2014: The Year of Cost Controls

With the New Year just two days away, key provisions of the Affordable Care Act (ACA) are about to kick in. Investors in the health care sector should pay careful heed.

On January 1, private coverage purchased through the state and federal health care exchanges will be taking effect, assuming consumers were able to navigate the bevy of technical glitches that plagued the federal system.

According to the Obama administration, more than 1.1 million people enrolled in coverage through the federal exchange site between October 1 and December 24, the last day that consumers could sign up and still receive coverage effective January 1.

That figure comes just shy of 1.2 million people the administration originally projected would sign up, but it also doesn’t include enrollment numbers from states that run their own exchanges or an estimate of how many Americans signed up for coverage under the expanded Medicaid program. That said, in early December the administration estimated that at least 803,000 people have been deemed eligible for Medicaid or the Children’s Health Insurance Program because of the ACA.

January 1 will also see the end of coverage restrictions based on pre-existing conditions as well as limiting how much insurers can boost coverage rates based on age, geography or tobacco use. Annual coverage limits will also come to an end.

The New Year also brings the individual mandate with it, though consumers have until March 31 (which is also the day open enrollment in the marketplaces ends) to have coverage in place before the penalties begin. Anyone without insurance by that date will face a fine of $95 or 1 percent of taxable income, whichever is higher, when they file their 2014 taxes. The penalty increases to $325 in 2015 and $695 by 2016.

Minimum coverage requirements, which were the driving factor behind the millions of policy cancellations a few months ago, are a! lso kicking in, forcing insurers to cover services such as hospitalization, pre- and post-natal care, mental health services and a whole host of others.

With the new rules now taking effect, we’ll finally begin seeing the steady ramp up in volume growth as a growing pool of insured patients enter the market with access to more services than before.

Unfortunately, though, some of those volume gains will be offset by cost control features of the ACA such as reimbursement pressures under both the Medicare and Medicaid programs, and industry taxes such as those on medical devices and new fees. So the biggest open question in the health care industry for 2014 will be just how big of a boost it will get from the ACA.

As I’ve written on numerous occasions, I look for the deepened patient pool to result in a net gain for most health care companies regardless of cost control pressures. But I suspect those companies that have less exposure will be the top performers at least in the first half of the year.

Express Scripts (NSDQ: ESRX) is one of those companies that is largely immune from cost control measures and will most likely even benefit from them.

It’s the largest pharmacy benefit manager in the US, serving more than 150 million patients and covering more than a third of all the prescriptions written either through local pharmacies or through its own mail-order pharmacy.

Given the bargaining power the company enjoys by virtue of its sheer size, it benefits from keeping prescription costs down and encouraging the shift to greater utilization of generic drugs which widens the company’s profit margins.

Operating margins have already been increasing for the company, up by nearly 2 percent in the company’s most recent quarter alone, while revenue on an adjusted claim basis increased by 6.5 percent. Operating profit shot up 17.3 percent, as more than 80 percent of the prescriptions it handled were higher margin generics.

Despite ! that soli! d performance, shares are currently trading at just 0.6 times trailing 12-month sales while its forward price-to-earnings (P/E) ratio is just 13.8 compared to its 30.4 P/E on a trailing basis.

I’ve been covering the company for more than two years now, having first noticed it when it was in a pricing dispute with Walgreen Company (NYSE: WAG) and working to complete a merger with Medco Health Solutions but there were concerns that the government might scuttle the deal. I haven’t seen the company’s shares this cheaply valued since then and it’s entirely due to investor worries over the ACA.

With the ACA set-up to be more of a help than a hindrance to Express Scripts’ business model, the stock is a buy up to 78.

Dr Reddy’s Laboratories (NYSE: RDY) will be another major beneficiary from both volume increases and cost controls.

It is the second-largest pharmaceutical company in India and a leading manufacturer of generic drugs. While nearly three quarters of the company’s revenues are sourced in India, its revenues here in North America grew by 43 percent in its second fiscal quarter of 2014.

That growth was almost entirely due to increased generics penetration, a trend that will only accelerate in 2014, particularly as Dr Reddy’s pushes into the biosimiliars market.

Biosimiliars are generic versions of biologic drugs such as Humira (a rheumatoid arthritis treatment) which are made from living microorganisms. About 150 biologic drugs are approved for use and many of them have lost patent protection over the past 18 months.

Dr Reddy’s is beginning to push into biosimiliars, taking on a European partner to begin marketing a biosimiliar drug in the region, a generic version of Johnson & Johnson’s (NYSE: JNJ) rheumatoid arthritis drug Remicade.

A successful entry there would bode well for the drug’s entry here in the US market, especially since the ACA created a streamlined process for a! pproving ! biosimiliar drugs shown to be essentially interchangeable with a biologic drug already approved by the FDA. The goal is to control costs in a class of drugs that are experiencing phenomenal growth, but which cost thousands of dollars per year largely due to the more complicated manufacturing processes.

With the ACA tailor made to encourage the growth of Dr Reddy’s Laboratories, the stock is a buy up to 43.