Insulin prices in America. What the……!? (Part 2)

In last week’s blog (Part 1) we tried to answer the complex question of what is flawed with current insulin pricing system in America. But that left out one vital bit- the why. This week I want to explain why it is so dysfunctional and how the forces at play – given the wonder tyranny of compounding – are so opaque in the short term, yet so aggressively malevolent over the long-term.

Inverted Incentives
Let’s cut to the chase. A reduced rebate rake on a very big market generates much more revenue than an increased rake on a small market. Think about that. This means Pharmacy Benefit Managers (PBMs) are incentivised to increase the size of the market and the best way to do this is by allowing price rises. Yes, you read that correctly – the party designated to negotiate prices down, benefits from prices going up! And this is not a socialist conspiracy theory, this is widely recognised by the sell-side analyst community:

“The rebate basis of the system has a fundamental conflict of interest which has perversely encouraged high list prices for drugs (and concomitant price increases)…. Thus the theoretical fiscal sweet spot for PBMs are high priced drugs, with high rebates and high co-pays….[this is the] “frictional costs” in the drug pricing ecosystem as money (ultimately) paid by the “society” for drugs that do not end up as revenues for Biopharma companies.

-Analyst, Evercore ISI

A Case of Compound (Self) Interest
Why has this been allowed to happen?  We could stop here and just blame lobbyists but that would be too easy. Fundamentally, it happens because the slow-acting and pernicious effects of compounded inflation falls under the radar in the short term. And most things are managed on the short-term. The average human generally struggles to comprehend the non-linear power of compounding, so how can we expect politicians – managing a short-term electoral cycle and influenced by well-funded lobbyists – to fare any better?

I have built a quick model to show how the math works and the chart below is the output. I have used the real price rises per vial of insulin. To show the extent of the inverted incentives, I have assumed the drug price discount actually increases from 50% to 70% and that the PBM rake declines from 20% to 15%. Despite these ‘improving’ terms, the compounding effect of the annual price increases still mean that the revenue growth for drug companies and PBMs is inordinately large.

Insulin prices: Company revenue share & patient costs


Source: Kames Capital
Note: General US inflation between 1997 and 2017 has been +55.6% or a compund annual rate of 2.2%
CAGR = Compound annual growth rate
Vial = 10ml or 1000 units (approx 1.5 vials used per month on average)

The illusion of ‘improved’ terms offered by drug suppliers and PBMs is very important for this political narrative. Mr Machiavelli would be impressed. They can point to these as proof that they are ‘doing their best’. Short-term discounts and reduced rebates rakes are much more intuitive than non-linear compound interest.  Drug makers and PBMs can reasonably claim to be offering bigger percentage discounts and taking lower percentage rebates rakes, all while seeing their revenues, patient prices and the frictional costs paid by society grow massively.

Conclusion: Societal Friction Leads to Disruptive Innovation
This is a remarkable system and a sorry state of affairs, however I believe the historic ‘market forces’ narrative behind the current US healthcare system is running out of road. The statistics have been conflated for too long. The absolute dollar burden on society – not to mention the very real and painful costs to individuals that are so often wilfully overlooked – is becoming too large to ignore. Value based care. Regulation. Populist revolts. I believe these will increasingly pressure the valuations, revenues and cash flows of the companies that have been systematically over-earning from patients and society. The duplicity will become common knowledge. But it won’t stop there.

Disruptive innovation is naturally attracted to such problems and it is here that market forces still have a say. The outrageous frictions caused by a rigged system ultimately create opportunities for mission orientated disruptive entrepreneurs. Indeed, we are already seeing numerous young and innovative companies challenging the norm and leveraging technology to provide better and more cost-effective outcomes for patients. These types of companies have eminently more sustainable business models and are the ones that I think will be the long-term winners in the health care space. They will be supported by those advocating change.

It is undoubtedly true that the change cannot come quickly enough. Sadly, it is too late for many but in the words of Sam Cooke, ‘A Change Is Gonna Come!’ Actually, that would have been a good title for this blog too – and a much more positive one.

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience (as at 30 April 2019).

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Insulin prices in America. What the……!? (Part 1)

I often struggle to come up with a title for my blogs, but other times – like this week – it’s difficult to pick between all the options. I had thought about ironically calling it “No collusion!” but you’ve probably had enough of that phrase. I considered “Because we can!”, but that had already been used by a journalist writing on this very topic. In the end an implied expletive was really the only way to go.

Consumer good prices from 1996-2017
Sources: www.bls.gov, www.ibm.com/watson-health/learn/truven-health-analytics, insulin.substack.com/p/insulin-list-price-data-sources

A dysfunctional market
In my opinion, the US drug market is broken. To me, it looks more like a system designed to gouge a cornered customer base than a typical ‘market’. In the case of insulin this ‘market’ equates to 30 million diabetics (2.5 million of whom are type 1 diabetic). It could more appropriately be defined as a racket. Thinking about it, “What a racket!” would have been a good title for this article too.

As an outsider looking in, the US healthcare system can be difficult to get to grips with, particularly for someone who can access socialised universal healthcare. The logic of a private healthcare system is predicated on market forces and justified on the basis of high quality, but if this is true then in the US it comes at a very high cost. Indeed, the stark difference between private healthcare costs in the UK and the US was noted recently by our UK equities team when reviewing the Spirax-Sarco management benefits.  Guess what country Mr Whalen is based in?


Source: Spirax-Sarco company reports

Market forces can be distorted when a product is non-discretionary (like a lifesaving drug), and supply is tightly controlled (or poorly regulated). If those who supply the product are allowed to raise prices significantly above the rate of inflation for 20 years, questions need to be asked. In the case of Insulin, they should have been asked long before prices went up 1171%.

I have written a series about abusive pricing and why fairness can be a source of competitive advantage (see part I, part II and part III). I have also written on the intersection between healthcare and market forces (see Human life: A cost-benefit analysis and Can technology disrupt and democratise drug development?). Our research has translated into a long-term investment theme in our portfolio which I call “Healthy Healthcare”.

We believe companies that deliver improved health outcomes and take cost out of the healthcare system will deliver long-term value for shareholders. Our bottom up stock picks, which we believe fall directly into this category, include Insulet, Peptidream, Cochlear, Illumina, Penumbra, Medidata, Diasorin, Amplifon and Veracyte. Conversely, we believe companies that do the opposite will be put under increasing pressure. In many cases, the drug companies are the focus because they seem to be pushing unreasonable price increases through with little to no added value.

Back to insulin. How and why have prices been rising so fast? A few reasons.

The dark art of ‘patented generics’
I believe insulin is effectively a generic that is patented. What do I mean by this? I would argue that insulin formulas have not improved that much in 20 years. Purity has improved and formulas have been tweaked, but I suspect this has been achieved at relatively low cost. Most importantly it has been just enough to maintain patent protection and prevent generic competition. These improvements are used as justification to push through large prices increases year on year. According to the Lancet, 90% of US patients are put on the most expensive insulins. I strongly suspect this dynamic means that diabetics are used to heavily subsidise R&D in other drug categories – small mercies if this is the case. NB – This all seems somewhat perverse when you consider that Frederick Banting (who discovered insulin in 1923) felt it was unethical to patent or profiteer from his innovation. His co-inventors sold the patent for $1.

The system is opaque
Most American diabetics “co-pay” for their insulin. This means that insurance companies pick up part of the bill. So if insurance companies are paying, why don’t they fight to push prices down or want patients on cheaper formulations?  Well this is where the Pharmacy Benefit Managers (PBMs) come in and it all gets very complex and opaque… so please bear with. A full definition of what PBMs do can be found here but in simple terms, they are buying groups designed to negotiate drug prices down on behalf of insurance companies and patients.  But as part of their role as the patients advocate middle man they are allowed to take some of the discount that they negotiate as their cut or “rebate”. Sounds reasonable right? Except they don’t need to disclose what the discount is or what percentage their rebate rake is. The net price is a closely guarded secret. So patients can’t see how much of the benefit is passed to them.

Poacher turned game keeper… ehh… turned poacher!?

All of the PBMs have been acquired by insurance companies. This means the insurance companies get to keep the PBM rebate rake, whilst also passing on price rises to patients via increased insurance premiums and the patient’s deductibles upfront claim penalty. Thus, assuming competition is rational co-ordinated, insurance companies will pass insulin price rises on to patients whilst also capturing the PBM rebate rake.

Ok, so the system is never going to be perfect. Pharmaceutical companies will obviously push for price rises but the market mechanism should still keep prices down to some extent, right? Wrong.

Next week I will explain why this is …….

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience (as at 30 April 2019).

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Short & Distort

Forget “pump & dump”… boiler rooms of dodgy salesmen convincing poor retail clients that a stock is going to the moon is soo 1980s. This decade is all about “FAKE NEWS” … and as we know, fake news is much more effective when it’s bad, very bad, maybe the worst EVER!

Enough of the Trump references Craig! What do you mean more effective?

The tangible fear response to potentially losing money on something you own is always greater than the equivalent greed response to missing out on something you don’t. The incremental energy required to shake out weak holders is therefore less than that to encourage an incremental buyer. There is a short-term asymmetry that can be taken advantage of.

Wait a minute… where are you going with this? Is this some moral crusade against shorting?  

No no no… I have no problem with short sellers operating in the market and we operate funds at Kames that short stocks. At its best shorting can help push up the cost of capital for unsustainable businesses.  If short sellers uncover the next Enron early, they will do the market and investors a great service. But short & distort schemes do exist and are a bigger issue today than in the past. This is a negative second order impact of the ease with which Information (including misinformation) can be spread these days and this needs to be better understood. Controversy sells and is often thoughtlessly distributed.

But market manipulation is illegal, so bad actors will be caught in the end. Don’t you know *SEC Rule 10b-5? Surely this covers it? 

Ahemmm….. of course I do (*cough*) and there are other rules too. The FCA Market Abuse code is also very clear but proving “intent to deceive” can be very difficult. Market participants can have their opinion (free speech) and are allowed to be just plain wrong (plead ignorance). It is very tough to untangle a story that deploys a web of fallacies. For example, manipulation of factual content that encourages faulty deduction (e.g. red herrings), garbled cause and effect (e.g. conflating timelines or confusing past issues with the business now) or making personal attacks (e.g. unfairly attacking management integrity or suitability) can be layered together.

I get it…. Bad stories are tricky to regulate and prosecute but the truth will out in the end.  Does this not give the smart long-term investor the chance to buy more?

Most of the time yes and we would certainly try to buy such opportunities.  But short ‘attacks’ also create real and often lasting costs for the companies in terms of management time, legal expenses and / or perceived reputational damage. It can impair the valuation for an extended period. At worst, a share price fall can create a “reflexive” negative spiral which triggers debt covenants and takes a perfectly innocent company down.

Ok, you win. But what do we do about it?

No easy solutions. For one, I would welcome a more aggressive stance by regulators against the schemes. We have started to see this happen more in the US as regulators recognise the increasing risk. In the meantime, I guess I’m just reminding investors to be wary of those posing as experts and spinning scary stories. From a sustainability perspective, we try extra hard to protect ourselves against investing in companies which deserve to be shorted. We do this by doing an extra layer of due diligence on every company we invest in. We call this sustainability analysis. We believe it’s an underused method of quality assessment that takes into account strategic product risk, second order impacts, material operational performance risk factors, business culture and governance analysis. At the very least….. it’s all grist to the mill.

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience.  *As at 30 April 2019.

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Soapbox Speaks: Amplifon podcast

In the latest Soapbox Speaks podcast, Craig Bonthron meets Enrico Vita, the Chief Executive the world’s largest hearing aid supplier. Since joining Amplifon 5 years ago, Enrico has taken on the challenge of running the business while also meeting sustainability standards, and launching the company’s not-for-profit research centre. Listen for more.


About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience (as at 30 April 2019).

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Soapbox interview: Technogym

In a world where people are becoming increasingly conscious of their health, diet and fitness, they also seem to be ever more willing to pay top dollar for the equipment they use to keep in shape. And as technology advances the desire to have the best equipment grows. One of the leaders within this premium equipment space is Technogym, so while I was over in Italy I thought why not visit the Technogym Village in Cesena and grab a quick coffee with the founder.

Below you can read the Q+A with Nerio Alessandri, Founder of Technogym (pictured).

What are you most proud of in terms of what the business has achieved from a positive impact perspective?

Alongside our business we have been promoting wellness lifestyle for over 25 years and every day 50 million people train with Technogym products and digital solutions in 100 countries around the world. In a global scenario in which health issues related with sedentary and other bad lifestyles are seriously threating economic and social sustainability, we are really proud to give a contribution in making society more active and healthier.

Do you think a sustainability mind-set has ever had a role in helping to build a competitive advantage?

Definitely yes! In the Technogym case, we have always promoted health and wellness, so sustainability mindset and corporate social responsibility are naturally part of our business strategy.

Some might say your equipment is quite expensive- are there any plans to increase access and the ‘inclusiveness’ of your products?

Technogym is a premium brand with a full range of innovative solutions to improve end-users lifestyle not only through equipment. Beside our home offering, with an exclusive positioning, today Technogym is available in over 80.000 wellness and sport centres offering different programs and services for different people with different needs and different economic clusters: from public hospitals and community centres to exclusive clubs or resorts.

Technogym has historically been an early adopter in the fitness space. With the increasing use of fitness ‘wearables and trackers’, how does Technogym plan to maintain its relevance?

On this respect we have a precise strategy: Technogym is a Total Wellness Solution Provider. We are not only interested in developing new and more innovative smart equipments but we have been able to develop dedicated services, digital solutions and more recently contents to offer consumers a personalized training experience and operators a complete solution for the different market segments (fitness clubs, hotels, corporate, medical centres, schools, condos, private homes). That’s why we have created our unique Technogym Ecosystem – made of connected smart equipment, our Mywellness cloud platform, apps and digital training contents) – to offer our unique experience anywhere and anytime, also leveraging on the already available technologies such as the wearables and trackers you mentioned above. Our platform is in fact already automatically connectable with all the major outdoor tracking devices or Apps. Moreover with the launch of the Technogym Live platform we will make professional training contents accessible at home by the end users, thus supporting a further increase in people interested in training at home and not only in public venues.

Do you care what ESG ratings (MSCI, Sustainalytics, ISS or others) agencies say about Technogym? And do they consult with you before they rate you?

We respect these agencies but we believe that their ratings give no justice to our sustainability level. Unfortunately they never consulted with us to give us the opportunity to explain and provide material elements to their analysts; we definitely hope this will change in the near future.

What are your most material sustainability risks & opportunities with regard to how you operate the business day to day?

In a scenario in which non-communicable diseases, exclusively caused by unhealthy lifestyle, represent the first cause of premature death we have a great opportunity of spreading awareness on the benefit of regular physical exercise and of helping people in being active every day. This represent an incredible social opportunity for Government, businesses and citizens. In terms of risks, our industrial footprint is pretty low compared to other sectors, and we believe our potential sustainability risks are pretty low both in terms of environmental and social sustainability.

What sort of environmental impact does the business have? And what typically happens to a Technogym machine when its useful life ends? Can it be recycled or reused?

Despite a usual lifecycle inside a Club can be estimated in c. 5 years all our products have a second life and we have a specific second hand program called Still Novo. Most of our sales contracts include a buyback option which allows the customer to keep the location updated with the last models and resell to Technogym the equipment after a specific period of time pre-defined at the signature of the contract. Once back, those equipment are completely reconditioned and sold to customers willing to accede to more affordable options.

What is the philosophy around talent acquisition (e.g. staff education and engagement) to maximise quality and minimise turnover?

Human resources is very high positioned in our priority list. Since years we are running a project called “Working 4 Wellness” which includes a very strong training component and a corporate wellness program ranging from medical check-ups and nutrition programs to sport activities and educational seminars. We strongly believe that a trained and motivated staff do represent a strong asset for the company and for the business in terms of innovation and productivity.

Pay and incentives are an important part of the governance process. How do you feel as a public CEO being interrogated over how much you and your leadership team are paid?

We have no problems with this, this is part of a listed company transparency. Our pay and incentives are in line with industry standards and company sustainability.

Has the change in media changed the risk / reward dynamic with regard to being sustainable?

Reaching and gathering around our products, services and brand, different communities – united by passions, for sport, fitness or health – is a key element of our marketing strategy, that’s why social media represent a very important opportunity for us.

Have you ever taken a cost in the short-term purely for social or environmental reasons?

We do not have an example on this respect. We tend to invest / focus in mid-long term strategies.

Can you see ways to profit from providing solutions or being relatively proactive on certain issues vs competition?

Yes. A good example is our “Let’s Move for a Better World Campaign” our global campaign which leverages our digital ecosystem to involve fitness clubs in a social project to tackle child obesity. People, inside fitness clubs, can track their movement on Technogym equipment and contribute to a donation of Technogym equipment to schools or community centres running sport educations projects for the young generations. This campaign on one side generate a concrete impact in local communities and on the other side promotes Technogym’s digital services business.

What is your biggest ambition for the company from a sustainability perspective…. And will this make shareholders money?

We strongly believe that wellness is an opportunity for all stakeholders – Governments, Companies and Citizens – both under the social and economic standpoint. Today, thanks to Technogym, 50 million people train every day all over the world. The more people we will be able to involve in regular physical activity in the future, the more we will contribute to a more sustainable future for the entire society. Technogym is one of the few companies that can really support the world in becoming a better place and in improving the quality of life of millions of inhabitants: Healthy people, healthy planet. Our 2021 goal, which we shared with the entire team in our global convention few months ago, is to be able to double our user’s community and to reach 100 million people.

 

Kames Capital invests in Technogym in its fund range.

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience (as at 30 April 2019).

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