"Economist" In Me Says This Is A Threat To Gilead

New York Attorney General Eric Schneiderman recently launched an investigation into 16 health insurance companies' coverage of HCV and their restrictions. I concluded that [i] by offering more access to high-priced HCV drugs, insurers might incur higher benefit pay outs and [ii] insurers could potentially form coalitions to negotiate steeper discounts from Gilead GILD and AbbVie ABBV.

SA author Jonathan Weber has a totally different thesis. I address his arguments below.

Mr. Weber Believes Less Restrictions Lead To Higher Volume, Higher Profits For Gilead

• Let's look at what would happen if insurers were forced to expand coverage and are able to negotiate lower per unit prices due to higher volume rebates. Gilead grossed $12.5 billion from its US HCV franchise in 2015, curing 225,000 patients (for a per patient cost of $55,000). Its gross margin is 88 percent, which means the proportional cost per patient is $6,600, whereas the profit contribution per patient is $48,400.

• When Gilead's patient count in the US grew 50 percent, whilst prices per patient dropped 20 percent, this would mean revenues of $44,000 per patient and a profit contribution of $37,400 per patient. Its total profit contribution would grow from $10.9 billion to $12.6 billion ($37,400 per patient times 338,000 patients). Additional $1.7 billion in profit contribution would lead to net income growth of $1.4 billion ...

My Response:

I totally get Mr. Weber's argument that expanding coverage could drive profits in spite of lower prices. Actually, I made that same argument a year ago:

To limit their exposure to the cost of Sovaldi, insurance companies had only purchased the drug for patients with advanced liver disease. Abbvie's discounted HCV regimen made it more affordable to offer the treatment to all HCV patients; this also implied there was pent up demand that was not being satisfied due to Gilead's unwillingness to lower its prices. ... Though the 46% gross to net has initially lowered Gilead's revenue, it may have expanded the universe of patients the company can treat.

While BipharmaDive had projected the HCV market size would be $15 billion in 2015, it's actually about $20 billion despite the price war between Gilead and AbbVie. It begs the question, "If Mr. Weber and I both know this to be true, then why doesn't Gilead lower prices for HCV drugs through health insurers?" It seems irrational not to. Below are a few theories:

• 16 Health Insurers Could Extract Huge Discounts - The price war with AbbVie drove the now infamous "46% gross to net" discount. Though certain health insurers may be late in garnering discounts, it could work to their advantage. I believe that by negotiating as a group they could have more negotiating power. Secondly, they could piggy back off of discounts garnered by Express Scripts ESRX, CVS CVS and the VA to either match or exceed them.
• To give a sense of just how steep a discount the VA has garnered, in Q3 2015 Gilead's HCV revenue per start was bout $53,000; in Q4 it rose to nearly $73,000. VA sales in Q4 were limited due to uncertainty over funding. While total HCV sales in the U.S. fell sequentially, I believe the loss of VA sales also caused revenue per start to spike.
• If health insurers were to garner discounts anywhere close to those of the VA, Gilead's 88% gross margin Mr. Weber referred to could deteriorate.

• Potential Loss Of Scale - The volume Gilead gained from price reductions added top line growth and economies of scale. For instance, Q4 2015 HCV sales and total products sales grew Y/Y by 27% and 16%, respectively. Meanwhile, the company's operating margins increased to 66% from 59% over that time frame. That might not be the case going forward.
• The more infecteds Gilead and its competitors cure, the smaller the pool of potential patients becomes. If a large pool of customers from insurers like Anthem ANTM, Aetna Inc. AET and EmblemHealth Inc. had started on HCV regimens in 2015, it could have been a boon for the company. However, Gilead has infrastructure in place to support nearly $5 billion in HCV revenue. When that revenue trails off -- and it will -- its operating margins will likely fall from loss of scale.
• The longer Gilead can maintain its "HCV runway" the longer it can hold onto its hefty margins.

• It Leaves More Revenue In The Till - The biggest risk to holding GILD is that its HCV sales will fall. I am on record saying that the pharm has peaked. HCV represents over 50% of the company's total product sales; HCV sales also fell 7% sequentially in Q4. I believe the lack of a robust pipeline could be a concern going forward.
• U.S. starts peaked at 70,000 in Q1 2015 and fell to 60,000 in Q3. Again, Q4 starts of nearly 33,000 were skewed by the loss of VA sales. There appears to be pent up demand for Harvoni by patients of certain health insurers. If that pent up demand is realized in 2016 or later, management could give the impression that the pharm hasn't peaked.
• Gilead is a publicly-traded company and investors and analysts reward consistent earnings. Squirreling away demand from state prisoners or patients of New York health insurers could generate steady-state earnings and give the "illusion" that the pharm hasn't peaked.

Conclusion

The economist in my says "people are rational." If Gilead believed that lowering prices and unlocking pent up demand from patients of certain health insurers was positive, it would have done so already. Avoid GILD.