IBB: Proposed Self-Regulation On Drug Price Increases May Be A Tailwind For 2017

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Summary

Allergan CEO Brent Saunders has led the charge in the proposed self-regulation of drug price increases, vowing to limit drug price increases.

Novo Nordisk fell in-line with a similar commitment: “This has become a responsibility that needs to be shared among all those involved in healthcare."

Johnson & Johnson announced it will publish a report on drug price increases in the U.S. next month, saying the company is a “responsible actor in healthcare.”.

Will the confluence of the new administration, potential merger and acquisition activity, and proposed self-regulation be the answer for the biotech cohort?

IBB sold off by more than 20% in 2016 and 40% from its 2015 highs of around $400 per share. 2017 appears to be a much more favorable environment for IBB.

Will the proposed self-regulation with regard to future drug price hikes be the right prescription for the healthcare cohort? The political uncertainty has abated in terms of which political agenda we'll be faced with in the White House. With a perceived pro-industry administration, potential merger and acquisition activity may heat up and serve as a tailwind due to chronically depressed valuations as a result of the 2016 biotech sell-off. Much of this sell-off was due to the public and political distaste for surging drug prices on a whole while singling out a few bad actors in the process.

The biotech cohort saw a very tumultuous 2016 as the political backdrop, drug pricing debate and presidential election grabbed the spotlight. Biotech stocks were volatile to any news that would have a potential impact on the cohort. Since Donald Trump voiced his concerns over drug pricing during his interview with Time, the initial rally in biotech has largely eroded to pre-election levels.

The iShares Nasdaq Biotechnology Index (NASDAQ:IBB) traded in a wide range throughout 2016 with pronounced volatility throughout the presidential election cycle logging a range of ~$240 to $344 or a 104-point range (Figure 1). Will the confluence of the new administration, potential merger and acquisition activity and proposed self-regulation be the answer for the biotech cohort?

Figure 1 - 2016 IBB performance, via Google Finance.

A Few Bad Actors and Political Backdrop

Throughput 2016, the entire pharmaceutical supply chain from drug manufacturers - i.e., Mylan (NASDAQ:MYL) and AbbVie (NYSE:ABBV) - to pharmacies/pharmacy benefit managers - i.e., CVS (NYSE:CVS) and Walgreens (NASDAQ:WBA) - and the drug wholesalers in-between - i.e., McKesson (NYSE:MCK), Cardinal Health (NYSE:CAH) - were hit hard. The confluence of proposed legislative action via Proposition 61 in California, continuous threats by potential presidential candidates such as Hillary Clinton and Bernie Sanders, Senate summons for Valeant (NYSE:VRX) and Mylan to defend drug pricing, pricing pressures throughout the pharmaceutical supply chain have pummeled the sector (Figure 2).

Drug manufacturers, wholesalers, pharmacy benefit managers and pharmacies have not been immune to this massive sell-off. With the presidential election now finalized, the mere absence of political uncertainty may have provided a temporary lift to the sector however we're still faced with the drug pricing debate.

Figure 2 - Hillary Clinton tweet coming out against drug pricing increases

Proposition 61 was defeated in California which aimed to cap the state's drug expenditures by linking all future costs to match those costs paid by the Veterans Affairs (NASDAQ:VA) for the same drugs. This initiative would've prohibited state agencies from buying any prescription drug from a drug manufacturer at any price over the lowest price paid by the VA.

This misguided proposition ran a high risk of increasing prescription drug prices for the VA, reducing patient access, creating more bureaucracy and lawsuits. The amount of any savings was highly uncertain and would've likely resulted in very little to no savings and companies may have increased pricing to the VA and selectively omitted discounts for certain drugs altogether. The failure of this proposition in a largely liberal state may derail similar attempts in other states thus removing a pharmaceutical headwind regarding pricing.

Proposition 61 took aim at the drug pricing debate which continues to be at the forefront of politicians' attacks towards pharma companies while the same fight is being waged in the court of public opinion. As potential presidential candidates threatened drug companies with containing the costs of drugs, their actions negatively impacted biotech stocks in particular.

In my opinion, the price gouging instances were confined to a handful of irresponsible and egregious bad actors. This was capitalized on via political posturing by Hillary Clinton, Bernie Sanders, Donald Trump and others which proved detrimental to the entire biotech sector. Turing Pharmaceuticals and its former CEO (recently arrested by the federal authorities and summoned before Congress), Martin Shkreli, faced sharp criticism after he increased the price of its drug Daraprim from $13.50 to $750 per pill, or an over 5,000% increase, shortly after acquiring the drug. This price gouging of a decades-old drug drew backlash from the general public on social media, and in particular, the presidential candidate and Democratic frontrunner Hillary Clinton. Daraprim is an isolated and egregious example being exploited by political campaigns for political gains. This price gouging incident has elicited widespread backlash, and in my opinion, rightfully so; however, this criticism has been unfairly painted with a broad brush across the entire sector. The political assaults by Hillary Clinton didn't stop with Turning Pharmaceuticals and were extended to Valeant Pharmaceuticals as well.

Proposed Self-Regulation On Drug Pricing?

The drug pricing debate has been a hot topic and will likely persist into the new administration. Donald Trump has made that clear during his interview with Time Magazine for his Person of the Year award. Donald Trump stated "I'm going to bring down drug prices" and "I don't like what has happened with drug prices". Pharmaceutical executives seem to have taken note of this and are attempting to get out in front of the issue.

Brent Saunders, CEO of Allergan (NYSE:AGN), has led the charge in this movement. He vowed to limit drug price increases to single-digit percentages once a year. This seems to be working to some extent with Novo Nordisk falling in-line with a similar commitment. "We hear from more and more people living with diabetes about the challenges they face affording healthcare, including the medicines we make," Jakob Riis, Novo Nordisk's U.S. president. "This has become a responsibility that needs to be shared among all those involved in healthcare and we're going to do our part."

If drug companies self-regulate and get this drug pricing issue behind them along with a favorable governmental landscape, this will likely bode well. Johnson & Johnson (NYSE:JNJ) announced that they will publish a report on drug price increases in the U.S. next month with the aim of demonstrating that the company is a "responsible actor in healthcare". The company says that two-thirds of its sales growth comes from selling more drugs, not raising prices. This is in contrast to companies such as Mylan and Valeant. J&J stated that they already keep drug price hikes confined to single-digit percentages after discounts.

More M&A Activity on the Horizon in 2017?

Merger and acquisition activity within the biotech/pharma space has heated up as of late with Pfizer's acquisition of Medivation for $14 billion, Allergan's acquisition of Tobira for $1.7 billion and J&J's acquisition of Abbott's (NYSE:ABT) Medical Optics unit for $4.3 billion. Recently, Ariad Pharmaceuticals (ARAD) was acquired by Takeda Pharmaceuticals (OTCPK:TKPHF, OTCPK:TKPYY) for $5.2 billion. As the cohort remains suppressed, many prospective buyout candidates become more financially appealing to the acquirer due to beaten down valuations in concert with the maturity of pipelines coming into play. As this acquisition activity heats up, be on the lookout for stocks that have been rumored as takeover targets to heat up and possibly take IBB along for the ride.

Conclusion

The proposed self-regulation of drug pricing increases will likely serve as a catalyst as this gains footing. IBB sold off by more than 20% in 2016 and 40% from its 2015 highs of ~$400 per share. Considering the aforementioned factors laid out in concert with the double-digit sell-off, I feel 2017 appears to be a much more favorable environment for IBB to see gains. At current levels, IBB has significant upside based on 2015 highs of $400 per share. This bullish set-up may be further accelerated if M&A activity takes off due to chronically depressed valuations throughout the sector.

Disclosure: The author is long IBB. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. The author is an individual investor who analyzes investment strategies and disseminates analyzes. The author encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback; the author values all responses.

Disclosure: I am/we are long IBB.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.