Introduction - setting the thematic stage
On Wednesday, both large cap biotechs (NASDAQ:IBB) and their small cap brethren (NYSEARCA:XBI) reversed down about 4% during a press conference given by President-elect Trump, in which he threatened the pharmaceutical industry with tough bargaining from the Federal government. One suspects he was referring to Medicare Part D, where each insurance plan serving Medicare beneficiaries works out its own formulary with the drug companies. The VA and Defense Department already have great deals and group purchasing.
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Note that Adrenaclick is not a generic to the current controversially-priced EpiPen version that Mylan (NASDAQ:MYL) markets; Teva (NYSE:TEVA) may finally gain FDA approval next year. However, Adrenaclick is indeed similar to EpiPen and in my opinion may be an acceptable product for many people.
CVS is doing something very similar to what I advocated last year, when the controversy was timely. In an August article titled EpiPen: Facts Vs. Opinion; With Cost-Benefit Analysis, the part of the article most relevant to the CVS move read this way:
The great thing about capitalism is that price signals can guide consumer behavior...
A better solution... may be to promote Adrenaclick or basic syringes where felt medically appropriate.
CVS is acting as I said the free market could, not requiring government intervention. (I also mentioned in the article that I was negative on MYL's stock, and it is down 15% since then; read on for the relevance of that point.)
I tie the Trump dump in biotechs and the CVS move to bring much lower-cost epinephrine to people this way: When investing in pharmaceuticals today and tomorrow, think of real, differentiated innovation first and foremost.
That's the main theme of this article. It feels right to reorganize my views of the specific names I follow by judging them primarily on how protected they are from price-cutting, whether imposed by the government or by the free market.
Other factors, of course, come into play, namely valuation, management quality, and the mix of all that a company is doing. It turns out, however, that the way I've been looking at biotechs is best exemplified by which companies are least vulnerable to these sorts of attacks.
Another way to look at this analysis - a historical perspective
Today's generic and branded pharma companies are much more highly leveraged than they were when they were in the 1970s and early '80s, when they were very much out-of-favor stock groups. Back then, the high inflation of the day meant that these were low-margin businesses; the corresponding very high interest rates made debt unattractive.
This has come full circle. Pharma, even generics to an extent, reverted to being a glamour sector as it has been in the 1950s and '60s.
Then came the era of persistently low interest rates, and pharma, even generics, and even some junior biotechs, began taking on growing and generally now large debt loads (junior biotechs only do this occasionally, though). As an example, AbbVie (NYSE:ABBV) is running about a $31 B long-term debt load, about 4X its TTM profits. Celgene (NASDAQ:CELG) is also burdened with a long-term debt load around 4X TTM profits (which are rising rapidly). Merck's (NYSE:MRK) ratio is lower, around 2.3X, but Pfizer's (NYSE:PFE) is around 3X. Note that these ratios do not take current assets into account.
Teva, which is largely a generic house by revenue, got to a ratio around 6X; MYL got close to that level.
What accounts for the passion for debt?
It's clear. Borrow at a blended rate of, say, 3%, and reprice existing products upward at a blended rate of, say, 5% (higher in the US), et voila, you have a built-in 2% profit increase that goes on forever.
Until it doesn't.
This situation is what I've been alluding to for over a year, when the most flagrant balance sheet culprit and aggressive price raiser, Valeant (NYSE:VRX) had already dropped from the high $200s to just below $100, yet I wrote an article about VRX that said:
My view for some time has been that VRX has been valued in a nonsensical manner. Its gigantic debt load should lead to a low P/E, so that investors would be rewarded if the company grew strongly and brought its finances to a much stronger level...
Mr. Market was in my view pretending that VRX should be valued by new metrics, when I believed that the old metrics of GAAP EPS and balance sheet analysis were fine, and that Mr. Market had lost his mind with VRX...
Even if the allegations of corporate misbehavior are unfounded, I think that at a price in the $90s, VRX trades well above fair value.
VRX is around $15 today.
Underlying my argument in that article was that the price increases that VRX had been taking were unsustainable.
Now, that's an extreme case, but just as EpiPen is now faced with visible price competition (few had heard of Adrenaclick before now), all sorts of pricing and margin assumptions throughout the pharma industry require re-examination.
Forthwith, a discussion of a number of pharma companies and their susceptibility to price competition.
I'll begin with picks, then move to pans, and neutrals.
Here are some of the companies I think are best-positioned, and where there are reasonable arguments for their stocks when considering valuation and technical position.
This is the best. CELG has developed a stable of three leading growth engines for which it will make little or no difference if the Feds revamp the Medicare Part D program. At this point, Revlimid has an unassailable position in treating myeloma. It is getting stronger, not weaker, as the company publishes more outcomes data and as newcomers to myeloma treatment such as J&J's Darzalex incorporate Revlimid in their own studies.
Similarly, the more potent version of Revlimid that works by a similar mechanism, Pomalyst (Imnovid in the EU), has limited direct competition, though there are more choices now than before in 2nd-3rd line myeloma treatment.
The other fast-growing drug for CELG is Otezla for psoriasis and its common and nasty complication, arthritis. This is becoming the go-to treatment for more serious cases that might require injectable (and even more expensive) biologic treatment. Eventually, there will be additional competition to Otezla, but right now, CELG is pretty much a sole supplier of effective, well-tolerated advanced therapy for moderate or moderately severe cases of psoriasis.
CELG has forecast GAAP EPS for 2017 around $6. At a price around $117, CELG is trading below the GAAP P/E expected for the S&P 500 (NYSEARCA:SPY), an unusual situation. (However, if past performance predicts future performance, CELG will make an expensive deal or two - or three - that will knock GAAP EPS down, perhaps a lot.)
This company's lead drug, Jakafi (Jakavi ex-US), is the only approved agent for the blood disorder myelofibrosis or MF. Gilead (NASDAQ:GILD) had disappointing results in its Phase 3 program for a competitor. If a patient has MF, which is quite a serious condition and generally is found in Medicare-aged people, one has to forget about competitive bidding against Incyte (NASDAQ:INCY) here. It's the only game in town. Also, for refractory cases of a related blood disorder called PV, Jakafi is also the only alternative treatment.
One of INCY's most prominent pipeline drugs, epacadostat, is in combination trials with MRK's PD-1 antibody Keytruda. INCY regained the $110+ level on the news that MRK and INCY have found this combination to have had encouraging enough results to move it into Phase 3 for a number of cancers, including some common ones such as lung cancer. Epacadostat has a modest amount of pipeline competition in its class, but if it emerges onto the market with a well-supported set of indications, it will have a lot of pricing flexibility.
INCY is pricey, but we see this as a junior biotech emerges to profitability with a blockbuster product that's growing rapidly, as Jakafi is, along with a promising pipeline. This is basically a rerun of CELG around 2005 in my view. Since then, CELG, which traded around 20X revenues in 2005, has had a CAGR around 12% per year, far outdistancing the SPY's performance. So, for smaller companies, valuation is not static. I like INCY and think that a number of large companies are considering whether paying a premium will pencil in for them (perhaps not).
As with INCY, the focus of Regeneron (NASDAQ:REGN) is cutting-edge science to produce superior molecules that have limited competition. Its flagship drug Eylea took on and defeated the incumbent, Lucentis from Roche (OTCQX:RHHBY), by having both a longer activity leading to less frequent injections into the eye and an additional mechanism of action. This provides it partial insulation from pricing pressures; and, REGN has never taken a price increase on Eylea, which has been on the market since late 2011. Eylea is now selling $5 B globally, a number that is rising and that I believe exceeds the pace set by Revlimid and almost every other drug in history (inflation not accounted for, though).
In its pipeline, REGN is pointing to a breakthrough drug, Dupixent, that is awaiting FDA approval. If approved and successfully launched, this could be a one-off as well, both for moderate-to-severe atopic dermatitis (eczema) and half the cases of refractory asthma that currently have no effective biologic treatment.
Payors will have little leverage on REGN, which has an arrangement with Sanofi (NYSE:SNY) by which SNY is the lead marketer. Of course, the drug has to be priced fairly, as with all products. But as we will see next, there are areas where investors need to worry.
Areas where price competition could be more of a problem
Many moons ago, I had some nice things to say about TEVA on Seeking Alpha. The company was talking a good game, spurred I believe by the energy imbued into it by Dr. Phil Frost, who served for all too brief a time as chairman. However, TEVA has relapsed into what I think is a form of corporate incoherency and is facing a potential down-cycle in generic pricing.
As mentioned, I've had negative things to say about MYL, and about Perrigo (NASDAQ:PRGO) last year, which I reviewed when its CEO, Mr. Papa, suddenly left it in the lurch when he took the helm at VRX.
The generic business is a tough one, and the industry has, by and large, leveraged up in the good times to do deals. I much prefer the buyers of generics, such as CVS, over the manufacturers in general, but especially now (note I'm neutral on CVS).
This is the hottest area of immunotherapy, led by MRK's Keytruda and the current leader, Opdivo from BMS (NYSE:BMY). Yet Roche's Tecentriq is going to be a serious contender. AstraZeneca (NYSE:AZN) has durvalumab near commercialization. And SNY/REGN have REGN2810 in a potentially pivotal trial for an indication that would be novel for the class, a non-melanoma form of skin cancer.
So there could be 5 similar agents on the market. If Gilead has had it tough with at first only one competitor in its HCV line, then a second for some of its business (first ABBV, then MRK), then perhaps one should be skeptical about any projections for revenues from Keytruda, Opdivo, etc.
Also, the more competition there is, the greater will be the need for (costly) clinical studies to try to differentiate the drugs from each other, and the greater will be the need to advertise in medical media and send drug reps on foot into the office. In other words, the specialty market that has helped make oncology so great can work in reverse for this class of drugs. Yes, it will be profitable, but hoof beats are appearing.
Led by Biogen (NASDAQ:BIIB) and others with interferons, then TEVA with Copaxone, then BIIB again and others with highly effective oral agents (and other important drugs), treatment of MS has improved markedly over the years. Now, the major advance is coming from Roche's pending product introduction this year, Ocrevus for a previously untreatable form of MS, namely PPMS. This uses BIIB technology and thus will tend to offset BIIB's loss of market share if Ocrevus has a successful product introduction.
However, the effective oral agent Gilenya may go generic in two years, and BIIB's Tecfidera may fall to generics in three years. The MS sector may see a reversal of the aggressive price increases it has taken all decade.
Just as is the case with EpiPen, the price increases that the industry has taken over the years, and in the case of Tecfidera continues to take this year, could turn into price cuts even for brands. Except for the happy outlier such as Ocrevus for PPMS, my bias is not to give a very high multiple for earnings from the major type of MS, namely RRMS (relapsing-remitting).
All this sort of discussion is forward-looking; a way I have begun to think about the industry. It may be overly cautious, but since it's personal and family money I'm putting at risk, I sleep better thinking of new paradigms such as this.
In the past, one never had to think this way. I used to watch in amazement as some company introduced the 10th ACE inhibitor (or whatever the number was) with no benefits over the prior ones, or the 7th ARB; even the 4th H2 blocker and 4th PPI seemed one too many. Yet the companies found all these product intros worth the cost of manufacturing and marketing. A small price cut to get on some formularies was enough. Now, the bargaining would be more difficult.
Thinking of stocks, the question I ask is whether there is more complacency about a new, tougher regime structurally coming into place than is appropriate.
To ask the question is to answer it in a sense; so I take that possibility into account.
Now, a few comments on "in between" situations.
Stocks with partial exposure to price pressure
Gilead is in an effective duopoly with ViiV, majority-owned and controlled by GSK (NYSE:GSK), in the HIV/AIDS arena. Most of ViiV's strength is in the EU, whereas GILD, the market leader, is strong all over, but is especially dominant in the US. So I expect it to have a reasonable amount of price flexibility overall in its HIV/AIDS business. As it rolls out Vemlidy (the next-gen version of Viread) for hepatitis B and probably next year its next-gen single tablet regimen for HIV/AIDS, it may be able to justify somewhat aggressive pricing strategies. On the other hand, the EU will be tougher.
In HCV, GILD faces unremitting price pressure from ABBV and MRK. ABBV is going to introduce a non-nuc-based two-drug HCV combo this year in the US to treat all genotypes of HCV in only 8 weeks, though even mild cases of cirrhosis will not be labeled for that treatment duration if at all. In the US and globally, that's going to pressure both pricing and market share, assuming the specialists accept the presence of a protease inhibitor in first-line use.
GILD has argued against this strategy, so we shall have to see. The refusal of insurers to reimburse at current pricing for many infected patients is pressuring the industry's pricing structure further. This is a sign of a new paradigm, and a bad one for human health.
The words and "body language" of GILD's CEO at his healthcare conference presentation this week lead me to expect poor HCV results from this business in 2017.
Still largely dependent on its TNF inhibitor Humira, ABBV's growth drug is Imbruvica, for cancer and perhaps autoimmune disease. Imbruvica is highly differentiated and has lots of price flexibility in the US. However, Humira falls more in the intermediate category. It competes with Enbrel and Remicade in the US and globally, and increasingly is faced with competition from oral agents that are less costly and preferred by patients wherever possible. So I doubt there is much price flexibility left for Humira. Then there is the likely biosimilar competition to it in the EU by the start of 2019 and in the US by 2022 or so according to ABBV, but perhaps earlier.
ABBV does have a broad pipeline, most of which is in areas where there will be at least some competition.
I therefore look at ABBV as a bond substitute, and at a 4% yield, a reasonable stock to own either just to hold for the income or for a buy-write strategy using covered calls.
Still largely a legacy product stock, Amgen (NASDAQ:AMGN) has little in the highly differentiated category. If it can knock Praluent out of the market, then its Repatha would represent such a drug. Otherwise, in a more difficult pricing environment for branded drugs, I would revalue AMGN's TTM GAAP P/E down to 10X or so. So I think it's a risky stock. For income and possible safety, I prefer ABBV - but, one never knows. That's what makes markets so interesting.
Now that its hematology spin-off Bioverativ (BIVVV) is official, BIIB is purely a CNS company, mostly MS. With a sales and marketing expert as its new CEO, it has priced its new Spinraza drug aggressively, and has taken price increases on existing products as much as the market will bear. I would give a low P/E on the additional profits gained from price. How much spread between the ex-US price and US price can and should investors expect BIIB to maintain? I cannot answer that, but at a certain point, a Trump administration that made parallel importing part of its campaign pledges may take at least verbal action against this sort of situation.
There are a few mega-pharma/biotech stocks that cannot be classified, because they are so very large. In biotech, there is the Genentech division of Roche. It's everywhere, especially in oncology. It will suffer from biosimilars here, gain from a new product intro there. More of a small molecule company, Pfizer has such a large product line and operates in so many countries that I think one needs to look carefully at its upcoming quarterly reports, using GAAP as the main metric given its massive debt load.
Another giant, Novartis (NYSE:NVS), is like PFE though without as many acquisitions and therefore a moderately less leveraged balance sheet, with a projected long-term debt load only 1.5X this year's projected profits (Value Line estimates).
I was hit last year when Novo Nordisk (NYSE:NVO), very heavily a diabetes company, downgraded its multi-year sales and EPS forecast when the US diabetes market turned more price-competitive. Even though NVO has some differentiated products on the market and pending approval, and even though diabetes is an "epidemic" in most of the world, this caused a large P/E compression. To a lesser extent, this has affected Eli Lilly (NYSE:LLY).
If it can happen suddenly to a premier company in diabetes, it can happen in immuno-oncology; it can happen in MS; it can happen in generics; it can simply happen without warning.
The "Trump dump," a sharp sell-off simply based on comments made in a press conference, suggests that one cannot assume that the bottom is in for the sector as a whole. It will be easier to make that call if this sort of comment is followed by no sell-off, then a rally. So I'm keeping powder dry for additional investment in the biotech/biopharma and even Big Pharma sectors. I would like to think that this is the year to scale in, though. Could a traditional August-through-October bottom be the time?
By then, we may know what we need to know about what Washington will do about drug prices, if anything. We also may have faced rising interest rates, which tend to bring down P/Es, even if there is a lag time for this to happen.
However, market timing has its limits in my worldview. Think back to the Tech Wreck. One of the big losers, Amazon.com (NASDAQ:AMZN), peaked in late 1999 and bottomed in 2001, a year before the SPY and Nasdaq bottomed. AMZN was well off its lows when the overall market bottomed.
Thus, my inclination is to think of the best names with objectively strong charts, such as CELG and INCY, as attractive, though with risk and lots of risk.
These fit within the way I have begun thinking of these companies, namely having differentiated products that may (no guarantees) provide protection from a new and harsher pricing regime in the US.
New money investment in other stocks that have some of these characteristics, such as REGN, but that have weaker charts, would represent more of an argument with Mr. Market; this is rarely my favorite strategy.
Stocks of companies with aging product lines with existing competition, many of which have seen aggressive price increases year after year, may be especially exposed.
To repeat the main thesis, the high, and until now or recently, growing price disparity between US pharmaceutical prices and the prices of the same drugs in rich ex-US countries may not be a sustainable phenomenon. I have rethought part of the paradigm I use when assessing the industry to give additional weight to the most innovative companies with the most highly differentiated products. That has led me to begin my planned scale-up back to higher levels of exposure to the industry carefully, with CELG and INCY my choices for price performance, with some ABBV for income and a possible options strategy.
This could be an interesting year for biotech and Big Pharma investors.
Thanks for reading and sharing any comments you may have.
Disclosure: I am/we are long CELG,GILD,INCY,REGN,BIIB,ABBV,RHHBY,NVO.
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.
Additional disclosure: Not investment advice. I am not an investment adviser.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.