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2 Big Back-Alley Brawls Break Out in Washington Over Policy

This week, Aetna (NYSE: AET) reported plans to cut its presence in Obamacare exchanges by 70%, joining UnitedHealthcare (NYSE: UNH) and several other insurers in the growing pool of healthcare companies that are exiting the Obamacare exchanges.

On this episode of Industry Focus: Healthcare, Kristine Harjes and Todd Campbell explain why companies like Aetna, United, and others are fleeing the exchanges, how they could make the exchanges profitable (or at least manageably unprofitable), and what opting out will mean for these commercial insurance companies and the Obamacare program.

Also, the hosts take a look at the recent DEA announcement on the scheduling of marijuana and how investors should look at investing in this still-incredibly-volatile nascent industry.

A full transcript follows the video.

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This podcast was recorded on Aug. 17, 2016.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today, we'll be digging into some healthcare sector trends, specifically insurers fleeing the Obamacare exchanges, and some issues around the federal scheduling of marijuana. I'm your host, Kristine Harjes, and joining me via phone is Motley Fool healthcare contributor, Todd Campbell. It's August 17th, which, Todd, did you realize that it is Portola day?

Todd Campbell: I did, actually. I've been watching all day long, the news feed.

Harjes: So, one of my favorite biotech stocks is called Portola Pharmaceuticals. If you've been listening to the show for a while, you've heard us do a deep dive on it. Even though that's not what we're going to talk about today, there's a very important decision coming out about one of Portola's lead drugs today, whether or not it gets approved by the FDA. So I've just been refreshing my internet feed all day long, looking for this announcement.

Campbell: Me, too. It's going to be a big deal for Portola one way or another, and, obviously, for shareholders. If you've been following us here on the show, this is definitely a day to punch it up and see whether or not it's good news or bad news day for them.

Harjes: Yeah. I'm excited. But like I said, that's actually not what we're going to be talking about today, particularly because we don't have the decision yet. Our first topic of the day is Obamacare. Aetna, which is one of the major health insurers, announced yesterday that it plans to cut its Obamacare exchange presence by about 70% ish. It was present in 778 counties, and now it's cutting back to just 242 counties. What does that mean for Aetna and for Obamacare?

Campbell: We have a good old fashion back alley brawl here between insurance companies and Washington. And there's a lot of backstory, Kristine, that you and I are going to talk about for our listeners that I think is pretty fascinating. The nuts and bolts of this is that you've got insurers participating on the exchanges through Obamacare that are losing money. And, obviously, that's not what companies are in the business to do. So, as a response to that, Aetna is the latest company of these insurers to say, "You know what? We're going to reign in significantly our participation." -- as you noted before -- "significantly reducing the number of counties that we participate in, and significantly reducing the number of states that we're going to be doing business in." Aetna's taking their exposure to the exchanges down to four states from, I think, 15.

Harjes: Right. And that's because they reported ... Well, there are kind of two reasons here. The first that you touched on is because they just haven't been profitable, these exchanges. Aetna reported a loss of $230 million on Obamacare in the second quarter. They cite rising utilization, which, really, what that gets at is, Obamacare patients are just more expensive than anybody was anticipating. None of these health insurers realized just how difficult it would be to price these plans properly in order to actually make money on the exchanges. So, what you're seeing now is this mass exodus from them, where they're throwing their hands up and saying, "We don't want to keep losing money on this." 

When you look at a company that's losing money, it boils down to two options: you can either cut your costs or bring in more money. If you're going to bring in more money, you need to actually raise the prices of your plans. But the other option there, with the other issue at heart here, is what happens if these companies decide to try to team up and maybe lower their costs via some synergies, via some mergers? And that is the other really interesting side of this story.

Campbell: Right. You have Aetna, specifically, looking to combine with Humana (NYSE: HUM). Humana is another insurer, they have a huge Medicare business, but they were also participating in 19 states' exchanges for Obamacare. And the thinking was, "OK, if we leverage all of this size against fixed costs, get rid of overlapping positions and the like, then we're able to turn more easily a profit." Aetna had said previously earlier this year that it expected to break even on its Obamacare of business. It even actually indicated that it could expand into more states, going from 15 states -- I think it was -- to 20. So, this is a fairly rapid deterioration in their risk pool. 

You talked about, how do you price these plans and charge the premiums so that you can turn a profit if you don't really know how healthy your members are going to be? And it's been very much struggle trying to get healthier younger patients to sign up for Obamacare. Obviously, people who signed up originally were those who were the sickest, because, you know, they needed insurance. And that's great. And I don't think that's what these companies are saying, that these people don't deserve to have access to care. I think what they're trying to say is, "Listen, we need to find a way to be able to make this profitable for ourselves and our investors." No one's going to cry any tears, though, Kristine, for these companies over their lack of profitability in the bigger picture, right?

Harjes: Shareholders might.

Campbell: Yeah. Investors will always look at it from the perspective of -- or they have a tendency, sometimes, to look at it from the perspective of -- "What have you done for me lately?" And they look at the profitability of each of these companies on a quarter-to-quarter basis. I think an argument could be made for long-term investors to look at it and say, "Isn't it better for you to continue to participate in these exchanges, even if they're operating at manageable losses, as long as the end game suggests that you'll reach that scale where you've got the right premium for whatever care those patients are going to need."

So, there's two ways of looking at that: the short-term view of saying, "OK, yeah, but if we stop participating in these programs, right away, I can add $300 million to my bottom line in 2017," versus, "OK, well, now I'm no longer getting the experience of operating in these markets, experience that could be beneficial if these turn out to be very profitable markets -- say, five years from now -- because of policy changes or anything else."

Harjes: I mean, I think Aetna did have that kind of long-term view. They wouldn't have continued to be in these markets, and they wouldn't have planned on expanding their presence on the exchanges, if they didn't have that sort of long-term mentality.

Campbell: Which begs the question, right, Kristine -- what's changed?

Harjes: Exactly. That's your big "but ... " here. So, the Department of Justice sued recently to block Aetna's proposed merger with Humana, which was a key part of Aetna's strategy. I'm quoting right from Aetna's CEO here. He says -- and before, he had been talking about how they had been on the public exchanges since the beginning of 2014, they had been losing money, blah blah blah -- and he goes on to say: "Our ability to withstand these losses is dependent on our achieving anticipated synergies in the Humana acquisition." And then, he goes on to say, essentially, if the DOJ blocks this transaction, their hands are tied, they're going to be forced to reduce their exchange footprint. Which might be true, but, I think the even more interesting reason behind this is, that's them playing this strategic game with the Department of Justice, saying, "You know, you don't really want to block this merger."

Campbell: Yeah, it's throwing the gauntlet down, almost, and saying, "Listen, we actually will consider expanding into more markets, if you OK this deal, because we think we can better afford to operate within the exchanges as a combined entity. But if you block it, then who knows how this is all going to play out? I think there's a little bit of gamesmanship going on here. You have to remember that, even despite the drag on earnings from the exchanges last quarter, Aetna remains nicely profitable. I think their net income was about $800 million. Actually, if you look at United, Humana, and Aetna, and combined their net income over the course of the second quarter, it comes out to about $2.8 billion, despite the ACA headwinds. 

There could also be, not only this undercurrent of quid pro quo, you passed my deal and I'll expand my exchanges, but it could also have something to do with the fact that part of the risk corridors and the reinsurance provisions of the ACA that have been smoothing the profitability across the industry, those are expiring at the end of this year. So, they're looking at 2017 and they're saying, "OK, we're not going to get the benefit of reinsurance risk corridors," which, again, have been smoothing profitability across the industry, "and that means there's a lot of uncertainty regarding how we should be pricing our plans for next year. Why take on that uncertainty if the DOJ isn't going to work with us on leveraging a bigger foot print?"

 Todd, can you remind our listeners what exactly the risk corridor was?

Campbell: Sure. Risk corridor, basically, what they do is they collect money from plans that are profitable, those plants that have had extraordinary, unexpectedly high gains, and then they redistribute those to the plans that have had unexpectedly high losses. It was a way of helping to reign in the need to price these plans at such a high level to guarantee profitability. It was the way for Washington to say, "Listen, we want you to participate, and we're going to provide a little bit of insurance to the insurers to make sure you don't lose your shirt by being part of the exchanges."

Harjes: Exactly. So, before we move on to the second part of our show, I want to bring back to you our investing take away. That's what we're doing this show for. Todd, what do you think, looking at this recent news and everything going on with the Department of Justice and these proposed mergers? How should an investor be looking at this?

Campbell: I think that United Healthcare, of the companies that have said they're going to walk away, is probably the one with the least question marks, only because it doesn't have the Department of Justice overhang. If these deals get scuttled by the DOJ, Aetna's going to have to pay a breakup fee. So, that's a drag on earnings. Then, there's the uncertainty of, how will all these changes shake out? I don't know, I think it's best for most investors to avoid these names until we get a little bit more clarity. If you're really interested in insurance, maybe focus instead on some of the Medicaid players, or some of the other stuff, rather than the commercial insurers.

Harjes: Sounds good. OK, so, as promised, moving on to the second half of our show today, we want to talk a little bit about marijuana and its federal scheduling, meaning how the federal government classifies the drug. Last Thursday, there was some news that came out that the Drug Enforcement Agency will keep marijuana as a Schedule I substance, meaning that there are no accepted medical uses and a high potential for abuse. This comes on the heels of a push to get marijuana rescheduled to Schedule II, which would mean that it still has a high potential for abuse, but it does have accepted medical uses. In the press release, the DEA cited that the drug's chemistry is not necessarily known, it's not reproducible, there aren't enough studies out there on its safety, there aren't enough studies proving its efficacy, and essentially, the evidence just isn't there to support reclassification. What do you think, Todd?

Campbell: This is something that you and I have talked about a lot. People who listen to our show understand the value of highly controlled scientific trials. I mean, the ability to prove beyond a shadow of a doubt that the reason someone is getting an improved outcome is because of whatever they're taking. Absent that kind of proof -- and unfortunately, the FDA's review of the information that they have available to it, was unable to find that proof -- absent that proof, the HHS could not go to the DEA and say, "Yeah, we think there's truly a medical benefit associated with taking marijuana that's scientifically provable."

That really put the DEA in a box, because marijuana is listed in the Single Convention on Narcotic Drugs, an international treaty. It has to be either Schedule I or Schedule II and the only difference between Schedule I and Schedule II is having a medical use component of it. So, the DEA kept it at Schedule I, and unfortunately, that deals a little bit of a blow to marijuana policy advocates who really have been doing a very good job of moving forward as far as decriminalizing marijuana and increasing the ability to use it nationwide.

Harjes: And I'd like to point out a bit of a catch-22 going on here, which actually was made clear to me by one of our other Motley Fool healthcare writers, Cory Renauer. He noted that the DEA based this decision on a recommendation from the HHS, which based its recommendation on an FDA review that cited the lack of available evidence to determine that marijuana, in its natural state, has an accepted medical use. And this lack of available evidence cited by the FDA is a direct result of marijuana's Schedule I status, which is enforced by the DEA.

It's like, you have this cycle here where, until you can get better evidence on marijuana, you can't loosen the restrictions on it, but it's really, really hard to study it, particularly in its natural form, because of its scheduling.

Campbell: Right. It's Schedule I, which means that you have to get it from one grow facility, a grow facility down, I think it's in Mississippi. You have to comply with all sorts of regulations on the storage of it, you get recording of it, how you use it, everything -- all of these road blocks that are put up against the scientific research into its benefit. That means that nonprofit researchers -- those at universities and such -- are less likely to embrace that kind of research than, say, for-profit companies that maybe have deeper pockets and access to capital via stock offerings and the like.

Harjes: Right. And interesting like, they are actually expanding the number of DEA-registered marijuana manufacturers. Previously, there was just one, as you had mentioned. But now, hopefully, there should be a couple more coming on board. That is a slight relaxing of the restrictions, but ...

Campbell: Right. It's like the DEA said, "Look, we can't give you what you want, but maybe we can meet you halfway, and if we can provide more supply, then maybe that tears down or breaks down some of these barriers to research." Although, looking around and talking to people who are doing the research, it doesn't necessarily seem to be that the supply is the biggest issue that's preventing that. So, I don't know, we'll see how that plays out. 

We also have another entirely different dynamic at play here, because after the announcement came out of the DEA, spokespeople for Hillary Clinton -- who, as everyone knows, is running for president -- have come out and said that if she's elected, she would make it a Schedule II drug. So, that opens a whole other can of worms.

Harjes: Right. Clinton has also referred to the laboratories of democracy states rights argument, saying basically, "We should let states figure it out for themselves, the states where it's currently legal. And after we have a little bit more evidence on what actually happens within a state when you have either medical, recreational or both, legalized, then, where do we go from there?"

Campbell: Right. And the other thing the FDA did on this -- I don't want to forget about this -- the other thing the DEA did is, when they were talking to the FDA, the FDA came out and said, "OK, well, we can't show you that there's proof that marijuana is helpful, but what we can do is provide a little bit of guidance toward researchers and how they should design their future studies." And they offered up some different insight, including making sure that any studies that get down from here are not dosing marijuana via smoking, they're using either tinctures or some other way of being able to evaluate it. It seems like the ball moved slightly forward, but you certainly didn't get a first down.

Harjes: I think it's also important to go back and say, "Alright, why are we talking about this to begin with on Industry Focus, which is primarily an investing focused show?" The marijuana industry sounds like it would be really lucrative for investors. There's research out there that estimates 30% annual growth in the cannabis industry for the rest of the decade. Legal marijuana sales hit an estimated $5.4 billion in 2015. This trend looks poised to continue with 58% of respondents to a Gallup Poll supporting nationwide legalization. So, I totally understand why you have investors out there salivating at the prospects of getting in on this industry.

Campbell: Right, this would be like us talking about alcohol during the Prohibition. What will happen if they repealed Prohibition? And, of course, we ended up with huge companies, Coors and Budweiser and the like, that were investment-worthy, if you will.

Harjes: Exactly. And we do currently have a couple of companies that are operating legally and are in this industry. But, of course, it is also very much a speculative industry at this point.

Campbell: It's a wild west. I wouldn't recommend that any investor goes out for all marijuana stock, per say. There are two drug makers that are doing FDA-quality research and conducting programs, and those are: GW Pharma (NASDAQ: GWPH) is one of them, and Insys Therapeutics (NASDAQ: INSY) is the other. Those are two companies that investors can consider. They have pros and cons to them. But those are, at least, two real companies with real potential chances to get FDA product approved that are based on marijuana, and be able to generate revenue and profitability someday down the road.

Harjes: And Insys, I'll point out, is not primarily focused on marijuana. GW Pharmaceuticals is pretty much your only bet if you want a pure play marijuana stock that's not trading on the pink sheets for pennies.

Campbell: Right. They're doing research into the use of CBD, which is a chemical compounds found within the marijuana plant. CBD has been demonstrated in early -- and now in some late stage trials -- to be very helpful in the use of controlling epilepsy, epileptic seizures in epilepsy patients. There could be a filing for FDA approval for this drug as early as 2017. We'll have to continue to keep an eye on them. But you're right, they are the only pure play company of substance that I think investors ought to consider. But, of course, there's other risks there. They're not profitable yet, they're spending money on this research and they have nothing to show for it yet.

Harjes: Of course. Interestingly, I think this DEA ruling could actually benefit GW Pharmaceuticals. When you think about a Epidiolex, it is made from this liquid form of something that you extract from marijuana. It's not just, "Here, take the marijuana leaves and smoke them." It's completely other side of the ballpark from that. So, if the DEA had announced that all of the sudden, everybody can start studying marijuana in its natural form, in a smoked form, something like that, then you could potentially get these studies coming out saying that marijuana, in its natural state, is just as good as Epidiolex. And that would destroy its pricing power. So this is actually kind of good news.

Campbell: Buy from Charlotte's Web Dispensary, rather than having to get prescribed Epidiolex from your doctor.

Harjes: Exactly. Yeah, I thought that was interesting element of this story. So, that's pretty much going to do it for today's episode of Industry Focus. Remember that we have our investing in pet healthcare show coming up, and we're looking to feature your voice on the show. Leave a message at 866-677-3665, which is 866-MRS-FOOL, and tell us your best "Why I had to take my pet to the vet" story, or leave us a tip about saving money on pet healthcare. 

As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Kristine Harjes, and on behalf of myself and Todd Campbell, thanks for listening and Fool on!

Kristine Harjes owns shares of Portola Pharmaceuticals. Todd Campbell owns shares of Insys Therapeutics and Portola Pharmaceuticals. The Motley Fool recommends Anheuser-Busch InBev NV and UnitedHealth Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.