Reducing Prescription Drug Costs in Colorado


An Evaluation of the Department of Health Care Policy and Financing Report, Reducing Prescription Drug Costs in Colorado

Last week, the Colorado Department of Health Care Policy and Financing (HCPF) published a report on prescription drug costs in Colorado and what might be done to bring them down. It’s an extensive report, so I thought I’d distill some of what was discussed, as well as provide an evaluation of some of the proposals contained within.

For those who are interested in a little background and rhetoric concerning trends in drug prices, costs and utilization, feel free to read pages 11-14 of the report. These pages are concise and informative.

The true conclusions HCPF draws begin on page 15, within a section entitled “Major Drivers of Prescription Drug Prices”. HCPF covers 11 drivers, to which I’ll add my two cents below:

  1. Patent Protections. HCPF faults the pharmaceutical industry’s habit of evergreening patents in order to extend the period under which companies enjoy high prices and exclusive marketing rights. A simple example of evergreening might be to reformulate a pill that’s taken three times a day in order to provide the convenience of once-a-day dosing. The manufacturer would then ask for a new patent on the improved formulation. While evergreening is definitely something the industry does, it is much less successful than it was years ago. Today, Pharmacy Benefits Managers (PBMs) and their clients (states, employers, etc.), simply won’t pay for these incremental improvements. Thus, in most cases, drug exclusivity and monopoly pricing usually expire at the time the composition-of-matter patent expires on a drug. What’s more, while evergreening does add to the cost of pharmaceuticals in the U.S., there isn’t an obvious fix to what we do already. Generic companies challenge patents all the time and now even use a new technique known as Inter Partes Review, which accepts a lower standard for defeating patents.
  2. Anticompetitive Practices and Price Fixing. In addition to evergreening patents, HCPF alleges that the industry engages in anti-competitive behavior in order to protect profits. Specifically, the report asserts that brand companies pay generic companies not to introduce low-priced alternatives. As a point of fact, this is a correct statement. However, the reverse payments brand companies make to generic companies aren’t terribly common, nor are they usually major drivers of pharmaceutical cost. The most important element is the fact that brand and generic companies “split the baby” by settling on a date upon which the generic company can launch. This is usually a date after the expiration of an early patent, but before the expiration of a later patent. By agreeing to a date certain launch, both sides take the risk of a total legal defeat out of the equation. In my experience, companies do abuse this stratagem, but not egregiously. What’s more, the issue has been challenged legally on numerous occasions, with the industry position being upheld virtually every time.
  3. Specialty Drugs. Look up the definition of a specialty drug online, and you’ll get 100 answers. In theory, a specialty drug is one that requires special handling, packaging, patient support, supply chain management, etc., but the practical answer you’ll get from pharmacists is that a specialty drug is just an expensive drug (usually for a small population). In its report, HCPF points out that the industry has focused its R&D efforts disproportionately on specialty drugs and that their introduction is contributing significantly to costs. This is all true. However, this is an artifact of a few factors. First, the industry is struggling to identify widespread diseases with addressable unmet needs. Certainly, this issue should be the industry’s to solve. However, because the industry hasn’t yet figured out a solution, it’s turned to charging very high and sometimes unjustified prices. Second, the Medicare Part D drug benefit splits the costs of catastrophic coverage 95% government and 5% patient. Thus, by charging extremely high prices, the industry knows it can put the onus on the Federal government disproportionately. There are some green shoots regarding new value-based models of drug pricing, as well as Part D reforms that might help blunt the specialty drug trend, but I don’t think we should expect any dramatic changes near-term.
  4. Hospital Pricing Mark-up and Site of Care Pricing Differentials. This is probably the first issue on HCPF’s list that both can and should be addressed. At issue is the fact that providers direct where a patient receives outpatient injectable drugs. Since health insurers and governments typically pay more in a hospital outpatient setting when compared to a clinic or doctor’s office, providers direct patients to get their infusions at the hospital. Drug companies certainly help sustain this practice when it is in their interest. Johnson & Johnson, for example, made it very difficult for physicians to prescribe Pfizer’s Remicade biosimilar, Inflectra, by contracting aggressively with hospitals and physician groups. Unfortunately, industry lobbying and litigation works, and both hospital and pharmaceutical trade associations have fought hard against “site neutral payment policies”, which is the term of art for this issue. In fact, the Trump administration is currently appealing an adverse ruling relating to its own site-neutral payment policy governing evaluation and management services. While I consider this to be a tractable problem under the umbrella of runaway drug costs, injected and infused drugs administered by medical professionals are a smallish part of the overall drug bill. For reference, the Kaiser Family Foundation estimates that Medicare Part D (patient-administered) drug spend runs nearly 4x that of Medicare Part B (drugs administered incident to medical professional services).
  5. Medicare’s Inability to Negotiate Prices. When the Medicare Part D drug benefit was created, legislators included what’s known as the “non-interference clause”, which prevents the Federal government from negotiating prices with manufacturers directly. HCPF would like to see this change, because it would no-doubt lead to lower drug prices. I agree. Perhaps we’ll see movement on this issue once the next election cycle has been concluded.
  6. Prescription Drug Rebates. The report covers a few of the elements of why rebates are ground zero in the debate over drug pricing. Conceptually, a rebate is a reduction in price offered after the achievement of some performance goal (for example, a certain level of market share), where a discount is a price reduction offered up front. What makes drug rebates so problematic is that PBMs and their counterparties keep all their rebate contracts secret. Thus, buyers don’t really know if they are getting the best deal, and patients don’t know what to expect from year to year in terms of out of pocket expenses. Because the rebates aren’t part of the net price known at the outset of a plan year, patients end up paying co-insurance on an inflated price.
  7. Pharmacy Benefit Managers (PBMs): Pricing, Profits and Consolidation. HCPF asserts that industry consolidation has helped engender an acceleration in PBM industry profits. This is probably true to some degree, but large customers (states, large employers) have never enjoyed many options when it comes to PBM services. Often there are only a few PBMs involved in a price check or Request For Proposal (RFP), and survey after survey suggests that price is only one component of a client’s ultimate decision. As with intellectual property reform and the pay-to-play debate, I doubt we’ll get relief regarding antitrust issues any time soon.
  8. Prescription Drug Promotional Marketing. Number eight on the list has to do with the fact that the U.S. is one of the only countries in the world that permits prescription drug companies to advertise directly to consumers (DTC). While I don’t have empirical evidence beyond the anecdotal here, I think that HCPF may have a decent argument. It’s not uncommon for a consumer to hear of a new drug and ask for a trial from his or her doctor. A doctor isn’t in the business of denying care, so he or she may comply so long as the drug is perceived to be safe and well-tolerated. Earlier this year, the Trump administration tried to take a small bite out of drug companies’ DTC advertising efforts by mandating that companies disclose their prices in DTC ads; however, industry challenged Trump’s rule and a judge subsequently ruled in industry’s favor.
  9. Marketing to Physicians. Drug companies still market aggressively to physicians. However, where efforts used to include lavish trips and gifts, the industry and physician groups have self-policed to a significant degree. There’s little question offering speaker bureau appointments and conducting continuing education symposia lead to higher levels of prescribing (if they didn’t, industry wouldn’t bother), but the impact of these activities is probably much reduced from years past.
  10. Lobbying Contributions to Drive Industry Policy. HCPF rightly raises lobbying efforts as a major driver of drug costs. As with clandestine rebate contracts, I put this one high on the list of culprits. Drug companies spend like no one else, and they defeat nearly every initiative designed to uproot their outsized levels of profitability (HCPF could easily write another 50-page report on the various wins industry has racked up over the past decade). I’m repasting a graph from the report for effect. For context, remember that drugs are only a small part of our health bill; however, the industry is immensely profitable and very well organized, which is why we rarely see Congress take action.
  11. Rising Prescription Drug Manufacturer Profits. Number eleven is simply a corollary to number ten. A typical prescription drug gross margin is better than 90%. Operating margins, before R&D expense, typically approach 50-60%.

(Pages 28 and 29 of the report highlight other states’ initiatives, in part to inform some of the recommendations for Colorado that HCPF covers in the ensuing pages.) 


What does HCPF recommend for Colorado, and does it make sense? 

Beginning on page 30, HCPF outlines its “Solutions for Colorado”.  The Department offers a long list of specific proposals and potential areas of exploration.  Thus, for the sake of brevity, I’ve classified these proposals into three broad areas – transparency, value-based pricing and drug benefit best practices.  I’ve also quickly included a fourth area – the notion of importation. 


HCPF offers several remedies intended to help customers 1) better understand how drugs are priced, 2) get the best deal, and 3) protect themselves from arbitrary price increases.  These initiatives make sense, and many should be enacted/promulgated immediately.  Here are some examples: 

  • Mandate that manufacturers provide ample notice when they plan to take a price increase of greater than some percentage (10% seems like a good #).  Moreover, demand that manufacturers provide an explanation for the price increase.  Sometimes, it might be justified:  for example, if they have to source from a different active ingredient supplier, leading to increased input costs.  Other times, it may have to do with nothing more than a desire to “hit numbers” or take advantage of a competitor’s supply issues. 
  • Mandate that PBMs disclose and pass on 100% of any remuneration received from manufacturers for market share, formulary access, etc.  This includes, but is not limited to, rebates.  For Colorado in particular, this kind of initiative could be very impactful.  The state’s Medicaid receives 100% of rebates from its PBM partner, resulting in the trend we see below (from the report): 

Notice not only the absolute dollars at stake ($557mm in 2018!) but the year-on-year trend in rebates paid (26% compounded over four years!).  Without 100% pass-through, Colorado’s pharmacy expenditures would have grown 14.7% instead of 5.7%, on a compounded basis.  As the report notes, Colorado is a small business state.  These are exactly the kinds of organizations that don’t have the negotiating power or sophisticated human resources consultants at the ready in order to obtain comprehensive pass through arrangements with PBMs.  Thus, it’s great to see the state supporting full transparency and pass through arrangements.  

  • In a section that bridges transparency and best practices, HCPF encourages the adoption of utilization best practices (implementation of tools like prior authorization and step therapy), as well as PBM negotiation best practices (e.g. working to avoid common PBM tactics like offsetting lower rebates with higher administrative fees, disadvantageous terms on mail order fulfillment, etc.).  HCPF suggests that there’s room to provide employers with information and support in this regard. 

Value-Based Pricing: 

Under the value-based pricing umbrella, HCPF riffs on ways to avoid unjustified price increases and paying for overpriced therapies.  The report does not specifically cover what I’ll call Intelligent Pharmacy Benefit Design (iPBD) — customized financial constructs that incentivize consumer and vendor behavior in a more bespoke manner – although this could, in theory, be a part of the solution. 

  • HCPF suggests that the cost of new treatments be compared to that of current treatments.  This is what’s known as comparative effectiveness, and really ought to be employed for all health care products and services.  Health Technology Assessment (HTA) organizations do this kind of work and already reside both within health insurers and independent entities.  
  • HCPF recommends evaluating patents for evergreening, and this too could be handled by HTAs.  If a new product only offers incremental value, it’s perfectly reasonable to incentivize the use of a currently available alternative. 

iPBD, a Term I Just Coined

For better or worse, health care coverage usually spans a year, at which time you choose to renew or change plans.  Obviously, you can stop paying premiums at any time, at which your coverage will lapse.  Drug benefits mirror this construct.   While today’s pharmacy management systems permit creative plan designs, most plans incorporate only a few blunt, and sometimes counterproductive tools (clinically speaking).  For example, each time a patient picks up a supply of medication, he or she pays a co-pay or co-insurance.  Insurers call this “skin in the game”.  However, co-payments don’t really make a ton of sense for most prescription drugs.  A patient can only receive supply enough for one individual (to go beyond this, the doctor would be committing fraud), and benefits and side effects are specific to that drug and disease.  If the patient ought to be getting the therapy (they’ve paid for access through their premiums and the physician thinks it’s appropriate), why provide them a financial disincentive to do so?  One obvious stopgap would be to have the patient pay a co-pay for the first script in a plan year, then nothing more so long as the patient continues to pay his or her premiums.  If this approach were to be adopted, significant consideration would need to be paid to two issues, 1) front loading any financial incentives to choose one therapy over another and 2) the comparative effectiveness of various alternatives.

  • Today, many plan designs include a deductible that must be met before benefits kick in.  Thus, for persons in high-deductible designs, the notion of a front-loaded year is already well understood.  HCPF, the DOI or others directing health policy in Colorado could take into consideration desired vs. current consumer behaviors in crafting a one-time financial obligation (deductible + co-payment) that must be met for therapies of various clinical values.  In my opinion, the state should have PBMs and payors do-away with straight co-insurance designs.  If a plan design incorporated enough granularity, it could do an adequate job of discriminating between a variety of net price points and product profiles without the need for percentages.  These dollar amounts could then be posted at the beginning of the year so that consumers wouldn’t be surprised at the pharmacy. 
  • Today, PBMs and manufacturers negotiate formulary status between tiers (generic, preferred brand, non-preferred brand, specialty), and the level of exclusivity that prevails within various therapy categories.  They could still do this, just with the new financial construct, and patients wouldn’t be put in a position of having to switch therapies or ration therapies throughout the year (this happens). 
  • Finally, PBMs and payors could keep in place prior authorization requirements (maybe even refine these) but might be able to forego step therapy (the idea of having to try a cheaper drug and fail it before being granted access to a more expensive therapy).  Frankly, this latter tool isn’t terribly well aligned with best practices anyway and is often gamed.   

Drug Benefit Best Practices: 

  • HCPF is negotiating with bidders to develop and distribute a prescriber tool for physicians.  Such a tool would be implemented in two phases, with the first phase providing a prescriber patient-specific copayment information, as well as his/her plan’s financial obligations for a given drug.  Phase 2 would provide the prescriber plan-specific health improvement program information to be considered and/or recommended.  HCPF believes making this tool available will help change prescribing behavior and improve clinical and financial outcomes for the state and its residents.   
  • HCPF suggests that the state explore options relating to manufacturer coupon programs.  This is a good idea, if implemented carefully.  To my prior point, the state shouldn’t dissuade consumers from remaining compliant with their medications.  However, manufacturers don’t coupon old, low-margin drugs; they coupon new, expensive drugs.  Thus, the state should consider comprehensive programs that blunt unjustified efforts to promote low-value-added prescription drugs. 
  • Two new boards?  HCPF suggests that Colorado could benefit from the establishment of a Prescribing Best Practices Board, and a Prescription Drug Affordability Board.  Arguably, these boards would sit at the intersection of best practices and value-based pricing/reimbursement.  Experts would make recommendations that would feed into prescribing tools and electronic medical records, and the affordability experts might be called upon to recommend upper limits to what the state and other customers pay for certain drugs. 


  • HCPF recommends that SB 19-005, which already permits drug importation from Canada, to be amended to include other countries.  I guess this can’t hurt should the notion of importation take hold.  Developed territories like Australia and western Europe might offer opportunities to augment affordable supply.  However, I just hope that the state of Colorado appreciates how different the environment can be from country to country, even in areas falling under a single regulatory body like the European Union.  I’d also stress that compliance and inspection conditions vary from country to country even if facilities are FDA approved. 

(Pages 42-45 cover solutions for “All Americans”, which I don’t cover in this evaluation.) 


My Summary in Brief: 

Our drug delivery system is a Frankenstein monster built over many years and with many perverse incentives incorporated for non-clinical reasons.  We should consider starting from a clean slate where doing so provides the biggest benefit with the least disruption.  What HCPF concludes then proposes in its Reducing Prescription Drug Costs in Colorado report makes a lot of sense.  However, the two areas, in my opinion, that best fit the bill from the point of view of the state are 1) mandating rebate reform and 2) drawing a hard line on value-based pricing.  We should also develop a scorecard for our state representatives and hold them accountable for their willingness to accept support from prescription drug lobbying groups. 

Here’s a link to the full report:

Et Tu, Drug Price Reform?


Drug Prices:  Is Ceding Political Victory No Longer a Showstopper? 

Tuesday, the Congressional Budget Office (CBO) scored the Elijah Cummings Lower Drug Costs Now Act (H.R. 3).  This is the U.S. House of Representatives’ current best effort to provide drug cost relief.  The Senate has its own drug cost bill known as the Prescription Drug Pricing Reduction Act of 2019 (S. 2543); it too has received a preliminary CBO score.  While many are skeptical we will witness the passage of drug pricing legislation in an election year and in light of the vituperative discourse between Democrats and Republicans, I am struck by two observations.  First, it appears legislation can get done, if both sides can claim victory.  On the day that Democrats in the House introduced articles of impeachment, they also announced an agreement with the White House on a revised U.S.-Mexico-Canada Agreement on trade.  Second, the guts of drug price reform don’t appear to be radically different from the House to the Senate to the White House.  Below, I describe some of the key elements of the two lead bills, as well as what the White House has proposed: 

According to the CBO, the Elijah Cummings Act: 

  • Would require the Secretary of Health and Human Services to negotiate prices of selected drugs such that these prices didn’t exceed 120% those paid in a reference group of developed countries.  These prices would be required to be used for Medicare Part D plans, and available to commercial plans.  Manufacturers that failed to comply would be subject to an excise tax that would not be deductible for income tax purposes. 
    • Medicare would spend about $448bn less from 2023 through 2029 as a result.  This is a huge amount of money relative to what is spent today.  For reference, CMS estimates that the Medicare Part D program spent about $155bn on drugs (gross) in 2017.  In 2027 alone, the CBO projects the program would spend $94bn less than if we kept the status quo.  
  • Would limit annual price increases to the rate of inflation in the Consumer Price Index – Urban (CPI-U), with manufacturers rebating back any increases in excess of this rate. 
    • As a result of this change, Medicare would save $37bn over the planning period, according to the CBO. 
  • Would upgrade the benefit Part D beneficiaries receive.  Specifically, the Act would eliminate the coverage gap commonly known as the doughnut hole, introduce an out of pocket maximum at the point at which catastrophic coverage kicks in today, and modify other elements of the benefit. 
    • These changes would increase direct spending by $9bn over the planning period, according to the CBO. 
  • Would require higher levels of cost and price transparency from manufacturers, increase the number of seniors eligible for low-income subsidies, add dental, vision and hearing care benefits to Medicare, and increase government funded research. 

At this time, the CBO has not yet issued an updated cost estimate for S. 2543, which the Senate Finance Committee (SFC) introduced on September 25.  However, the CBO has provided a preliminary estimate for the bill, based on the Description of the Chairman’s Mark provided to the CBO on July 25.   

According to the CBO, S. 2543: 

  • Would require that manufacturers include coupons in their estimate of Average Selling Price for their drugs. 
  • Would modify Medicare Part B reimbursement with a goal of increasing the adoption of biosimilars. 
  • Would require that Part B drug price increases above CPI-U be rebated back to Medicare. 
  • Would upgrade the benefit Part D beneficiaries receive.  Primarily, the Act would introduce an out of pocket maximum at the point at which catastrophic coverage kicks in today. 
  • Would require that manufacturers provide drug payment information to Medicare and Medicaid advisory groups, including certain rebate information.  The Act would also require that HHS publish less sensitive information on pricing and discounts on its website. 
  • Would require that Part D drug price increases above CPI-U be rebated back to Medicare. 
  • Would make modifications to Medicaid requirements, including the use of Pharmacy and Therapeutics committees and Drug Use Review boards, rebate oversight and price calculations. 

The White House: 

While it doesn’t appear that Alex Azar and Seema Verma are likely to sip hot cocoa by the fire together this holiday season, the one thing they have in common is a desire to impress the President with their loyalty.  Thus, I think it’s reasonable to expect that HHS and CMS will tout the President’s initiatives publicly, while working cooperatively with those working to reduce prescription drug prices.   

Specifically, I would remind readers that the President’s Blueprint to Lower Drug Prices: 

  • Was the first to introduce the notion of a reference pricing mechanism. 
  • Promotes the idea of improving transparency through the Medicare pricing dashboard. 
  • Contemplates measures to limit drug price increases, including inflation caps. 
  • Promotes the idea of introducing an out-of-pocket maximum for seniors. 

The President is also in favor of drug importation from countries like Canada and HHS is currently working with several states to establish guidelines for how this might be accomplished more broadly. 

With these various facts in place, I think it’s natural to ask — can legislation be passed, what will it look like, and what are the implications? 

As far as I can tell, reducing the cost of drugs is a bi-partisan issue.  The Republicans certainly view it as a winner for the upcoming elections, and the initial spark for reform actually came from Hillary Clinton in the fall of 2015.  According to a recent Kaiser Family Foundation poll, lowering prescription drug costs is the top health care priority amongst voters.  Obviously, we now have a Democrat-led bill in the House and a bi-partisan bill in the Senate that 1) don’t look to be at odds with one another, and 2) incorporate many of the changes the President would like to see implemented.  The trick, as is customary, is to keep fringe elements from blowing up the final bill while positioning the passage of such a bill as a victory for both political parties and the president. 

Kaiser Family Foundation Tracking Poll (September 12):

I believe that the Senate’s bill will form the corpus of anything that’s likely to get done.  First, it focuses more narrowly on the drug benefit and delivery system.  Second, it contemplates reforms that are limited to government programs, rather than both government and private plans.  Third, it focuses on pragmatic solutions with moderate financial impact and modest operational impact.  Fourth, it arises from the legislative body where consensus matters to a greater degree (i.e., notwithstanding the occasional fringe caucus revolt, the Speaker can usually get her way in the House). 

I think that it should be relatively easy both to implement a price inflation cap and establish an out-of-pocket maximum for Part D beneficiaries (seniors).  Both sides of the aisle generally agree that these wouldn’t be disruptive operationally and would like to see industry pay for a greater percentage of the benefit.  However, both worry that insurers will raise premiums if the government shifts to much of the bill onto their collective backs.  Thus, I envision the government picking on the drug manufacturers when it comes to determining how much of the doughnut hole and catastrophic benefit reforms each entity picks up.  I also think that we should expect the government to demand greater levels of price transparency from insurers, pharmacy benefits managers and manufacturers. 

On the other hand, I don’t think we’ll witness the passage of anything that includes a reference pricing mechanism, direct negotiations between CMS and industry, or the addition of new entitlements (e.g. dental benefits).  These are very disruptive from an operational point of view and are likely to invite much more vociferous and widespread opposition. 

According an article by The Hill1, Mitch McConnell and selected republicans aren’t in favor of certain elements of the Senate bill, including the inflation cap.  While the article goes on to say that opponents equate such a cap to price setting, I think it’s important to note that such a cap already exists under Medicaid.  Thus, this argument represents little more than a straw man, in my opinion.  For now, it doesn’t appear that President Trump is twisting any arms in front of the election cycle (perhaps he’s sensitive to the fact that the impeachment trial is about to begin?).  However, I expect that as the groundswell of support grows amongst voters, we’ll see more jawboning and increasing Congressional support for a simplified proposal, and that we may truly be talking about passage in the Spring. 

If we do get a new drug price reduction act, I don’t think we’ll see a big impact on productivity and access, broadly speaking.  Nor do I think we’ll see a big impact on access one way or another.  However, there could be pockets of pharmaceutical business that become less attractive as a result.  If a bill were to pass along the lines I’ve described above, high priced medicines for the elderly population become less attractive, all else equal.  Let’s take a simple example – a person being treated with a cancer medication beginning January 1st under the standard Part D benefit design.  Here’s the current construct: 

If this medicine costs $10,000 per month and is used for 10 months, the drug company receives $95,680.46 — $3,820 up to the doughnut hole (from the enrollee and plan), 30% of the gross costs up to $8,139.54 (split 25% enrollee and 5% plan), and 100% of everything thereafter (via enrollee, plan and Medicare). 

Under the Senate proposal, which still may change, this same medicine would provide the drug manufacturer only $80,620 – 100% of payments up to $3,100, then 80% of any payments made above this threshold.   

A lot obviously still depends on the final agreed-to split between manufacturers, plans and Medicare above the catastrophic threshold, as does the practical matter of whether a beneficiary is on other medications that count towards the out-of-pocket max.  Still, I think that the companies most affected by these changes would be those already selling oral cancer medications (pills), since those companies would be unable to change prices meaningfully in order to respond.  Injected/infused cancer medications are typically covered under Part B, which is a separate benefit.  Amongst multi-national branded biopharma companies, Pfizer probably has the most to lose, although there are some biotechnology companies that sell only oral cancer medicines.  In addition, any other drugs disproportionately used amongst the elderly would theoretically be affected, subject to pricing and the catastrophic threshold (e.g. certain antiviral medications and anticoagulants).  

Informal Thoughts on BDXA


As with everything that I will post to the investing section of this blog, the following should not be construed as investment advice.  It is simply meant to be the ramblings of a now-retired individual with some time on his hands.  I am not affiliated with any organization and have no interest in publishing other than for the intellectual exercise.  While I make an effort to be accurate with my facts, I do not assert that any of the following information is 100% reliable.  If I own a stock upon which I comment, I will always say so.  In  this case, I own BD Depository Shares Representing the Mandatory Convertible Preferred Stock (BDXA) in a personal account.


The Mouthful:  Becton Dickinson Depository Shares Representing 1/20th of One Share of 6.125% Mandatory Convertible Preferred Stock, Series A

Thoughts on Becton Dickinson

For those who don’t know that much about the company, Becton Dickinson is essentially a medical products supermarket. The company manufactures and distributes a wide variety of products, including the Vacutainer tubes technicians and nurses use when drawing blood, sharps (e.g. pen and safety needles), catheters (e.g. urological catheters for drainage, therapeutic catheters, etc.), diagnostic reagents and instrumentation, infusion pumps, surgical materials, medication management products and others. The company’s operations are well diversified from a geographic point of view, with roughly 44% of revenues generated overseas. Finally, I believe it’s important to recognize that, while BD operates in highly regulated markets, 1) its products don’t typically rise to the level where customers feel the need to “do something” about their costs, and 2) BD is somewhat insulated from the economic cycle, given the amount of business that is reimbursed under fee schedules comprising both medical devices and medical professionals’ reimbursement. While analysts get worked up over whether the company grows its top line 4%, 5%, or 6% in a given year, I think that the ability to grow reliably is more important for long-term, income-oriented investors. In this regard, BD is hard to beat.

Over the years, it appears that BD’s strategy has been to move up the value chain and become more important to its primary customer base – hospitals and clinics. While the organization spends about 6% of net revenues on R&D, its principle method for doing so has been by making acquisitions. Every few years, it seems, BD makes a significant acquisition. Most recently, the company closed the $24bn acquisition of C.R. Bard, in late 2017, bringing the company a host of interventional and surgical products. Before that, it was the infusion pump company, Carefusion, which BD bought in 2015 for $13bn. Given that BD is about a half-turn away from its leverage target post the acquisition of Bard, I think it is reasonable to expect BD to begin shopping for its next target.

Not surprisingly, BD’s willingness to return cash to shareholders ties to its M&A strategy. As debt comes down as a multiple of EBITDA, the company raises its dividend more aggressively. In the early periods post an acquisition, dividend increases are more modest. Most recently, the company announced a 2.6% increase to its quarterly dividend (to $0.79/sh.), suggesting the company is still in debt pay-down mode. The forward yield on common equity is only 1.2%. Over the longer-term, BD ought to be able to grow earnings in the high single digits, organically, and its dividend growth ought to match. This is certainly consistent with the company’s history. Capital intensity has been coming down, and capital expenditures clocked in at 5.5% of net revenues in BD’s Fiscal Year ending 9/30/19.

An Investment in BD

BD’s shares trade at roughly 20x forward earnings. That’s not cheap in an absolute sense, but it’s cheaper on a relative basis than they’ve been in a while. This valuation is also arguably attractive when you consider where “defensive” stocks typically trade and the shrinking list of investable companies that are truly defensive. Consequently, I’m O.K. owning BD common at these levels.

However, when it comes to what I actually own, it’s the Becton Dickinson 6.125% Mandatory Convertible Preferred Stock depository shares (BDXA). Becton Dickinson issued these securities in conjunction with the financing it did in order to complete the C.R. Bard acquisition. The key features of this issue are that the Preferred shares 1) sit higher in the capital structure (not an issue for BD), 2) pay a higher dividend and 3) convert into common according to specified terms. On this latter point, the Preferred converts into BD common according to a fixed ratio when the common trades above $211.80 and below $176.50, but along a sliding scale between these two prices. In other words, as BD common approaches $211.80, the Preferred stock ought to start offering better downside protection.

Today, BD common trades at roughly $257/sh., or roughly 21% above the Threshold Appreciation Price of $211.80. Thus, we’d have to undergo a rather violent correction between now and May 2020, by which date the Preferred shares must be converted into common, for the Preferred shares to stand out. In other words, BD Preferred share receipts really aren’t much more interesting than BD common right here, right now. Still, I bring this security and its feature up in consideration of what I outlined earlier. Specifically, should BD engage in another acquisition of size, this form of the financing might be included and offer total return investors a solid investment opportunity that fits their objectives. If it informs the potential timing of such an event, BD should be at 3.0x D/EBITDA by the third quarter of calendar 2020, at which time significant M&A again becomes a possibility; BD did the financing for Bard roughly a month after having announced the proposed deal.