Blessed by the Potato

The Globe and Mail has an article today on Ontario’s Bitter Pill to Swallow, the recent changes to generic drug pricing that has pharmacies up in arms.

Once again, I think I’ve got to side with the public good on this: it’s a kick in the nards for pharmacies, but the government isn’t exactly bankrupting or socializing them. From the article:

At Lovell, Ms. Winn estimates each of her stores gets about $300-million [sic] annually from generic drug makers, in exchange for exclusively stocking their products. Like it or not, she says, without that money there are no funds to keep operating, since the margin on the drugs is minuscule; dispensing fees – the $10 to $12 that she collects on each prescription of which $7 is covered by Ontario for its public plan – have not been increased in years.

[…]

Before the day is done, they will fill 300 prescriptions, about one every two and a half minutes. There are three pharmacists on duty, along with three pharmacy technicians to help fill bottles and blister packs with drugs, and a cashier to ring through the purchases.

[…]

The province requires that the allowances are used for activities that directly benefit patients, and pharmacies must submit their spending to be audited each year. But the Ontario government figures that almost 70 per cent gets used for salaries, bonuses and fringe benefits.

Yes, the new rules are definitely going to pinch profits — but this article neglected to point out the offsets that the government is bringing in. Those kick-backs were supposed to be used to improve patient care, but many were simply used for salaries/profits. So now there is a direct payment for counselling and some other new services (flu shots). Those pharmacies that fully serve their patients should come out pretty close to how they did before according to the government*; those that are just bottle-filling robots will see a profit cut.

Speaking of bottle-filling robots, look at the numbers given in the article: 300 prescriptions a day, at $11 per just for the filling fee (i.e., on top of the markup on the drugs themselves – and that’s assuming just one fee per script; I know Wayfare generally has four or more dispensing fees every time she hits the pharmacy). $3300 per day, $16500 per (5-day) week, over $800k per year. I don’t know how much overhead the store has, but there is some mark-up on the drugs (even under the new rules), so let’s assume that covers the overhead**. That $800k split between 3 pharmacists and 3 technicians looks pretty healthy to me — and those dispensing fees will be going up a bit under the new rules (~14+%), despite their lament that they haven’t gone up in the past few years.

All this gnashing of teeth and fighting and threats to cut services or go out of business coming from the pharmacies rings false with me. I know it sucks to have this great profit orgy and have the government come in and smash it up, but I don’t think any pharmacists are going to go hungry under the new rules (except perhaps the students Shoppers and Pharma Plus decided not to hire this summer as part of their temper tantrum with the government). If any pharmacies do have to close, it’s probably because there were too many pharmacies to begin with. Near my old house in London there were three pharmacies within 500 m of each other on one street, and it wasn’t even all that densely populated an area (with people or doctors’ offices). Within the ~4 km² area of downtown London, there are nine pharmacies that I know about, and quite possibly more.

* – sorry, lost the source where I read that one. If anyone finds the article where that was mentioned, I’d appreciate being able to reference it!
** – again, using the reported numbers of $0.50 per script for mark-up under the new stricter rules, that’s $3.3k/mo — I don’t know what the lease and other overhead is on a store that “could fit inside the cosmetics department of a Shoppers Drug Mart” but that sounds like it’s in the ballpark to me.

This week, Ms. Winn and her staff began drawing up a list of services they now provide free, which they may need to charge for in the future. Everything from faxing prescriptions to calling doctors offices comes at a cost, and may need to carry a fee at some point in the future.

It’s a model similar to a law office, where every hour of the day is accounted for, with a value attached to it. Ms. Winn says she isn’t sure what services to charge for though, but feels the pressure to cover costs without the allowances.

Last week, a teenager came in to get a prescription filled and, as Ms. Winn puts it, “was overmedicated.”

The 19-year-old was on six other prescriptions.

“When he came to the counter, I could just tell by looking at him, he didn’t understand a word I was saying.”

The pharmacy spent about 20 minutes to a half hour on the phone with the doctor and talking to the man about how to manage his medications properly. Ms. Winn admits she’s not sure what that time is worth.

In that case, I’ll tell you exactly what that time is worth: $50 (damn, another case for capital numbers). Yes, that is pretty much exactly the definition of a 30-minute consult under the MedsCheck program. A pharmacist reviews a patient’s medications, and bills OHIP for providing the service (and of course, they have to actually account and bill for those services, instead of just handwave and rake in the cash like under the old system).

I’m going to conclude by stealing the thunder from another article I’ve been working on: health care costs are going to be perhaps the defining issue of the coming decades, due to population demographics as much as anything else. I completely support the government’s effort to start getting prescription costs under control now, even if it pisses off a few druggists.

Shoppers Drug Mart has decided to strike back at the Ontario government’s plan to rejig how pharmacies are paid by cutting hours in many London-area stores. London was probably chosen since Deb Matthews is both a local area MPP and the Ontario Health Minister, rather than because of its long history as a test market. This is a classy move.

Shoppers has been the darling of many a Canadian investor’s eye: they’ve been growing like crazy the last few years, and pay a dividend to boot. However, even before this, I wasn’t too keen on the SDM story. I used to love Shoppers as a consumer. They were open late or 24 hours, they had, like, everything, and it was all reasonably-priced. Then a few years ago they started jacking the prices up; just last week I went in to get some half-priced Easter candy, picked up some OTC drugs too, and came home… I was checking what I bought, and even though I paid the price I usually pay, I found the packages were half the size of what I got from Pharma Plus last time — they’re now charging twice as much as Pharma Plus! Since this wasn’t just candy but expensive medicine, I took it back, and went to Pharma Plus instead. Yes, their Optimum program is one of the better loyalty programs out there, and yes their stores are bigger and better and stocked to the gills with everything and (until now) open later… but I don’t think I’ll be going back unless there’s a blockbuster sale sometime. This is, of course, years after we stopped going to Shoppers for actual prescription drugs because their dispensing fees were ridiculous — again, double what many other drug stores charge (and what my drug plan covers!).

Plus a lot of that juicy growth has been in expanding the square footage of their older, smaller stores. There aren’t many of those left, and with almost half as many SDMs in Canada as there are Tim Horton’s, I can’t see a whole lot of growth left for ex nilhio locations. So that pretty much leaves their high-margin beauty and cosmetics business as the only place left to continue growing. I think that actually will work out fairly well for them, but it’s not the rock-solid recession-proof pharmacy business that investors are being sold on.

I should say that I do have a bid sitting open for SC, but at $35.50 I don’t expect to get filled since the panic over the drug plan rules seems to be fading. At its current price ($38) I think it’s probably a decent enough buy for the low-growth long-term story, but I’m not convinced it’ll shoot the lights out of the broader market index, so I might as well buy that.

John Hempton just put up a post about why he is short First Solar. I got out of FSLR just a month after getting in, in large part because it had a nice little rally that brought it closer to the upper end of my value range, and also in part because I realized that I have very little idea of their competitor’s economics, and could have been too optimistic in my initial estimates.

His preamble on why technology stocks can flounder in the long term is great. I’ve been looking on and off at RIM: on the one hand, even if they lose market share over time to Apple and Google for smartphones, more and more people are getting smartphones (I might even get one soon!), so it’s a declining share of a market that’s growing rapidly, so absolute growth should still be there. On the other hand, 4 years ago I got my Motorola Razr, and they seemed to be near the top of the cell phone game at the time, yet now are floundering (and similarly, their stock price is down ~50% in that time). Sentiment (especially consumer tastes) can change quickly. Right now people want to surf the net and level their pool tables with their phones, but if the next generation of voice devices is the size of a bluetooth earpiece now, the trend may revert to tiny and voice-only.

As for the specifics to First Solar, I’m kind of neutral on it now, but lean long, so I have some thinking to do on JH’s post. Questions that come to my mind though:

Silicon prices, are they temporarily low, or will First Solar’s edge in pricing disappear? If the low silicon prices are a temporary nadir due to the recession (and many raw material prices crashed last year), then their competitive edge may return. Unfortunately, a quick Google search suggests that the crash in prices was due to the supply-side expanding extremely rapidly and overshooting demand… so low prices will probably stay for a while.

Political risk has always hovered over this company — it (indeed, any solar company) depends pretty heavily on subsidies to make the economics work. However, on the short side, if the US gets serious about greening its grid and starts to introduce subsidies, that could delay declines for a while longer. I had hoped that would be the case when I was long, but still haven’t heard anything about that. Up here in the great white north, our federal rebates are over, and the provincial power purchase subsidies are due to expire shortly, and there hasn’t been word of renewing them.

However, his insight into the new technologies that allow less silicon to be used for wafers (further reducing the cost of the technically superior crystalline panels) may be the killer. The question then is what is the volume capacity in that world, and how long will it take for the crystalline competitors to catch up to take over First Solar’s market?

I just finished reading Michael Lewis’ The Big Short this weekend. It was a pretty quick read, and fairly informative on just what sort of shenanigans were going on in the CDO market of repackaged subprime loans. Even though I’ve been reading about these for something like two years now, I learned more scary facts about them. The book comes off as a really long newspaper article (albeit a rather good one), quoting the people who were there, and retelling the story of the guys who figured out early on what was going on, but there isn’t a central narrative (aside from subprime itself). Not too many of them seemed to grasp (or care about) the societal clusterfuck that would be unleashed if they were right until it was nearly upon them — they were just trying to make a buck on a mispricing of risk.

He has a few very interesting anecdotes about the generation of these financial instruments and the people behind it all, and it does contain a good explanation of what exactly a CDO is if you still haven’t picked that up.

I found it amazing that the raters (Moody’s, S&P) were so complicit in all of this. He makes a good point that our system is not set up to incentivize the “cops”: raters and regulators are paid far, far less well than the traders they’re trying to monitor. As a result, generally the “dumb” finance guys end up in those positions, and they get walked all over by the smart money (indeed, the big bucks in finance draw away some bright minds from physics, math, engineering, and even medicine who might do more societal good in those positions, rather than coming up with complicated computer models of how to redistribute capital). Some of these characters in the book who had figured out that these groups of subprime mortgages were doomed to fail asked the rating agency people to do a better job of rating the paper, since it obviously wasn’t AAA. Of course, they were doing that because they wanted the ratings lowered so they could make money on their shorts, and not out of some altruistic motive, but still. They pointed out things like how high default rates were in a period of rising house prices, and asked what their models said would happen to all this stuff if housing went down, even modestly — the ratings guys said they didn’t test negative numbers when rating the bonds.

I was also surprised to hear of just how dodgy some of these CDOs were created. I knew that they took a pile of mortgages, say 1000 of them, and grouped them together, and then created tranches, or levels. Each level suffers defaults in a certain order: the lowest level takes the hits of defaults first, and if just ~8% of losses occur in the underlying mortgages, that level is wiped out, and it gets some low rating from the agencies (BBB-). The top level has a fair bit of protection, some high number of losses must occur before they’re wiped out, so that stuff gets rated AAA. Then what I found out is that first off, the characteristics of the whole group of loans was only ever described on average: so a group of 1000 loans to borrowers with a credit score of 610 was rated the same as one to 500 borrows with a credit score of 510 and 500 with a credit score of 710, yet the second pool was much more likely to suffer huge losses that would wipe out the bottom few rungs of the bond ladder since any small economic setback would lead someone with a score of 510 to default. Secondly, there was so much demand for these asset-backed securities that the firms started creating synthetic CDOs: they’d take all the lower-level paper (rated BBB) that they couldn’t sell because it was too risky for people to buy, then create a new tower of paper and tranche it out, and again the top level would get an AAA rating, even though it was entirely composed of the low-rated dreck they couldn’t sell individually. The theory was that not all the bad paper would go bad at once, so the top level would have protections similar to the group of 1000 mortgages. Except since this was all the paper that went to nothing with ~8% losses on the underlying pools of mortgages, anything that affected all those mortgages at once, even if just a little, would make this whole tower worthless… the risk models were in no way reflecting the reality of the situation. Then on top of that, when they started running out of mortgages to reshuffle, they made CDOs out of the credit default swaps these shorts were buying, just synthesizing securities out of whole cloth.

There was one anecdote in particular that really blew my mind though: The tale of Option One, which was creating subprime loans that were so bad, people were defaulting in the first month. I had some idea of how bad the subprime lending was in the US. I know that it’s better in Canada, but I’ve always held that it was merely a matter of degree and not of kind, and that as our market got away from fundamentals, a correction would be needed. For a brief instant when I was reading about how bad some of this stuff was, I started to wonder if the “it’s different up here” crowd might actually be right… then I remembered that in Toronto and Vancouver, you can’t buy a house/condo today and expect to make a profit renting it out in the long term (i.e., when rates return to something resembling normal).

I look to be in dead last:

HBU is up, but I had shorted it (-0.6%)
FRE-W is down a bit, but the more liquid -Z preferred issue is up (-11.6%)
IM is up to $6.64 (+25.3%)
AONE is down to $13.74 (-38.8%)

If my math is right, these picks are down 25.7% overall on the quarter (note that my real-life investments are not this risky and have not been as terrible!)

Note that this is a game with a set end-date so looking for value is not necessarily the way to go — often a shoot-the-moon approach works well in these kind of games. So bear that in mind, and don’t consider any of these as recommendations for you to actually buy!