Health Care Re-reform

By Kyle Schneider, CFA
April 2017
We have been deliberate in targeting companies whose competitive advantages should persist under any reasonable outcome.

With five minutes to go until the vote, the American Health Care Act (AHCA), the bill to repeal and replace the Affordable Care Act (commonly known as Obamacare), was pulled from the House floor. Despite President Trump’s efforts to broker a deal, the conservative Freedom Caucus wouldn’t rest until every provision of Obamacare was gone. Moderates were quietly voicing concern over the Congressional Budget Office’s estimate of 24 million people losing insurance and were unwilling to move the bill further to the right. Moments later, Speaker of the House Paul Ryan declared Obamacare would remain the law of the land, at least for now. Trump explained to Fox News, “It can’t do well. It’s imploding and will soon explode. And it’s not going to be pretty.”

For the Republican Party, the clock is ticking until midterm elections. Many were elected to fix Obamacare. Doing nothing is not really an option, but the backlash from those losing their health insurance could be worse. Simply patching the public exchanges by boosting subsidies for young, healthy members, allowing states to water down mandatory benefits, and revamping protections for insurers would be easier politically and less disruptive. However, there are still ongoing discussions about resurrecting the AHCA or developing another comprehensive replacement.

While a bipartisan compromise would bring a much-overdue sense of stability to the health care sector, it’s probably wishful thinking. Republican patches to Obamacare may accomplish largely the same thing. At Diamond Hill, we have been deliberate in targeting companies whose competitive advantages should persist under any reasonable outcome. Below, we describe the impacts to our managed care, provider, and medical device investments under various scenarios.

Managed Care

Under Obamacare, most managed care companies have been burdened with heavy losses on the public exchanges and higher taxes — the worst of both worlds. We established a position in Aetna Inc. (AET) after the stock sold off due to pressure in its public exchange business and antitrust concerns about its proposed merger with Humana, Inc., which has since fallen through. We liked Aetna’s standalone prospects, and the merger would have been a bonus by increasing the company’s exposure to Medicare Advantage, the private alternative to government-run Medicare. We also liked the fact that both companies had the ability to just leave the exchanges if the situation did not improve, which they eventually did.

We believe the market is underestimating Aetna’s growth prospects. Its own Medicare Advantage plans are highly rated, and it has an opportunity to develop a health care services business similar to UnitedHealth Group’s Optum. Taxes are one variable to watch. Aetna’s tax rate was 42% in 2016, which will temporarily drop to 36% in 2017 due to a one-year suspension of the health insurer industry fee. Aetna will benefit if the fee is permanently revoked, although most of the savings are currently being reinvested into Medicare Advantage as the company organically builds out its footprint. If the GOP stabilizes the exchanges, Aetna could look to re-enter, although the health insurer industry fee would likely be reinstated.

Additionally, we own Universal American Corp. (UAM), which also focuses on Medicare Advantage. The company is in the process of being acquired by WellCare Health Plans, Inc., validating our belief that Medicare Advantage is an attractive insurance market due to demographic tailwinds and bipartisan support in Congress.

With broader corporate tax reform on the docket, it is worth noting that both managed care companies and providers typically have tax rates at or above 35%. A large percentage of their competition is non-profit, and accordingly we would anticipate only a portion of any tax savings to be competed away.

Providers

Providers have the most at stake from repeal and replace efforts. Legally, hospitals must provide emergency care to the uninsured, which subjects the industry to large write-offs. Whatever its faults, Obamacare has reduced bad debt expenses by lowering the number of uninsured patients, mainly by expanding Medicaid eligibility. Previously, Medicaid was limited to mothers, children, and disabled adults. Under Obamacare, states are now permitted to opt-in to a program which raises the cutoff for Medicaid eligibility to 138% of the federal poverty line. The federal government initially pays for 100% of the costs associated with this expansion, which will ramp down to 90% in 2020. Approximately 10 million people obtained insurance in the 31 states that expanded, which is equal to 20% of the uninsured population pre-Obamacare. The public exchanges provide coverage to another roughly 10 million, although a subset previously had insurance.

The AHCA would prohibit additional states from expanding Medicaid and would cut enhanced federal funding in states that have already expanded. However, these provisions are likely to encounter opposition on a state level. Kentucky, an expansion state, provides hints as to what may happen if Congress attempts to curb the program. Matt Bevin was elected governor in 2015 after running on an anti-Obamacare platform. Polling data later suggested some of his supporters were unaware that Medicaid coverage was part of Obamacare and viewed Medicaid more positively1. This is likely true in other Trump strongholds such as West Virginia, making the Freedom Caucus’ goal of rapidly unwinding the Medicaid expansion program a tall order.

LifePoint Health, Inc. (LPNT) is a rural hospital system owned in multiple Diamond Hill strategies. Since Medicaid expansion began in 2014, the company’s bad debt as a percentage of gross revenue has declined from 15% to 12% in 2016. While the Republican replacement plan could be directionally negative for bad debt by eroding Medicaid benefits, it seems unlikely Trump or the more-moderate Senate would want to risk widespread backlash in states that voted Republican. Even if passed as-is, the AHCA recognizes the difficult economic situation most rural hospitals are in and would restore certain subsidies that were cut under Obamacare. Patients covered by public exchange health plans represent only a small percentage of hospital admissions for LifePoint, as its markets are skewed towards lower-income residents.

Medical Devices

Medical device companies are the least affected of the three groups. The most discernable impact from Obamacare was a 2.3% tax levied on U.S. revenues. This device tax was suspended until 2018, but could be resumed. However, the tax is unpopular with both Democrats and Republicans, as many device companies are located in liberal states. There were volume-related benefits from coverage expansion, but the impact was not dramatic. We believe it will be mostly business as usual for our device holdings, perhaps with some modest pressure on U.S. sales if insurance coverage declines.

Most of our device holdings have tax rates in the high teens, having implemented tax mitigation strategies or by inverting, as in the case of Medtronic PLC (MDT). The medical device industry would benefit slightly from corporate tax reform (mainly via a repatriation holiday), but not to the degree that managed care companies and providers would benefit. A border tax presents a more complex problem, but most companies have substantial U.S.-based manufacturing capabilities and could shift production as necessary.

Final Thoughts

The situation in Washington remains fluid, and we expect there will be no shortage of headlines (and tweets) in the months to follow. However, as President Trump correctly observed, health care is complicated. Change is likely to be more gradual than abrupt. While politics may affect our health care holdings to a modest extent, we continue to believe fundamental characteristics — such as the ability to take costs out of the system — will matter more.

1 http://kff.org/health-reform/poll-finding/survey-of-kentucky-residents-on-state-health-policy/
As of March 31, 2017, Diamond Hill owned shares of AET, UAM, LPNT, and MDT.

Originally published on April 18, 2017.

The views expressed are those of the research analyst as of April 2017, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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