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How Will Reform Treat Pharma and Insurers?

Erik Kobayashi-Solomon

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, coeditor of Morningstar's OptionInvestor. Today it's my great pleasure to welcome Damien Conover and Matt Coffina from the Morningstar health-care team. Guys, thanks for coming.

Damien Conover: Thanks for having us, Erik.

Kobayashi-Solomon: Matt, I want to turn to you first to ask, just recently the health-care reform bill has been passed. I just want to get a general idea, what does this do to the business of health care?

Matt Coffina: I think the biggest effect this is going to have on health-care investors is that there's going to much reduced uncertainty. This was really a huge overhang over the entire sector during this debate, and even though the bill was passed, we know exactly what it looks like. There's much less uncertainty out there, which I think will be a positive for this sector.

The other effect I would point to is I think there are going to be increased volumes pretty much across the health-care space. The number of uninsured people is expected to fall by 32 million over the next 10 years, and all of those people are going to be consuming more health-care than they were before, which is generally positive for this sector.

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Kobayashi-Solomon: One thing that our OptionInvestor subscribers will not be surprised at all is how many health-care ideas I've forwarded in the last few months--good health-care names.

Damien, you cover one of these health-care names. We talked just generally about the effect of this health-care reform. Your company, J&J, which we have a bullish position on, how do you think this going to affect J&J, particularly, and big pharma as well?

Conover: It's an important question. When taking a look at J&J, it has a lot of different divisions, but the pharmaceutical division is one of its largest and most important. So if we were going to take a look just at the pharmaceutical industry, I would say it's really going to be a net neutral.

We think health-care reform will be largely a net neutral for the pharmaceutical industry. There are two main drivers for this. One: Like Matt said, we're going to see increased volumes.

We have this huge bolus of patients coming into the system with insurance who once lacked insurance. We think that will ramp the spending for drugs. Now we think this is partially offset by the requirement for the industry to spend about $85 billion over the next 10 years to help fund this health-care reform.

Our initial estimates are that the increased volume should drive profits of about $100 billion over the next 10 years. So the net takeaway is slightly positive, but relative to the profits of the industry, we think it's largely neutral.

Going back to what Matt said, the most important thing that we see is the removal of the risk overhang of this reform. Now we've actually seen what's happened, and we see it as largely a net neutral for the industry as well as J&J.

Kobayashi-Solomon: You're talking about increased volume. Is there also going to be pressure on prices? With the government paying more, let's say, we could see pricing pressure on big pharma companies, or not so much?

Conover: I think we'll see some pricing pressure, particularly in the government spending portions for drugs. So I think there are going to be slightly increased rebates for some of the government payers.

Then on top of that, a big portion of the $85 billion in cost for the pharmaceutical industry is to go toward closing the doughnut hole in Medicare patients. Patients, when they get to a certain threshold of drug spending, they lose the reimbursement for Medicare Part D. Then you have to get to another threshold before you're reimbursed again.

So that doughnut hole will start to be closed by the pharmaceutical industry underneath health-care reform, and closing that doughnut hole will cost the pharmaceutical industry some money to help finance those drugs.

Kobayashi-Solomon: I see. But in general, for big pharma it looks like it's going to be net-net, about even, maybe a little bit of a positive.

Conover: I think so. I think we're looking at a situation here where there was a significant risk overhang on the pharmaceutical industry. But coming out of what we've actually seen, that risk probably was overdone.

So I think we're going to see some multiple expansion for the group and really see this whole bill as largely a net neutral, maybe some upside.

Kobayashi-Solomon: Those are my two favorite words: multiple expansion, especially for J&J.

So, let's turn for a moment to managed care.

Matt, you were nice enough to coauthor an article on UnitedHealth with me last November, I guess it was, and that position has been doing very well as well. How is this health-care reform going to affect UnitedHealth and its sector?

Coffina: Well, as in the case of pharma, I think there are pluses and minuses. On the negative side, they're cutting reimbursements to Medicare Advantage plans, so this is the private version of the Medicare program for seniors.

That's certainly a negative for UnitedHealth. About 25 percent of its revenue comes from Medicare Advantage. But the amount that they're cutting the reimbursements times the percentage of revenue it is, it's still a pretty small effect, maybe a couple percentage points of revenue, so not too big of an impact.

They're setting explicit limits on insurer profitability. They're going to have spend at least a certain percentage of premium revenue on medical costs. So in the event that it would have been lower than that limit, that could also be a negative for a company like UnitedHealth.

There's also going to be new industry taxes and fees that UnitedHealth is going to have to pay. We think for the most part those are going to be passed on to customers. But to the extent that they're not or to the extent that that creates some sort of demand destruction, that could be a negative for UnitedHealth.

Kobayashi-Solomon: I just want to jump back quickly to one thing. Are you saying that the government is regulating profitability for these companies?

Coffina: They're setting a floor on profitability, but the floor is going to be 80% in the individual market and 85% in the group market. So to a certain extent, companies are going to be able to transfer what was previously classified as administrative cost into medical cost for things like disease management programs. So that should help them meet the floors.

I think the really helpful thing is that the floors were set at a level that's pretty comparable to where these companies were already operating and were already going to operate. So really the net effect is pretty small.

If they had set that they can only have a 10 percent underwriting margin or something like that, that would have been a very severe impact. But because the levels are set relatively generously, they should be able to deal with it pretty easily.

Kobayashi-Solomon: I see.

Coffina: But I was going to say, on the positive side, they're going to benefit from 32 million people, fewer uninsured, that are going to be joining the insurance market.

Kobayashi-Solomon: And those 32 million are paying their premiums every month.

Coffina: Exactly. About half of them are going to be in the Medicaid program and the government's going to be paying their costs for them, and the other half are going to be forced to buy policies in the individual market using federal subsidies, which will also help the insurance companies.

Kobayashi-Solomon: So kind of like with Big pharma, it seems like there are positives and negatives, but in general it seems to net out.

Coffina: Yes, I think in this case it's slightly net negative for the insurance industry, but the biggest negative being the Medicare Advantage cuts. We thought those were going to take effect sooner or later with or without reform, so really relative to what the situation would have been, it's pretty neutral.

Certainly we already accounted for it in our valuation, and we don't expect to change our valuation.

Kobayashi-Solomon: That makes a lot of sense. Thanks for coming and explaining that, Matt.

Coffina: Sure.

Kobayashi-Solomon: And Damien, thank you too for coming. Very interesting.

Conover: Sure. Thanks for having us.

Kobayashi-Solomon: And thank you for joining us. Please stop by the Healthcare Observer website, where there are a lot of really terrific articles about this health-care reform issue.

Also check out OptionInvestor, where we have many more option ideas based on Morningstar's fundamental research.