Substantial Market Opportunity for Large Healthcare Providers

 |  Includes: CYH, IHF, THC, UHS, VRSK
by: Sydney Williams

Medicare-led physician reimbursement creates significant business risk for independent practices, and a substantial market opportunity for large hospital operators such as United Health Services (NYSE:UHS), Community Health Systems (NYSE:CYH), which is attempting to purchase Tenet Healthcare (NYSE:THC), and HCA Holdings, whose $4.6 billion IPO is expected in March.

Picture this. You're a lawyer or financial adviser. You operate independently and take enormous pride in the service you perform. At the same time, you understand that your service is a business, and that no matter how much pride or skill you possess, your business won't float if you don't cover costs.

Now imagine that an obscure regulatory body determines exactly what your clients pay you. Oh, and the people who pay you aren't the ones who actually consume your services.

Talk about out-of-control business risk. On the one hand, straightforward market supply and demand dictate the price levels of your expenses. On the other hand, an anonymous group of people big enough to fill the corner coffee shop presets the price levels of your revenues.

In the normal world, if your costs rise, you adjust prices accordingly. If you're a skilled business person and understand your market and customers, you'll set prices that match your specific demand.

In this alternative world, because you have no control over prices, you're reduced to vendor pleading. Any negotiating position—call it pricing power—you might otherwise have had simply does not exist.

That world, of course, is health care.

Committee-based pricing
In health care, the 240,000-member American Medical Association convenes a 29-person committee that 'recommends' physician reimbursement rates to the Centers for Medicare and Medicaid Services ("CMS"). Since CMS accepts and implements the committee's recommendations 90 percent of the time, the committee has become the de facto market price-setter.

Once a year, the Relative Value Scale Update Committee (or "RUC") makes its recommendations. Every five years, it submits broad reviews. RUC has "no official government standing", according to the Wall Street Journal.

Members are mostly selected by medical-specialty trade groups. Anyone who attends its meetings must sign a confidentiality agreement.

"In sessions that can stretch 12 hours or longer each day," the Journal notes, "the committee walks through dozens of services. The discussions can be mind-numbing—a subcommittee once debated whether to factor tissues into the payment for a psychoanalysis session."

But as obscure as RUC is, the formula that CMS uses to determine its fee schedule and implement the committee's recommendations might as well exist a hundred miles underground. Writing in the New York Times, noted health economist Uwe Reinhardt explains the Resourced-Based Relative Value Scale ("RBRVS") as follows:

In a nutshell, for a particular service (e.g., a routine office revisit or an appendectomy or a heart transplant) that we shall call Z, Medicare pays a fee calculated with this formula: FeeZ = (Work RVUZ x Work GPCI + PE RVUZ x PE GPCI + PLI RVUZ x PLI GPCI) x CV

FeeZ is the dollar amount of the fee paid for the service, Work RVUZ denotes the relative value units for the physicians’ work going into the production of service Z, PEZ denotes the relative value units of the physician’s practice expenses allocated to service Z and PLIZ denotes the relative value units for the professional liability insurance premium allocated to service Z.

Each of these three relative cost factors is adjusted for its own geographic price index, GPCI in the equation. Thus, there is one GPCI for the physician’s work, one for practice expenses and a one for malpractice premiums.

The sum of these three RVU components, adjusted by their GPCIs, is multiplied by CV, the conversion factor. This is the dollar amount that Medicare pays for one overall RVU.
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Maybe to a Princeton economist—or a PhD in mathematics or, for that matter, a Wall Street quant—it makes perfect sense. For most physicians, RBRVS is just the way the world works.

In fact, because the average doc contributes no input anyway, the formula could be any number of tangled algorithms. The consequences would be no different.

And let's not forget that CMS is the dominant payer. Commercial health plans, rather than undertaking an entirely different approach, simply base their rates on what it—the government—pays. (So much for moving to a single payer system.)

Price volatility
Perhaps one of the least noted risks to health care is a sudden and sustained change in vendor pricing levels.

The United States hasn't experienced double digit inflation for 30 years—10 years prior to Congress legislating the RBRVS standard. Nevertheless, price volatility ebbs and flows.

As the chart below shows, current volatility is the highest since the 1960s. (We calculate volatility as the annualized ratio of standard deviation in the Personal Consumption Expenditures index to its mean—the coefficient of variation.)

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Price VolatilityClick to enlarge
More than the absolute price level, what's important to business owners is the extent of variation. High variation increases business risk especially for folks with little or no pricing power, and vice versa.

Several experts warn that overly aggressive fiscal and monetary policy could resurrect 1970s-style inflation. Consumers need only visit the local gas station to experience one commodity already rapidly rising in price.

Volatility, of course, would persist (likely elevate) if the economy were to jump to this higher level.

What if rents, utility bills and other business costs remain unstable? How does RUC, which only makes its recommendations once a year, compensate for this?

In the collapsing municipal bond market, we see not just the dire finances of state and local governments, but extreme regional economic conditions—unimaginably complex for a 29-person body to manage.

Simply put, committee-based pricing contorts basic economics. It promotes obscurity over transparency and inflexibility over resilience.

For a lawyer, financial adviser or just about anyone else outside of the health industry, the ability to price a service is an essential business tool.

For a physician that inability is fast-becoming a sacrifice in independence.

Of the roughly 950,000 physicians in the United States, about half practice in groups of five or less, and the majority of these in solo and two-physician outfits. About a third practice in hospitals or large group settings of more than 50 docs.

Some of these independents—in particular the primary care ones—will form cash-only concierge-type practices, and others will vacate the profession altogether.

Many, though, will join large hospital groups, which typically compensate on a salaried basis.

And keep in mind. The 2009 Health Information Technology for Economic and Clinical Health (HITECH) Act and the 2010 Patient Protection and Affordable Care Act strongly favor large, deep-pocketed hospital operators over small, cash-strapped practices—by establishing, for example, the Meaningful Use mandate and the Accountable Care Organization incentive.

Until the economics realign, expect independent physicians to sell out and health care providers to continue consolidating.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.