard@ / hinds@sector-sovereign.com

August 15, 2011

The Market Appears to Misprice Risks to Healthcare Earnings from the Budget Control Act

  • Since details of the Budget Control Act were made public, Hospitals have meaningfully underperformed the broader Healthcare industry; Large-Cap Pharmaceuticals, Specialty Pharmaceuticals, Biotech and Medical Devices have performed in-line
  • This implies that the Act’s committee fails to produce legislation, which results in automatic cuts. In turn, this results in as much as a 2 percent reduction to Medicare, which presumably translates into a 2 percent reduction in Medicare payment rates. In such a (we believe relatively unlikely) scenario Hospitals are directly affected, and sellers of innovative products are not directly affected
  • The market appears to believe the committee will fail completely, i.e. that the members can find nothing to agree on. We suspect the market misreads the mechanics of the automatic cuts – if the committee fails to produce law resulting in $1.2T in deficit reduction, the automatic cuts kick in as an addition to whatever savings were produced by the committee’s law in order to reach a $1.2T total; the automatic cuts do not replace the cuts in a < $1.2T committee law
  • Because the automatic cuts contain significant political pain for both parties, both parties have a vested interest in avoiding as much of the automatic cuts as they can, even if the cuts cannot be avoided entirely. This means the question of whether the committee legislates new rebates and/or discounts for drugs and devices is not a broad / binary question of whether the committee can find $1.2T in deficit reduction; it is a very simple question of whether the committee (and ultimately the Congress) prefers ‘X’ dollars in (politically safe) new discounts and/or rebates on drugs and devices to ‘X’ dollars of (politically dangerous) automatic cuts
  • Accordingly we see a very real risk of new discounts and/or rebates for drugs and devices sold to Medicare and Medicaid, though this risk appears not to be reflected in share prices for the corresponding sub-sectors. Ignoring for a moment our longer-term investment views of each sub-sector; we believe that Hospitals have been oversold in the immediate reaction to the Budget Control Act, and that Large-Cap Pharmaceuticals, Specialty Pharmaceuticals, Biotech, and Medical Devices have been ‘undersold’ in the immediate reaction

We recently published[1] details of the Budget Control Act as they affect the investment case for healthcare generally, and also as they affect the relative earnings potential of key healthcare sub-sectors. We argued that the 12-member bipartisan committee charged with finding at least $1.2B in savings was at least somewhat more likely than not to be successful; and, most critically, we argued that if the committee is successful and its recommendations made into law, that discounts and/or rebates on innovators’ (e.g. Large-Cap Pharmaceuticals, Biotech, Specialty Pharmaceuticals, and Innovative Devices) products are a likely consequence

Since news of the Act first became public, Hospitals have significantly underperformed healthcare; however Large-Cap Pharmaceuticals, Specialty Pharmaceuticals, Biotechnology, and Innovative Devices all have avoided a similar re-rating (Exhibit 1). We believe the market is misreading the investment relevance of the Act. Specifically, the market appears to be viewing success or failure of the committee as a binary matter – which we believe it is not; and, the market appears to believe the committee will fail, which also may not be quite as likely as prices reflect. In contrast, we believe discounts and rebates on medical products may come about even if the committee falls short of its target of $1.2T in deficit reduction; and, we believe the committee is far more likely to produce a bill that creates some degree of deficit reduction, than it is to fail to produce a bill at all

We first want to clarify what we mean by success in the context of the Act’s committee, and then update our views on the committees’ chances in the wake of two events, namely the Standard & Poor’s downgrade of American debt, and the naming of the committee members

Success or failure of the committee is not necessarily a binary matter – critically, any deficit reduction produced by the committee and voted into law reduces the effect of the $1.2T in automatic cuts. Thus even if the committee fell short of significant changes to entitlement programs and/or the tax code, the committee still could produce a bill that reduces the size of the $1.2T in automatic cuts by including any and every deficit reducing measure the members (and Congress, under special rules) can agree on. Since we believe the members can agree[2] to reduce the input costs of care by reducing the prices of innovative products – especially because every dollar saved by (politically safe) price reductions is a dollar of (politically dangerous) automatic cuts avoided — we see a significant risk of new rebates and discounts coming out of the committee, even if the committee’s bill falls short of the $1.2T minimum deficit-reduction target

We believe the Standard & Poor’s downgrade simply means the committee is likely to produce – and Congress likely to pass – legislation that comes closer to avoiding the automatic cuts, and which might in theory even exceed the $1.2T minimum. Further (other agency) downgrades are a distinct possibility if the committee falls short of even some miniature version of an entitlement reducing / revenue raising ‘grand bargain’; and, given the format of the committee and the voting rules under the Act, both parties are likely to share somewhat equally in the political consequences of a committee (relative or absolute) failure. For example, any significant failure only feeds an historic level of populist anti-incumbent sentiment, which is a clear threat to Republicans’ control of the House, and Democrats’ control of the White House

Late last week the committee’s final members were named (Exhibit 2), which obviously allows another step forward in handicapping the committee’s chances. We believe the most important distinction is whether the committee members are loyal to their party, or more independent. The more secure the member is in the coming election, presumably the more willing he or she is to follow party leadership as a member of the committee. Five of the six Senators have at least 4 years remaining on their terms; Kyl (R-AZ) would have been up for re-election in 2012, but has chosen to retire – so effectively none of the six Senate members are up for re-election in 2012. Of course all of the House members are up for re-election. All six beat their opposite-party challenger convincingly in the 2010 general. Thus as long as the committee produces deficit reducing legislation that spreads the pain somewhat evenly, few of the 11 returning members have any significant reason to fear losing their seats in their next general election – provided they can survive primary challenges from their own party. In the case of Democrats, primary challenges are a relatively small risk. All three Democratic house members won their 2010 primaries by convincing margins – the closest being 88/12. And, the Democratic party – unlike the Republican party – is not meaningfully threatened by an increasingly independent set of actors on its extreme flank. In the Republican case, all of the House members have to be mindful of the risk of Tea Party challenges – especially Upton (R-MI), who narrowly defeated Tea Party candidate Jack Hoogendyk in the 2010 Republican primary. The other two House Republican members, Camp (R-MI) and Hensarling (R-TX), ran uncontested in their 2010 primaries, but this by no means insulates them from a 2012 Tea Party primary challenge – especially if they vote in favor of a committee bill that includes new taxes

Ideologically, committee Republicans are perhaps a little right of their average party peer, where Democrats are a little to the left of their peers. The average American Conservative Union (ACU) score of the Republican House is 93.7; two of the committees’ House members score a 92 (Upton (R-MI) and Camp (R-MI)), and Hensarling (R-TX) scores a 100. Notably, Upton was a 72 in 2009, and swung right to his current 92 score in the wake of a Tea Party primary challenge. Kyl (R-AZ) has an ACU score of 96 v. the Senate Republican average of 91.1; Portman (R-OH) and Toomey (R-PA) are not scored. The average Composite Liberal Score for House Democrats is 75.5; Becerra (D-CA) is a 90, Van Hollen (D-MD) an 82.7, and Clyburn (D-SC) a 75.3. On the Senate side Kerry (D-MA) is a 74, Baucus (D-MT) is a 49, and Murray (D-WA) is a 79, v. an average of 70.8 for all Senate Democrats

On net, we believe the committees members are sufficiently reflective of their broader party, and sufficiently insulated from near-term electoral risks, to be expected to more or less follow the direction of their party’s leadership. In effect this means whether (or more precisely, to what extent) the committee succeeds or fails probably has more to do with whether party leaderships can reach an agreement than whether we should expect the 12 members as independent actors to reach an agreement. Because the economic and political consequences of failure have risen in the wake of the S&P downgrade (and its real or perceived link to a falling stock market), we see the odds of a grand bargain having at least marginally improved; and, since a grand bargain almost certainly has to come from the leadership, the fact that the leadership appears to largely control the committee is crucially important. The wild cards to committee control are of course the three Republican House members; no level of assurance from party leadership can insulate a Republican from a Tea Party primary challenge in the event of a vote to raise taxes. Which means, if the committee’s bill proposes a revenue increase, that seventh vote presumably would have to come from Kyl, Portman, or Toomey – and most likely from the retiring Kyl

Investment Conclusion

We believe the Budget Control Act’s joint committee is likely to find some level of common ground; and, even in the event the committee cannot find sufficient common ground to meet the $1.2T target, that it is more likely than not to produce a deficit reduction bill that becomes law. Because rebates and/or discounts on innovative medical products (drugs and devices) are more politically palatable than an equal dollar value of automatic cuts, we see such new price reductions as quite likely. In contrast, share price reactions imply Hospitals take nearly all of the pain, and innovators none of the pain. Accordingly Hospitals appear oversold, and innovators ‘undersold’

  1. “Healthcare and the Budget Control Act of 2011”; August 3, 2001; Sector & Sovereign Research, LLC
  2. Of the twelve committee members, arguably only Kerry (D-MA) has some level of constituent-based interest (Rt. 128 biotech corridor) in voting against rebates and discounts. California is represented only by Becerra (D-CA), whose 31st Congressional District is in and around Los Angeles, away from major concentrations of biotech activity in the greater San Diego and Bay areas
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