The biotech sector has been one of the underperformers in 2016. Hence, valuations look more attractive today, and some stocks are on my watch-list. Among them is Celgene (NASDAQ:CELG), one of the few biotech companies with a product portfolio and pipeline that should allow the company to grow rapidly over the next few years.
The recently released preliminary figures, the 2017 outlook and the perspective until 2020 really look encouraging. 2016 revenues climbed 22% to $11.2B, and for 2017 further top line growth to $13.0-13.4B is expected. The long-term guidance sees sales of $21B and non-GAAP EPS of greater than $13 by 2020.
So the future does look promising, and Celgene has the products and the pipeline to meet or even exceed these targets, provided that the market conditions do not change. Celgene's top-selling product Revlimid generated $6.98B or 62% of the 2016 overall revenue. This reminds me of Gilead Sciences (NASDAQ:GILD), which is often called a one-trick pony because of its dependency on the HCV franchise.
One major difference is that Celgene's Revlimid is not targeting only one disease, but has a larger and even growing number of indications. In other words, Celgene's potential patient population is continuously increasing which should guarantee growth. Besides, Revlimid is the most effective treatment option for many patients. Lenalidomide which is the Revlimid's active ingredient has orphan drug status with currently nine designations in the US and currently three approvals.
The fundamentals look great for Celgene, but what concerns me is that Revlimid might be the ideal target for what Hillary Clinton was originally aiming at, and what is now also in the focus of President-elect Donald Trump when he says "I'm going to bring down drug prices. I don't like what's happened with drug prices."
Lenalidomide - a small molecule with an exorbitant price tag
Revlimid is a good example for a group of drugs that stipulates discussions. It is a highly expensive treatment for patients which are confronted with rare and life-threatening diseases. The average costs of Revlimid per patient and year in the US in 2014 was $112,000 (see EvaluatePharma's Orphan Drug Report 2015 which is actually a good introduction to the topic).
Revlimid is a so-called orphan drug, a pharmaceutical product which aims at rare diseases. The development of these drugs has been financially incentivized through US law via the Orphan Drug Act of 1983, and through similar legislations in other parts of the world. Orphan drugs are generally much more expensive than conventional ones, and despite the fact that they are aiming at rare diseases, patient numbers often are in the high five-digit or even six-digit range, so that the market potential can be huge.
I do not intend to discuss which price is justified for a pharmaceutical product, because I do not have an answer. On one side there are immense and continuously increasing costs for bringing a new drug on the market, a high risk to fail, and a limited number of patients in case of really rare disease. On the other side, there are costs which are typically in the high five digit or six digit area to treat a single patient which translates into huge profits for companies that were lucky enough to find a real blockbuster. These costs are one driver for healthcare costs going up, and to make things worse, big pharma increases prices year after year.
The biggest products which contribute significantly to costs are the first obvious targets for politicians to look at, because they offer the greatest savings potential. Gilead has been a company in the focus in the last couple of years with the HCV drugs Sovaldi and Harvoni. As a consequence, prices for the drugs have come down, and major payors were able to negotiate large rebates (which is one of the reasons why Gilead's HCV sales are falling).
Revlimid already belongs to the top-ten of the world's top-selling drugs, and it is expected to grow further. The Orphan Drug Report forecasts that Celgene will become the world's biggest orphan drug company by 2020, because of Revlimid. Revlimid could even become the top-selling drug in the world.
Production costs of a drug have nothing to do with its price. The major cost contributors in the industry are R&D and SG&A costs. Nevertheless, COGS will always be part of the discussion which price is justified which is not, and unfortunately for Celgene, lenolidamide is a particularly striking example.
Lenolidamide is a small molecule, not a biologic product, and it is the world's best-selling small molecule with orphan drug status. Biologic products are highly complex molecules, and often comprise mixtures or living entities. They are difficult and expensive to manufacture or to isolate. The characterization, impurities, and the formulation of these drugs are highly important. This is also the reason why biosimilars are very different from ordinary generic drugs and face a much more challenging approval process.
Lenolidamide is a chemical derivative of thalidomide, a former drug that caused one of the biggest pharma scandals of history in the 1950s. The drug was developed in Germany and sold under the brand name "Contergan" there. Thalidomide was sold as an OTC drug, a sedative which was broadly used among pregnant women. Unfortunately the substance is highly teratogenic which means that it causes birth defects, and several thousands of infants were born with severe phocomelia, a malformation of the limbs.
Lenolidamide is a relatively simple molecule by pharmaceutical standards, obtained from a conventional chemical synthesis. Nothing complicated, definitely not comparable to a biotechnological product, and chemically similar substance was sold as an OTC drug 50 years ago for no more than $1 per pill in today's prices.
In 2014, Revlimid generated $2.916B of revenue in the US alone. With 25,965 patients treated that is $112,000 per patient. The drug is used for several indications, but the single most important one still is multiple myeloma. Dose and duration differ from patient to patient, but Revlimid is administered in treatment cycles which comprise one capsule per day for three weeks with a one week rest period. Assuming that a patient is treated over a full year at the highest dose (which is 25 mg per day), she or he is administered close to seven grams of the active pharmaceutical ingredient per year. That is about a quarter of an ounce, priced at $112,000 in the US (at least according to the 2014 average). Compare this to the price of gold which is currently around $1,200 per ounce and you end up with a factor in excess of 300.
Again, it is important to stress that the production costs of a drug are not the cost driver in this industry. They neglect R&D, clinical studies, registration costs, and the investments in other candidates that did not make it to the market. But if a drug becomes a big success, the margins become exorbitant which represents a certain threat for a company like Celgene should politicians really take action.
What is at stake if politicians really tackle drug costs?
Are the profits of pharma and biotech companies really in danger? How realistic is it that politicians can enforce significantly lower prices? In any case, lobbyists will continue to do their jobs, if something is going to happen, it will take time and it will be a compromise. Therefore, a doomsday scenario is not realistic. We still have a free market and politicians cannot dictate prices.
Nevertheless, there is a lot at stake, and drug prices in the US are higher than in other developed countries which seems hardly justifiable. Moreover, with the price increases in the last years, pharma companies may have overplayed their hand. If actions were taken and if US prices came down to the European level, it would have a significant impact on industry profits.
If anything happens, some companies and products are obviously more vulnerable than others. Orphan drugs are the most expensive ones, with average costs per patient 14 times higher compared to non-orphan drugs. In addition, the number of orphan drug designations is growing in the double digit range which may make it harder to justify prices. Particularly Celgene's Revlimid looks like an ideal target for me: It is a multi-billion dollar product with an extraordinary price tag, and Celgene fate is depending on Revlimid.
This is why I am a bit worried about Celgene, and the reason I remain at the sideline in the current political environment. Fundamentally, the company's outlook seems great, with a lot of growth ahead, but any serious attempt to lower drug prices could have a severe impact. Therefore, I will wait, and if the Trump administration decides to take action, the stock will become cheaper. I am well aware this means I may miss the boat if nothing happens, but I do not feel confident enough to buy Celgene at the moment.
There are renewed concerns that drug prices will come under scrutiny, even under the Trump administration. Still it remains a vague threat, and besides a minor dip, it has not really hurt share prices. Should lawmakers in the US really take action (and some European countries have shown that this is possible), it could have a severe impact on the profitability of some products, one of them being Celgene's Revlimid.
Disclaimer: Opinions expressed herein by the author are not an investment recommendation, any material in this article should be considered general information, and not relied on as a formal investment recommendation. Before making any investment decisions, investors should also use other sources of information, draw their own conclusions, and consider seeking advice from a broker or financial advisor.
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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.