What a Democratic Sweep Means for Healthcare

The Democrats have won the remaining two U.S. Senate seats in the Georgia runoffs, and we expect Joe Biden's administration will seek to implement further healthcare reforms. However, with such a slim majority in the Senate, compromises on ideals espoused by the Biden campaign may be required to get healthcare legislation passed with support from moderate Democrats. With significant compromises possible in the next several months as the legislation is crafted, we will keep steady on our economic moat and valuation views until more clarity emerges on the potential changes to the healthcare industry.

Overall, even in a Democratic sweep where further healthcare reforms are possible, Biden's existing proposals to expand the insured population create a spectrum of opportunities and risks for healthcare players, in our opinion, and the devil will be in the legislation’s details in terms of how it will affect healthcare industry players. In general, though, the United States appears likely to remain in increasing access mode under Biden’s plan. The administration estimates that at least 97% of Americans would be covered under the president’s proposals, up from about 91% before the coronavirus pandemic and associated weakness in the U.S. employment market.

The following are expressed tenets of Biden's healthcare plan that we believe could substantially affect the U.S. healthcare system:

• Increasing tax credits to lower costs associated with coverage on the individual exchanges.
• Expanding Medicaid population with eligibility rules of the Affordable Care Act to all states, even those that opted out of Medicaid expansion (12 states have not expanded or do not plan to expand in the near future).
• Adding a public option with no deductible to the existing U.S. healthcare system.
• Lowering the age of eligibility for Medicare to 60 from 65.

The first two initiatives would merely be an extension of current ACA mechanisms for obtaining insurance and could actually benefit companies like Anthem ANTM and Centene CNC with big presences on the individual exchanges and in Medicaid managed-care contracts, but the potential public option represents the major wild card of the Biden plan. Based on our estimates for the public option's price range, we think it will primarily act as a way to improve affordability on the individual exchanges, rather than causing a substantial shift away from employer-based insurance, which helps inform our undervalued view of the managed care-sector.

At the top end of our public option pricing range estimate, we think the public option would only affect the individual exchanges, which would not materially affect the insurers we cover. Near the bottom end of our public option pricing range, mix shifts in employer-based market are possible in about 10% of that population, but we would note that the cost-advantaged insurers that we cover may even be insulated from the public option's competition at that level, especially local-scale (and pricing) leader Anthem. Beyond the uncertainty around the potential pricing of such an option, several potential areas of compromise are possible that could limit the public option's impact on industry players.

First, it remains to be seen who would be allowed to utilize the public option. For budgetary reasons, the public option may not be fully open to people who could get their insurance from employer-based plans, which could eliminate a lot of the mix shift risk for insurers due to the public option. Also, the public option based on a government-run Medicare plan may face substantive problems if it has to go through the budget reconciliation process in the Senate. Allowing Medicare Advantage-like plans from private insurers (which have a lot of flexibility about what health and wellness benefits can be offered relative to traditional Medicare plans) could alleviate some of those substantive concerns surrounding the public option in the legislative process. Including Medicare Advantage-like plans in the public option could create an opportunity for the private insurance industry, including top-tier Medicare Advantage plan providers UnitedHealth UNH and Humana HUM.

We think the health insurers represent the sector that could be most influenced by potential healthcare reforms, particularly by the potential public option. In terms of healthcare policy, we see the potential for increasing access in insurance rolls (up to a 6% increase), which could be positive for the sector; this could be offset by the potential for higher corporate taxes, which would be negative for the sector (in the mid- to high single digits). In this scenario where potential legislation primarily results in increased insurance rolls, our fair value estimates for the insurers may remain appropriate. However, in a high-impact public option scenario, our fair value estimates may prove too optimistic in this sector. We see the least risk (mid- to high-single-digit downside) to our fair value estimates related to potential policy changes in the most diverse managed-care organizations: CVS CVS, Cigna CI, and UnitedHealth. The more focused medical insurers--Centene, Humana, and Anthem--face more fair value estimate downside risk in the policy bear scenario--roughly in the midteens to about 20% downside. From a stock valuation perspective, most of the companies we cover are already trading near or below our downside policy bear scenarios, which creates a margin of safety for investors, especially at Centene and CVS, which represent the steepest discounts to fair value currently.

We Don't Expect Major Changes for the Device Industry For the medical technology industry, we expect few changes to our moats or valuations, although we anticipate that the firms that are not focused on Medicare patients will generally benefit from more volume if access is expanded again. With the implementation of the Affordable Care Act, increased access generally resulted in more patient volume.

Some areas of med tech benefited more than others. For example, LabCorp LH and Quest Diagnostics DGX--the large, independent reference labs--received a nice boost to volume from expanded coverage that brought in more patients and covered preventative services. In contrast, some categories of medical devices, such as knee implants and pacemakers, didn’t see the same kind of boost because most of those patients are already covered by Medicare. If patient access expands, as it could under a Biden administration, we’d expect a positive impact on the labs and any other medical device businesses that encompass more than the Medicare crowd, such as Dexcom DXCM and Insulet PODD for diabetes patients.

Another area of consideration is that consolidation in the sector could run into more resistance under the new administration, as more aggressive antitrust action is one of the reforms that Biden has put forth. As for the possibility of reinstating the medical device excise tax (which was repealed in late 2019), we currently think it's unlikely to re-emerge, given a 50/50 split in the Senate and how strenuously senators from California, Massachusetts, and Minnesota (where much of the med tech industry is clustered) resisted it when the ACA was originally hammered out. Debbie S. Wang

Potential for New Drug Policies Grows With the Democrats having won the remaining two Senate seats in the Georgia runoffs, we expect the Biden administration will seek to implement further healthcare reforms. However, with such a slim majority in the Senate, we expect significant compromises that will likely lead to watered-down drug policy changes. We continue to view the biopharma group as undervalued with strong underlying fundamentals, but we expect lingering concern about drug policy changes to weigh on the industry's valuations.

Even with Democratic control of Congress and the executive branch, we expect more-moderate policy changes to U.S. drug prices. We believe the most likely U.S. drug policy change will focus on the out-of-pocket payments for patients in the catastrophic phase in Medicare Part D. With the current system requiring seniors to pay close to 5% of costs of very expensive drugs, patients can be on the hook for over $5,000 per year. With bipartisan support for addressing these costs along with some industry support, we expect policies to change the cost structure, with the drug companies picking up some of these expenses. This change would probably affect the industry by only 2% on the top line but reduce a major voter complaint of high out-of-pocket costs for specialty drugs and could remove the constant threat of drug pricing reform that has weighed on the group's valuation multiples for many years.

Although less likely, we also see the potential for inflation caps in Medicare Part D, which could have a 3% negative effect on the top line of this sector. However, we continue to believe that more controlling U.S. drug pricing policies, such as international reference pricing (pricing U.S. drugs at a similar rate to other developed markets) and Medicare drug negotiation, look unlikely to survive such a narrow margin of Democratic power in the Senate. Damien Conover, CFA