We have updated our generic drug market tracking files to reflect February data. Overall, generic sales decreased 1.7% y/y in February compared to the 2.7% increase in January, with lower volume growth more than offsetting moderating deflation. Deflation on mature generics improved for the second consecutive month following the higher rate of price deflation that we noted with the December data, possibly driven by COVID-19 disruption and / or stocking activities. So far in Q1 our data suggests chain store acquisition costs have declined faster than independent pharmacy acquisition costs, which implies that distributor margins for independents are expanding.
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Late last night the text of the latest Senate stimulus bill was released. The Senate has since passed this version of the stimulus. As it relates to labs, the biggest change vs. the initial Senate and House bills is to pause scheduled Medicare Clinical Lab Fee Schedule reimbursement cuts driven by PAMA for 1 year in 2021. We see this as a well-deserved win for the industry, which has stepped up to the plate to ramp COVID-19 testing capacity and will likely shoulder a significant NT burden from lost utilization as a result of social distancing / shelter in place. Assuming the stimulus bill is passed by the House and signed into law, 2022 will now be the last year of PAMA reimbursement cuts required by the current data collection. The benefit of incremental cash flow in 2021 is worth about 1% to each company’s current equity value.
Over the NT, both the amount of COVID-19 testing and the amount core testing volume deferred or lost remain extremely difficult for us to forecast – which we imagine is almost certainly true for lab management teams as well. We have put together a framework to assess the potential earnings at risk for DGX and LH. Our sensitivity model allows the user to make changes to different types of physician office visits (driver of most lab testing), client bill revenue, patient collections, and importantly factor in the benefit from COVID-19 testing. On the cost side, the user can specify incremental / decremental margins for each revenue stream and also layer in SG&A savings. The results are compared to our current estimates, which we have not yet adjusted and thus are still consistent with each company’s 2020 guidance provided in with Q4 results.
Following the introduction of the Senate Republican stimulus bill over the weekend, last night House Democrats introduced their own stimulus bill. In the House bill healthcare providers would have access to a $100B fund and an additional $80B in low-interest loans – this compares to $75B available to providers in the Senate bill. Despite the lab industry’s rapid response to increase COVID-19 testing capacity, there are no dedicated provisions in either bill providing relief to labs. The $100B is to be used “for making payments, through grants or other payment mechanisms, to covered entities to cover or reimburse health care related expenses or lost revenues attributable to the COVID–19 outbreak.” The House bill also qualifies that HHS “shall prioritize making such payments for charity care furnished, covered entities with high volumes of health care related expenses or lost revenues directly attributable to COVID–19”.
Given the highly uncertain outlook for earnings and cash flow this year as a result of COVID-19, we wanted to assess each company’s comfort level vs. financial covenants where applicable and benchmark liquidity vs. recent cash flows. In short, liquidity is 2-3x annual cash flow and the CROs average a ~45% EBITDA buffer vs. covenants.
Distributors have outperformed the S&P 500 by 6% since the equity market sell-off kicked off on 2/24/10 but have underperformed the XLV by 2%. ABC has outperformed the XLV by 5%, while CAH and MCK have unperformed by 5% and 6%, respectively. We see ABC’s outperformance as a function of having the lowest leverage in the group and also the most exposure to the core U.S. Pharma distribution business. As we looked back at prescription trends during the financial crisis, we were surprised to see how well total prescriptions held up – total prescriptions never declined on a quarterly basis during 2008, 2009, or 2010. While the uncertainty introduced by COVID-19 is a completely different challenge vs. the financial crisis, we would expect prescription trends to hold up much better than other areas of health care utilization – likely boding well for distributors over at least the next couple of quarters.
On Friday (3/13/20) the New York Times provided an update on opioid settlement negotiations. The disagreement among state attorneys general continues, but the article included some notable details on potential settlement structure and the issues holding up the local governments from reaching a settlement. Based on a deal proposal outline obtained by NYT, distributors would only pay out 55% of settlement % until a state can confirm that its local govts are on board with the deal – this structure is referred to as a “cramdown”. Interestingly, Paul Hanley (a lead MDL attorney) suggested that the proposed payment amount of $19.2B would be acceptable “if it were paid over one, two or three years. But over a generation is too little, too long.”
As the reality of a COVID-19 pandemic sets in, the range of potential outcomes for the U.S. is being discussed in the context of the experiences of South Korea and Italy. South Korea is viewed as the best-case scenario for how to control an outbreak and flatten the curve, while Italy’s outbreak paints a sobering picture of how quickly caseload can intensify and overwhelm the local health care system. The U.S. response to COVID-19 to date can only be described as inadequate. We are practically nowhere with testing, and our current testing capacity is significantly below South Korea and Italy on a per capita basis. Clearly, the clinical labs will have to be a big part of getting U.S. testing capacity to required levels. However, we remain concerned that any benefit from this testing may be offset by loss of core testing rev as services are deferred – although to be fair having anything at all “positive” to come out of this situation puts the labs in a fairly unique position.
We are updating our MCK estimates to reflect the split-off of the company’s investment in Change Healthcare (CHNG, not covered). Our adjusted net income estimates are unchanged beyond removing the Change Healthcare equity income, which is already after-tax. We note that our CFO / FCF estimates are entirely unchanged given that there has not been any cash inflow to MCK from Change Healthcare equivalent to the equity income – it is entirely a non-cash income statement item. As MCK’s market cap moves lower post the share count reduction, FCF yield will improve by approximately 120bps. Our fiscal 2021 EPS estimate decreases by 0.7% to $15.77, but our fiscal 2022 estimate increases by 0.4% to $16.94 as we lower the assumed share price for MCK repurchases to reflect the recent sell-off. See Exhibit 1 on Page 2 for a summary of the changes.
Early this afternoon (03/10/20) Law360 reported that the upcoming New York opioid trial scheduled to start on 3/20 will now be delayed as a result of COVID-19. A status conference has been scheduled for 4/14 to see if a trial can begin shortly after that time. Recall that last week a New York appeals court rejected a request (unrelated to COVID-19) from various drug industry defendants including distributors to delay the trial. This trial combines cases brough by the New York attorney general, Nassau County (NY), and Suffolk County (NY). While the ongoing COVID-19 situation may also limit the opportunity for key stakeholders to come together and negotiate, this delay does in theory provide some additional time to continue discussions around reaching a global settlement ahead of the trial. However, we continue to see reaching a settlement specific to these plaintiffs as more likely than reaching a global settlement given 1) ongoing disagreements among state attorneys general and 2) discord between state AGs and local government plaintiffs. We note that we have not seen any reports or comments indicating NY AG Letitia James’ willingness to settle the case.
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