The biotech industry is fundamentally different from nearly every other industry in the economy. The way biotech is structured affects the way we write about it, analyze it, and invest in it. Those who make it their business to know more than just the basics of what's going on should ask themselves these questions: For any given new drug in the pipeline, how important is price versus safety and efficacy? Is a low price for a new drug even a good thing, or would investors, paradoxically, prefer to see a more expensive drug hit the market?
In almost every other industry, companies compete with one another to produce the best products at the lowest possible price. This is what free market capitalism is all about. Companies competing with one another to satisfy consumers' desires in the cheapest way possible is the very thing that raises our standard of living. It's why the average lower middle class working stiff leads a much more physically comfortable life than any medieval nobleman.
Generally, when two competing companies come out with similar products, investors ask themselves who will undercut whom, how much will the new product cost? Who will offer the cheaper product of a given quality, and may the best entrepreneur win.
This isn't really the case with biotech. While it certainly does not apply in every case and there are of course price limits, there is a clear tendency in biotech to applaud high price tags. To cheer for example when a new cancer drug comes out that will cost patients $10,000 a treatment (as the much hyped and famed Kyprolis costs), not to worry too much about competitors that may come in and undercut that price. That is a concern, but only secondarily, and usually only if a new drug is wildly expensive even for insurance companies. The primary concerns are always FDA approval followed by getting the medical community acquainted with the new treatment so doctors can start billing insurance companies. Price doesn't seem to factor all that much into the equation. We assume that the price will by definition be paid by the consumers regardless and then we start calculating in our heads how many prescriptions it will take for revenues to reach the $1B mark, which is why people are happier if the drug costs $10,000 instead of, say, $8,000. How and why is this the case with biotech?
Mandatory Insurance Warps Demand, Market Exclusivity Warps Supply
The problem with biotech, as it always is with prices, is supply and demand. Both are heavily warped by forces exterior to the market, and this creates a systemic danger to the entire biotech industry, a danger which I will explain shortly.
On the Demand Side
It is natural for the price of life-saving drugs to be much higher than other goods because, all other things being equal, the demand for life is much higher than the demand for any other good. But the amount of GDP being spent on healthcare is rising every year, and that cannot be explained by a snapshot demand curve in time.
According to Aetna, healthcare spending was $2.6T in 2010. That is 17.4% of total nominal 2010 GDP. In 1970, it was $75B, 7% of the total that year. That's 2.5x more health care spending per capita in 40 years. Either Americans are using 2.5x more healthcare services per capita than they were 40 years ago, or health care is 2.5x more expensive. The ugly truth is both. And the even uglier truth is that these two factors feed off each other in a positive feedback loop of higher usage/higher cost.
What are the extra market forces causing this money vacuum feedback loop? On the demand side is mandatory health insurance. The "employer mandate" is not something new to the scene since Obamacare. It has in fact been around since 1951 when the IRS declared employer-based health insurance a tax deductible business expense. The minute you have government taxing one thing for employers but not taxing another thing, demand for the thing not taxed grows beyond what it would have been naturally had employers not been taxed at all. With the added benefit of health insurance expenses becoming a tax shelter, money started crowding into it beyond the necessities of the services the insurance actually provided, and more for the benefit of it being tax deductible. More health insurance please. Additionally, the very fact that the employer is the broker between the insurance company and the healthcare consumer (patient) pushes up demand even further because the consumer does not directly pay for the service, so he cares less about what it costs, as does the employer, because again, every dollar spent is tax deductible for the employer anyway.
After 1951 came Medicare. When Medicare was introduced in the 1960's, demand was even further stimulated. If the government is paying for it, the consumer may as well splurge. It got even more extreme with Bush's Medicare Part D which targeted prescription drug demand specifically. All of this artificial demand has led us to the point where we are today: Only 9.8% of the massive amount of people with health insurance coverage have purchased it directly. The rest have either employer-based or government-sponsored insurance policies. The Obamacare employer mandate will only push demand to even more grotesque heights, as most employers will be actively forced to provide insurance instead of just being passively lured by a tax credit.
To complete the demand side of the picture, the current situation puts the insurance companies in almost complete control. This is not to fault them, because in order to support such a massive clientele liable to overuse the service as they are not directly paying for it, insurance companies need to be able to dictate what prices doctors can charge for just about everything or else lose control of their balance sheets and go under.
In a business where there are so many external non-market forces pushing demand wildly up, it is no wonder that investors cheer higher prices to support that demand. High demand requires higher prices. That's just economic law. And we assume almost any price will be paid by the end consumer. After all, he's covered by insurance he's not even directly paying for, be it government or employer. Bring on the ultra-expensive drugs.
What happens if all insurance is simply rejected? One Dr. Michael Ciampi in Maine decided to do just that in his local practice. As you can see in his price list, prices plummet. Unfortunately, insurance can only be rejected in the case of decentralized doctor services. It cannot be rejected for centralized pharmaceutical goods put out by the biotech industry.
On the Supply Side
When demand goes up, all other things being equal, price goes up. When supply goes down, all other things being equal, price goes even higher. And what is constricting the supply of new drugs? Market exclusivity grants based on patents. I'm not trying to make the case that there should be no patent protection or time-limited exclusivity rights on new drugs. Obviously there should be. I'm just stating what the facts are and the economic consequences of them.
A new molecule drug is patent-protected for 20 years from the moment the patent is issued. Since companies apply for patents during clinical trials and sometimes even before, the number of years the patent lasts on the market varies. Nevertheless, a patent-protected drug has automatically limited supply, being that one company simply decides what that supply will be with competition outlawed. Immediately when a drug goes generic, supply rockets and price drops drastically.
While the main problem is artificially stimulated demand via bloated insurance laws and tax regulations, constricted supply exacerbates the problem. Patent-constricted supply plus heavily stimulated demand equals extremely high prices.
The danger of skyrocketing prices to the biotech industry
Depressions come about when the supply of money in an economy drops suddenly after a protracted expansion. When the supply of money goes up, producers use the money to produce more goods and services. If suddenly the money supply goes down because more people for whatever reason take cash out of the fractional reserve banking system (in our current 10% fractional reserve system the money supply contracts by $10 for every $1 taken out in cash), consumers do not have the amount of money necessary to buy those goods and services at prices that would be profitable for the producers when they were produced at the higher money supply levels. This leads to one of two possibilities:
- The producing firm sells their stock of goods and services at drastically lower prices for a loss and the consumers benefit, while the economy readjusts to the new, lower price level with bankruptcies and capital changing hands
- The central bank prints more money to reflate the original price level, and everyone shares the pain of inflation and the boom/bust business cycle begins anew
This is what happens every time the money supply expands and then contracts, epicentered in whatever sector the money was mainly going into during the monetary expansion. Last time it was housing. But the artificially stimulated demand for housing is not like that of biotech. There is no insurance company buying houses for people. People buy houses with their own money, or money they borrow from other entities. Either way it's a direct transaction with the end consumer ultimately responsible for the money he used to buy the house. If he doesn't have it, the house goes up for sale cheap and prices start to plummet. The price of prescription drugs, however, can keep going higher even when money supply declines because insurance companies, latched on to the entire economy with an entry point at nearly every employer, can and will keep sucking up all the money needed to support the current pharmaceutical price structure. Again, I am not assigning blame here. Insurance companies need to stay in business, too. This is just what happens when demand and supply are completely out of whack.
But this can only go on for so long. The amount of GDP spent on health care can only go so high before the money simply is simply no longer there to support it, regardless of how many economic entry points insurance companies have to suck it out. No one knows what that point will be, but it's coming. When it does happen, many biotech companies will lose their shirts because the Fed will not be able to reflate again without destroying the currency.
In order to survive, Big Pharma, Specialty Pharma, and Little Pharma will all have to figure out how to lower their costs before they are all forced to do so by the market. A new business model needs to take hold, one that can lower prices even in the face of outrageously distended demand and constricted supply. I believe one company in particular, pSivida, (PSDV) can provide the biotech industry with a good model for how to proceed in lowering costs. What follows is less of a bullish case for the stock per se and more of an analysis of how pSivida's business model works to lower costs while maintaining profits and can and should be adopted by other biotech companies.
How pSivida lowers costs
pSivida's business model is basically to introduce nano-sized machines into the area of ophthalmic drug delivery, increasing effectiveness and, eventually, lowering costs. pSivida develops nano-sized ocular implants that are designed for sustained release of a given drug. It generally partners with other companies by providing the hardware while the partnering company provides the drugs that go into it. pSivida's first ocular drug implants have not been blockbusters, but with every advancement the company addresses a bigger market and could potentially increase the savings from these implants.
Its first product Vitrasert® was approved in 1996 for an obscure eye disease called CMV retinitis, which only occurs in late stage AIDS patients. It is licensed to Bausch and Lomb but royalties to pSivida officially stopped as of March 31. Royalties from Vitrasert have been immaterial for years anyway, as HIV treatments have improved significantly since 1996.
Its next FDA approved product Retisert® was approved in 2005 and licensed also to Bausch and Lomb for the treatment of posterior uveitis, a sight-threatening inflammation of the eye affecting 200,000 people in the US. Retisert is a tiny insert the size of a grain of rice that releases corticosteroids into the eye over a period of two and a half years. Retisert royalty to pSivida amounted to $1.4M (page 38) for 2012, substantially all of its royalties for that year. The rest of its revenues came from collaborative agreements with its partners. Total expenses since 2010 excluding impairment charges have been about $14.5M annually, so royalty from Retisert is not enough. Nevertheless, Retisert was a significant advancement for the company and proved the efficacy of its approach, but since posterior uveitis was generally treated with eyedrops beforehand, Retisert did not serve to lower the costs of treatment, only its efficacy.
pSivida's latest advancement brought to market is Iluvien, licensed to Alimera Sciences (ALIM). Iluvien is an ocular implant designed to treat diabetic macular edema, or DME, also by sustained release of corticosteroids for a period of 3 years. Due to serious side effects including increased ocular pressure, it is only approved for chronic DME patients who have not responded to other therapies, and only in Europe. As for the US, the FDA's decision on Iluvien for chronic DME is expected on October 17 (page 7). Despite pSivida's advances with Iluvien, it is still not cost effective at the proposed price in England. Also, two dozen insurance groups in Germany where most of the revenues are coming from have not yet made a decision to cover its costs. Still, pSivida has been improving its implant technologies, and I believe the cost lowering benefits are still to come, and they will come with Tethadur.
Tethadur would be the holy grail of nano ocular implants. It is basically a nano-silicon sponge with adjustable sized holes depending on what drug and how much of it needs to be released over a given period of time. Tethadur is in preclinical trials testing how insulin as well as Lucentis, Novartis' (NVS) wet AMD treatment, are released by Tethadur. To give you an idea of the sales size of these drugs, Lucentis sales topped $2.4B in 2012. Sanofi's (SNY) insulin drug Lantus reached $5B. We can't say if pSivida is pursuing a partnership with either Sanofi or Novartis with regard to these drugs (I would suspect not for Lantus at least, since insulin is injected in doses way too large for a nano-implant), but pSivida has published three press releases since April involving tech evaluation agreements with three "leading" and "global" pharmaceutical companies involving Tethadur.
Regarding Lucentis for wet AMD, current costs are $1500 per injection, and at this point repeated injections are required for treatment. If Novartis were to team up with pSivida on combining Tethadur with Lucentis, this is where costs could really be lowered as potentially only one injection would be required. Any expensive drug that requires repeat injections could end up being significantly cheaper when administered by a sustained release pSivida insert.
The question is, with Tethadur only in preclinical development, isn't it a long way until approval, if and when it comes? Yes, but here we come to the other aspect of pSivida's cost cutting benefits. Once clinical trials are conducted with one insert, pSivida can proceed straight to Phase III for the next drug application with that insert. Such it is doing with the insert used for Iluvien, proceeding directly into two Phase III trials (page 7) for a next-generation posterior uveitis treatment. This should be a comparative shoe-in (if any drug approval can be considered such) for pSivida as it already has an approved insert for that indication. That, and it is developing it independently, as Alimera was not given the licensing rights for treatment of uveitis. No more subsisting on royalties, at least in this case if and when it is approved.
The implications are that if and when Tethadur is approved for a single indication, the clinical pathway will be shortened by years for any indication that follows. This is where serious cost cutting happens - by drastically shortening the clinical pathway not only responsible for direct costs incurred by companies, but for the massive indirect costs embedded in the sheer amount of time it takes to get a drug to market. If costs for biotech companies go down, the costs of the drugs can go down without affecting profitability.
Back to the supply side
What's in it for Big Pharma? Why partner with pSivida? One partnership of pSivida's that isn't obscured in vague language about "leading global pharmaceutical companies" is its partnership with Pfizer (PFE). Pfizer is working with pSivida on what it calls the "latanoprost product" without saying much else. What we do know is that the "latanoprost product" is a pSivida insert designed for Xalatan. Xalatan is Pfizer's former blockbuster glaucoma drug. The patent expired in 2011, and sales last quarter were only $147M (page 65), Pfizer's third biggest sales decline for a single drug last quarter at 30%. The market is shifting to generic latanoprost.
If Pfizer successfully combines Xalatan with a pSivida's insert, the patent is renewed. That's what's in it for Big Pharma. And yes, restrictive patents will restrict supply and bring price back up, but not nearly as much as a shortened clinical pipeline will bring price down.
The entire insurance-based pharmaceuticals market structure needs to be scrapped and totally redone from scratch. With its given structure of parabolic price increases that do not abate, it simply cannot stand. At some point the money is going to run out and the price structure is going to reset itself with pharmaceutical capital and companies changing hands in restructuring as well. The companies that prepare for this by lowering costs now will weather the storm the best. pSivida as a company may or may not be the key to this specific goal, but its business model of partnering with Big Pharma with potential cost cutting hardware is one way this can, and ultimately will be accomplished. pSivida has already shown it can cut the clinical pathway in half with its approach by skipping Phase I and II with its next generation uveitis insert. That along with Tethadur, which can potentially be applied to a myriad of drugs that require sustained release but are prohibitively expensive, are significant steps in lowering costs in the face of massive government-inflated demand. By catching more Big Pharma flies with the honey of renewed patents, pSivida has a pathway of accomplishing this.
As for the near term movements of PSDV, the FDA's answer to Iluvien in the U.S. on October 17 should determine if PSDV halves or doubles.