How Tax Reform Will Impact Developmental Biotech

by: John Engle

The biotech industry will feel a serious impact from the impending tax reform vote.

Lower tax rates will reduce tax shields going forward; a reduced orphan drug development tax credit will limit the tax advantages of some research.

Changes to tax rates, credits, and the repatriation of foreign cash should fuel M&A activity in 2018.

Long-term, the reforms will benefit large players and small development firms, but may make the transition to commercialization more challenging.

The pharmaceutical industry as a whole is set to benefit from the tax reform vote to take place this week. The general reduction in corporate taxes and a special tax deduction for cash repatriated from overseas should see companies post improved returns to shareholders and a whole lot of cash freed up right away.

For most development-stage biotech companies, the news is particularly good. Let's take a look at how three major changes will impact the sector going forward.

Corporate Tax: Down to 21%

Dropping the corporate tax rate from 35% to 21% will be a boon for all cash flow positive businesses, but it may have some negative impacts on development-stage businesses that are currently burning capital in order to develop new products. Such is the case in much of biotech, in which a large number of development-stage companies make significant annual losses.

A lower corporate tax rate means a smaller tax loss carry-forward that development companies can rely on in future. At the same time, however, the taxes on their future earnings will also be lowered. Thus, for companies entering a new commercialization phase, the advantages probably outweigh the disadvantages on this score. Yet, for companies still largely in the development phase of their life-cycle, the loss of some tax advantages might prove to be a negative in some cases, such as when they are considered buyout targets. Acquirers are always keenly aware of the tax shields they can bring forward with an acquisition. If those are diminished, so is the value of a potential deal.

Special Repatriation Rate: 14.5%

Perhaps the most exciting part of the forthcoming tax law is its special tax rate for repatriating cash currently held overseas. American firms currently hold trillions of dollars abroad, money many of them would like to bring home, and a special reduced tax rate will help encourage them to do so.

While the Republicans in Congress assure us that this measure will help create new jobs as companies invest in new development and production on American soil, that is probably not going to be what most of the money is used for. After all, during the last tax holiday of this kind, in 2004, firms spent 94 cents of every dollar brought back on share buybacks and dividends. For a political reformer, that may be upsetting. For an investor, that should sound pretty good.

Big pharmaceutical and biotech have a huge hoard of cash overseas, with Amgen (AMGN), Gilead Sciences (GILD), Pfizer (PFE), and Merck (MRK) alone likely to bring back around $100 billion of currently stranded cash. As I have covered previously, these firms are already gearing up for an M&A feeding frenzy. So while the pharmaceuticals industry may follow suit with other industries and offer a raft of share buybacks and dividends, it is also likely to deploy a significant piece of that cash toward buying smaller companies in the biotech space.

Many of the stalwarts of Big Pharma need an injection of new big-earning products. Acquisitions may prove to be a popular way of obtaining them in 2018.

Orphan Drug Tax Credit: Cut in Half

One perhaps overlooked but potentially highly impactful feature of the tax reform bill is its slashing of the tax credit now available to companies developing orphan drugs and drugs for the treatment of rare diseases. Previously, pharmaceutical and biotech companies could avail of tax credit covering 50% of the cost of testing and clinical trials for drugs treating rare diseases. The new tax law is set to cut that deduction in half.

The short-term impact of the change will likely be minimal, especially given the likely flurry of M&A in that very sector. Big pharmaceutical and biotech concerns are already licking their chops about acquisition prospects, thanks largely to cash coming back from overseas. I discussed in a previous article how orphan drugs and treatments for rare diseases would be at the top of acquirers' wish lists, and that has not changed. Especially companies with drugs on the cusp of approval, such as Progenics Pharmaceuticals (PGNX) and Verastem (VSTM).

Further down the line, however, problems could emerge for the drug development industry as a whole. While most development-stage companies are not making much money to speak of - if any - they all intend to do so eventually. Loss of the tax credit, like the diminished tax shields from the corporate tax rate reduction, could negatively impact some companies' bottom lines over the longer run.

However, development companies also have a distinct advantage, thanks to that generally limited-earnings character. Since big pharmaceutical and drug development concerns will have lowered incentives to engage in development themselves, smaller biotechs may find a bit less competition across a range of rare diseases. Instead, Big Pharma may turn even more to acquisitions to add rare disease treatments to their offerings, rather than development in-house. That change to the landscape ought to keep M&A activity humming along in the biotech space even after the initial tidal wave of cash comes crashing in from repatriation.

Overall Impact

The short-term impact of tax reform will undoubtedly be considerable. With so much cash overseas likely to return home, the pharmaceuticals industry will be flush with cash - and the urge to go on buying sprees can already be felt.

Further down the line, the loss of tax shields may make buyout targets less attractive, especially in non-niche sectors. Meanwhile, in-house orphan drug development will be less attractive to Big Pharma. That opens up a window for developmental biotech in that space.

Overall, some biotechs, especially in the rare disease and cancer spaces, will do quite well. But the transition from a development company to a commercial entity may become harder thanks to lower tax loss carry-forwards and less generous tax credits. Life should be good for the biggest players and for the smaller, nimbler drug developers. For companies in the middle, with one or more commercial products - and especially those trying to go it alone on commercialization - it could become a tougher playing field.

Disclosure: I am/we are long PGNX. 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.

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