Background: A key health-related and financial development of the past year has been the advent of highly effective and well-tolerated treatment regimens to cure a form of viral hepatitis, namely hepatitis C ("hep C" herein). The two products that when combined in one treatment regimen that currently are the most advanced are Johnson & Johnson's (NYSE:JNJ) Olysio and Gilead Sciences' (NASDAQ:GILD) Sovaldi. The use of Olysio with Sovaldi is expected to diminish when Gilead's next hep C blockbuster enters the market, likely in October. This is a combination of the active ingredient in Sovaldi, called sofosbuvir, plus an Olysio-like drug called ledipasvir. The sofosbuvir-ledipasvir pending combo is expected to be the first of several that will allow interferon-free cures. Other competitors that are hot and heavy on the trail of this Holy Grail are AbbVie (NYSE:ABBV), Bristol-Myers Squibb (NYSE:BMY) and Merck (NYSE:MRK).
Relative to the size of the companies, this topic is most important to GILD and ABBV shareholders. The overriding question is how large, in patients and dollars, is this market, looked at from a period of many years. This article reports on certain research that the author has performed and suggests that a tentative conclusion could be that GILD is grossly undervalued.
Introduction: Hepatitis C viral infection is susceptible to a relatively easy curative regime because the virus lacks a prolonged dormant phase. Thus, even though it was recognized many years after hepatitis B was recognized, it and not hep B has begun to be cured rather than ameliorated. Hepatitis C is typically an indolent infection that may never kill someone infected with it. The disease starts with blood-borne exposure, most often from sharing of needles, also from transfusions, other forms of blood exposure, or sex. It is felt that sexual transmission is relatively difficult, but clearly can occur. Most but not all people who are exposed to hepatitis C develop an unrecognized acute hepatitis, which in most but not all cases becomes chronic. There is no vaccine for hep C, but the virus can be accurately detected in blood banks, so in the advanced economies, transfusion as a cause of new cases of the disease is now rare.
For these and other reasons, new cases of hep C in richer countries are on the decline, and will decline further among the native population as more people get cured through use of Sovaldi and other treatment regimens. In fact, an important source of new cases of hep C in the U.S. and certain other developed countries is immigration.
The upshot of the relative dearth of new cases is that for purposes of estimating the public health and commercial market aspects of hep C in developed countries, we should look at the number of cases as static. While it is not strictly speaking true to think of a cure as a permanent cure, because reinfections may easily occur, the principle that I will use here is that the number of existing cases, known as prevalence, is the market in perpetuity. With that, we can begin to assess what market opportunity the pharmaceutical community has with its drug products that treat this disease.
Hep C - epidemiology and market opportunity: I'm going to do this in two large sections. The first subsection quotes at length from a Global Alert and Response of the World Health Organization regarding Hepatitis C. Then I will look at other estimates:
HCV Infection occurs throughout the world, and up until the introduction of anti-HCV screening tests for blood donors, introduced in 1990/1991 in Europe and the United States, it has represented the major cause of transfusion-associated hepatitis.
The incidence of HCV on a global scale is not well known, because acute infection is generally asymptomatic.
As many as 2 to 4 million persons may be chronically infected in the United States, 5 to 10 million in Europe, and about 12 million in India, and most do not know they are infected. About 150 000 new cases occur annually in the US and in Western Europe, and about 350 000 in Japan. Of these, about 25% are symptomatic, but 60 to 80% may progress to chronic liver disease, and 20% of these develop cirrhosis. About 5%-7% of patients may ultimately die of the consequences of the infection.
Most European countries report a prevalence of HCV in the general population of between 0.5 and 2%.
WHO estimates that about 3% of the world's population has been infected with HCV and that there are more than 170 million chronic carriers who are at risk of developing liver cirrhosis and/or liver cancer.
Very high rates of HCV antibody reactivity (>70%) have been reported in injecting drug users and in haemophiliacs. Intermediate prevalences of 20 to 30% have been observed in patients receiving haemodialysis. The incidence is declining since transmission by blood products has been reduced to almost zero and universal precautions in medical settings are followed.
Transfusion-associated cases occurred prior to donor screening. Now they are very rare where blood is screened with 2nd and 3rd generation EIAs, about 0.004% to 0.0004% per unit transfused.
Most new infections are the consequence of high risk drug behavior (60%) or unsafe injection practices.
New HCV infections have decreased by over 80% since 1990 in the USA.
Now, the second sub-section relates to other research I have done on this topic.
Public health authorities are determined to identify the great majority of cases of hep C, now that curing it is becoming faster and safer. Investors need to understand that there is no fully accurate census of the number of Americans, or any population, who have chronic hep C. Estimates in the U.S. range from about 3 to 4 million. The latter number is the number that Gilead uses, so I will go with that, but as an offset in case that number is high, I am going to exclude new cases.
Regarding Europe, AbbVie has promoted 17 million cases, but while possibly accurate, that number is misleading regarding market opportunity, because many of those cases are in the most populous European country, Russia. Since this article first focuses on rich countries that collectively are willing to pay Gilead's price, Russia can be excluded. (I discuss macro pricing issues later.) A discouraging factor for the hep C bulls is that the richer countries such as Germany, the Netherlands, the U.K. and the Scandinavian countries have low hep C prevalence, roughly 1% of the population. More conservative estimates of hep C prevalence are closer to the 6-8 million range, and some of those include Russia as well. For example, an NIH-sponsored 2009 article said this (see link for definitions of acronyms):
HCV-specific burden of disease data for Europe are scarce. Incidence data provided by national surveillance are not fully comparable and need to be standardised. HCV prevalence data are often inconclusive. According to available data, an estimated 7.3-8.8 million people (1.1-1.3%) are infected in our 22 focus countries. HCV-specific mortality, DALY, and transplantation data are unavailable. Estimations via HCV-attributable fractions indicate that HCV caused more than 86000 deaths and 1.2 million DALYs in the WHO European region in 2002. Most of the DALYs (95%) were accumulated by patients in preventable disease stages. About one-quarter of the liver transplants performed in 25 European countries in 2004 were attributable to HCV.
There are other primary sources of information. A 2013 European study said:
Prevalence estimates of anti-HCV-Ab in the general population were found for 13 of the 34 countries in our review, ranging from 0.4% to 5.2% by country (Figure 1b, Table 2). The estimated number of people who were anti-HCV-Ab positive ranged from 3,122,779 in Italy to 37,025 in Sweden (Table 2). For only a minority of countries (9/34) information was available on both estimates. Countries in the north-western part of Europe had a low prevalence for both infections (i.e., hep B as well as hep C: ed.) whilst those in the south and south-east had an intermediate to high prevalence.
The above is shown graphically in the more recent article in the top and bottom charts showing hep B and hep C prevalence, respectively:
Hepatitis B and hepatitis C prevalence (%) in the general population by country, Europe, 2000-2009. a. Hepatitis B surface antigen (HBsAg) prevalence (%). b. Hepatitis C (anti-HCV-antibody) prevalence (%).
Looking closely, it is obvious that Italy alone acts as several "countries" regarding hep C. The disease appears to be much more prevalent in the poorer south than in the north.
Considering the importance of migration into western Europe from Africa, eastern Europe and elsewhere- areas of higher or very high hep C prevalence, and considering reinfections, I am going to estimate an addressable population of hep C cases of 8 million- roughly half of AbbVie's estimate.
The other major "western," i.e. rich country of note is Japan. One estimate of prevalence for Japan and many other countries is found in summary form at Hepatitis C - An Epidemic for Anyone. A much more detailed analysis is found in a 2011 Liver International article, A systematic review of hepatitis C virus epidemiology in Asia, Australia and Egypt.
Assuming a 1.2% prevalence in Japan and assuming that reinfection rates are actually low gives about 1.5 million potential patients.
So let us tally the count so far. It's 4 million from the U.S., 8 million from Europe and 1.5 million in Japan. Adding 0.5 million from other rich countries such as Australia/New Zealand, Canada and other smaller rich venues gives a total of 14 million.
Now we must consider two other sources of income for the pharmaceutical companies before we look at models for revenues and net profit.
One comes from richer infected individuals who live in China, India, Brazil, South Africa, etc. and who are excluded from the above analysis but who are willing and able to pay free market prices to obtain timely, state-of-the-art treatment of their disease. Counting the substantial reinfection rate in the rest of the world, we can easily estimate the gross number of rest of world (ROW) patients at 150 million. Completely arbitrarily, I am going to assume that 2% of these are the equivalent of well-insured infected patients in the developed countries. That adds another 3 million patients to be treated.66
The other potential source of income comes from all the other infected people on the globe. Given the effects of travel and migration on all countries, and general global public health considerations, it is likely in my thinking that over the next fifteen years, a large effort will be made to eradicate hep C. In the absence of a vaccine, this will not happen to the 100% level, but a substantial effort would be a boon to human health.
To summarize this section, we have the following three "buckets" of revenue. One is insured/wealthy patients in rich countries. Another is rich patients in poor countries. A third is everyone else.
In the next section, revenue and profit estimates will be made.
What's it all going to be worth to pharmaceutical companies?:
The first question to be answered is what an average revenue per treated patient is going to be. What we know is that list price in the U.S. for a 12 week regimen of Sovaldi is around $84,000 without discounts. This is a retail price to the payor, not the price to Gilead. The distribution chain at its simplest includes a wholesaler such as McKesson (NYSE:MCK) and a patient-facing company such as CVS Caremark (NYSE:CVS). When dealing with very high-priced, high-margined products such as Sovaldi, the manufacturer initially is in a dominant position, but the other players require their profit as well.
Arbitrarily, I'll assume that Gilead gets $60,000 of the $84,000 full-price pie. Fortunately for Gilead and unfortunately for our model, Sovaldi is expected to soon largely give way to a higher-priced, much more effective dosage form mentioned above, which contains sofosbuvir (Sovaldi) plus ledipasvir. How much more will Gilead charge for the combo versus Sovaldi, and what will the marketplace accept? We do not know. All we know is that paying full price for Sovaldi plus Olysio is said to run around $150,000. Gilead has stated that it will not approach that level of list price for the combo. Some have thought that it will ask as little as $100,000 for it. My guess is that it will come in somewhere in between, perhaps at $120,000.
Now, multiple U.S. purchasers get discounts. These include Medicaid, prison systems, and the Veteran's Administration. I'm going to add a decent amount to the guesstimated $60,000 for Sovaldi to get to $80,000 for the combo, and then come down to $65,000 for a blended average.
Next, there's the rest of the rich world to deal with. The large pools of patients in Italy and Spain are located in countries that even before the Great Recession and their own severe recessions/depressions were known in the industry to hate to pay their medical bills to suppliers. Arbitrarily, I'm going to give a severe haircut to the rest of the rich world so that the average comes to $50,000. This number assumes some Sovaldi use and predominant use of the higher-priced combo.
Before moving on to the other groups, the question is, what fraction of the infected population will be treated in a time frame in which the brand companies have effective patent protection on their products?
I'm going to assume this is a long-term business opportunity for them and that at a minimum 70% of patients will be treated during the period on which Sovaldi, ledipasvir and Gilead's improvements; and products from the other competitors, will be patent-protected. Going back to the 14 MM patient pool from this group of patients gives 10 MM patients to be treated. If the average gross dollar value is $50,000 per patient, that gives $500 B in total sales.
Importantly, I am not discounting for present value. Instead, I'm keeping the analysis simple and assuming that selling prices march upward with a realistic discount rate, which will change unpredictable as the years pass.
Also, we will assume a 15% SG&A plus production cost for these products from large purveyors of these meds such as Gilead. (Late entrants, however, will likely spend a lot more as a percent of sales in order to gain business.)
Let us then add the value of the 3 MM estimated patients from poorer countries who will, it is assumed here, pay the prices prevailing in the "first world." These patients will represent pure profit. Let's add $150 B for them.
Finally, my model guesses that 100 MM poorer patients are going to get treated at a revenue to the manufacturer of $1000 per patient. This prediction also assumes zero SG&A and production costs. This gives another $100 B in total revenue.
Adding these three buckets up gives $750 B in revenues to the industry.
Let's now focus on Gilead.
Gilead's future profits from hep C medications: After the combo comes out, Gilead will have close to a 100% market share for hepatitis C treatments in the markets it has marketing authorization and reimbursements arrangements in. How much share will it lose after ABBV, BMY and MRK presumably enter in the next two or so years? There's no way to know. In the HIV field, Gilead continues to maintain a 75-80% global market share. For this analysis, I am going to assume that over time, Gilead's market share reverts to an average of 50%, which assumes a terminal market share below 50% given its large starting lead.
Looking at costs, I'm modeling a 15% COGS plus attributable overhead off of the presumed 1/2 of $500 B developed country total revenues. This would be about $38 B to be subtracted from $250 B, or $212 B. Then we add 1/2 of revenues from the ROW, which would equal $125 B. Even at "only" $1000 per regimen, marginal cost of making the dosage form should, I would guess, allow a 1% COGS, and there will be no real marketing costs under this model. So these revenues would represent pure pre-tax profit. Adding $212 B plus $125 B gives $337 B. Now we get to deal with taxes.
Multinational pharma companies get to do tricky things such as assigning patents to Ireland, where corporate tax rates are low, and then in an intra-company transfer, charging the same company's marketing arm in the U.S. or other high-tax country the proverbial arm and a leg to purchase the product from the Irish subsidiary. This lowers the statutory tax rate, but there is a practical problem to the owners of the holding company: it cannot pass the book profits back to shareholders without repatriating the profits. So I am going to assume a 30% tax rate, again arbitrarily. Out of $337 B in profits, this comes to $101 B in taxes. This brings gross profits to $236 B. If we subtract some billions for product acquisitions and new clinical trials to protect and grow the franchise, I think we can thus crudely estimate about $225 B in future after-tax profits from the hepatitis C franchise for Gilead.
Discussion of other companies: Clearly there are attractive opportunities for all the other competitors, even if they are unable to displace Gilead by offering a superior product. As late entrants, though, they will all suffer some combination of lower selling prices and/or higher marketing costs. Still, given that the branded pharma business is perhaps the single most uncompetitive industry that has ever existed (almost on a par with central banks in an era or digitally-created money), they can all look forward to 99%+ profit margins on their marginal cost of production.
Risks: The number of assumptions made above is legion. Please do not invest thinking that all the many inaccuracies inherent in this analysis even out. I have made errors in either direction or systemically on the optimistic side.
"Validation" of the Gilead numbers: S&P Capital IQ uses a proprietary method to estimate an underlying "fair value" for the stocks it covers. With GILD around $80, its most recently estimated fair value at $147 per share. This is down from a recent estimate of $172, and is more realistic. Nonetheless, this remains an extraordinary discount to the current stock price relative to the many other stocks it covers that I have investigated. This discount would most likely be due to the potential from Sovaldi and the upcoming combo and related products. Thus it would appear likely that the analysts at S&P share my view that GILD is very arguably undervalued simply on the likely cash flows that its hep C franchise will deliver over time.
Summary: Now that most cases of hepatitis C are curable with well-tolerated medications, with a growing number of such regimens expected to come to market beginning this fall with a combo from Gilead, extensive screening of high-risk and medium-risk potential patients is anticipated to begin relatively soon. Over time, most patients will, I am guessing, be identified and treated with an effective, expensive regimen. Public health benefits will in this scenario go hand-in-hand with profitable operations for the pharmaceutical companies that gain substantial business from curing hep C. There are numerous uncertainties about the future profit flow from this business niche. Making a number of assumptions and guesses leads me to suggest that shares of Gilead, GILD, may be trading for not much more than half of the present value of future cash flows from its hepatitis C franchise alone. This degree of potential undervaluation might be considered attractive even to a conservative investor such as Seth Klarman, fresh from a big success with a much smaller hep C company, Idenix (NASDAQ:IDIX).
The opportunity for the other three competitors identified above, ABBV, MRK and BMY, is also substantial, most importantly for ABBV, given its smaller market cap and looming threat to its Humira franchise from biosimilars. Right now, however, no obvious improvement to Gilead's hep C products in registration and pipeline are seen, so I project that it might just go pole to pole as the market leader as it has done with HIV treatments for years, until hep C is substantially eliminated and curative regimens finally lose patent protection.
An individual investor who does what I have done, namely overweight GILD, may in my view wish to think carefully about the uncertainties surrounding its business lines, most prominent of which is the hepatitis C treatment arena.
Disclosure: The author is long GILD, JNJ. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.