I had the privilege of speaking at the Gurufocus Conference in Omaha earlier this month. The basis of my talk was finding value in healthcare. In the presentation I talked about the fact that new wide-moat companies are frequently found outside the traditional biopharma space. During the Q&A I was asked about Valeant and whether I saw value in the stock. I have written earlier about the company (which can be found here) and discussed the myriad issues for the company going forward. In this article, I want to discuss trends that started with Valeant but will affect many players over the next several years.
Drugs, Pricing, and Access
For the past twenty years the drug distribution model has been relatively static. Doctors write prescriptions, patients use a pharmacy benefit manager (PBM) to fill the prescription, the PBM evaluates whether the drug is on their formulary (meaning they will pay for the drug with a defined co-pay from the patient), and the patient’s insurance provider is billed. This model generally worked quite well as biopharma companies launched blockbuster drugs with relatively small costs (such as Zocor or Zestril). These drugs were in pill form and generally cost under several dollars per dose. Since 2005 this model has changed dramatically. Three trends in particular have created these changes.
The Rise of Specialty Drugs: Since 2005 there has been an explosion in specialty and orphan drugs (meaning medications targeting generally rare or “orphan” diseases. This is a disease with less than 200,000 patients in the US). To give some notion of the growth one only has to look at FDA drug approvals for the periods 1973 – 1983, 1983 – 1993, 1993 – 2003, 2003 - 2013. During the first decade roughly 15 orphan drugs were approved. In the second decade (after the passage of the Orphan Drug Act) roughly 65 orphan drugs were approved. During the third decade roughly 125 orphan drugs were approved. Finally, in the last decade roughly 180 orphan drugs were approved. In 2013 alone there was 260 approvals. By 2020 it is estimated orphan drugs will make up roughly 20% of total prescriptions totaling an estimated $175B in sales.
The Rise of Therapeutic Costs: With the rise in the amount of orphan drug approvals has come the rise in cost per treatment. A new immunotherapy for cancer can cost as much as $180,000 annually. Gilead’s Harvoni (treatment for Hepatitis C or HCV) is priced at roughly $90,000 for a 12-week course of treatment. Compared to the costs for treating hypertension (roughly $150 per year), these new drugs are placing enormous strain on insurers and patients.
The Rise of PE Biopharma: In the last decade we have seen the creation of what I refer to as private equity biopharma. These are companies engineered to take advantage of the United State’s unique healthcare model that is half for-profit and half not-for-profit. These companies acquire a target that has one or two approved drugs (sometimes branded or under patent protection and sometimes generic), strip the company of all R&D assets, and hike the price of the drug anywhere from 50-800%. An obvious example of this is Valeant but others such as Allergan and Endo Health follow the same model. Price increases are an essential component of these companies’ business model.
PBMs Push Back
Price inflation on some generic drugs and the cost of new specialty drugs has caught the attention of those who have to pay for these medications. These companies pay pharmacy benefit managers (PBMs) to negotiate prices and generate cost savings across the board. The largest PBMs have enormous leverage when negotiating. For instance Express Scripts covers roughly 85 million patients. The largest PBMs have taken steps to rein in these costs and seek out the cheapest option whenever available. In particular, two new trends will impact biopharma the most.
Market-Event Action: Currently PBMs are required to get individual patient approvals to switch to a cheaper version of their prescription. Several PBMs are moving to a more centralized – and quicker – process. Under new market action processes, employers or insurance plans will give Express Scripts advance permission to try to shift patients to cheaper alternative medicines when an old drug jumps suddenly in price. Express Scripts expects to have the market-event process in place by the end of 2016.
Indication-Specific Pricing: In Europe, regulators compare the clinical and cost-effectiveness of new drugs with existing treatments to determine whether a drug qualifies for inclusion in their formulary. The goal is pay an amount based on improving quality and/or length of a patient’s life without substantial side effects. For instance, Genentech’s Tarceva can increase the survival of a metastatic non–small cell lung cancer (NSCLC) patient by roughly 3 months. Treating a patient with pancreatic cancer with the same drug increases survival by less than 2 weeks. Indication-specific pricing would argue that the price should be different for each instance – based on clinical results - rather than one universal price.
Why This Matters
As any investor in Valeant or Gilead can tell you, the ability to drive earnings growth is highly dependent on gaining market share and increasing drug prices. As PBMs begin to reject coverage on some drugs, seek generic alternatives, and begin indication-specific pricing, the impact on Biopharma will be profound. Some companies will be impacted more harshly than others. PE biopharma will face the largest impact as their model is based primarily on price increases. Both market event and indication-specific pricing will likely prove to be catastrophic for these companies. Valeant’s 87% drop in share price reflects these new realities. Endo’s 44% drop in the last week is another example of the investment community grasping the magnitude of these changes. Large biopharma (such as Pfizer and Merck) will face similar pressure but the impact will be far less. That doesn't mean they are out of the woods. Far from it. Market event and indication-specific pricing will slow earnings growth significantly over the next decade. Conversely, if the major PBMs succeed in driving down prices, their revenue from shared cost savings (PBMs take a percentage of savings derived from price decreases) will likely expand significantly over the same time period.
Conclusions
Picking the winners and losers from these trends isn’t as easy as it may seem. Additional actions such as Medicare/Medicaid reimbursement, hospital order sets, and evidence-based medicine could play equally large roles in the future. With so many moving parts it will be vital to fully understand what is a remarkably complex marketplace. Companies that are one-trick ponies (focused on only price increases or having one product in multi-treatment therapy) will pay the highest price. Finding a company that blends new products, significant drug efficacy, and reasonable pricing will likely be your best bet. Companies like Novo Nordisk (I own this in the Nintai Charitable Trust) are well positioned. NVO has roughly 25% of the diabetes market with three of their products in either number one or two market position. Their drugs are highly effective with only one real competitor (Sanofi). The company’s financials are rock solid with no debt and roughly $750M on the balance sheet. Finding companies like NVO will take a significant effort but they are out there. Investors should keep their eye out for companies that thread such a needle. It’s a prescription for a healthier portfolio and adequate returns.
Drugs, Pricing, and Access
For the past twenty years the drug distribution model has been relatively static. Doctors write prescriptions, patients use a pharmacy benefit manager (PBM) to fill the prescription, the PBM evaluates whether the drug is on their formulary (meaning they will pay for the drug with a defined co-pay from the patient), and the patient’s insurance provider is billed. This model generally worked quite well as biopharma companies launched blockbuster drugs with relatively small costs (such as Zocor or Zestril). These drugs were in pill form and generally cost under several dollars per dose. Since 2005 this model has changed dramatically. Three trends in particular have created these changes.
The Rise of Specialty Drugs: Since 2005 there has been an explosion in specialty and orphan drugs (meaning medications targeting generally rare or “orphan” diseases. This is a disease with less than 200,000 patients in the US). To give some notion of the growth one only has to look at FDA drug approvals for the periods 1973 – 1983, 1983 – 1993, 1993 – 2003, 2003 - 2013. During the first decade roughly 15 orphan drugs were approved. In the second decade (after the passage of the Orphan Drug Act) roughly 65 orphan drugs were approved. During the third decade roughly 125 orphan drugs were approved. Finally, in the last decade roughly 180 orphan drugs were approved. In 2013 alone there was 260 approvals. By 2020 it is estimated orphan drugs will make up roughly 20% of total prescriptions totaling an estimated $175B in sales.
The Rise of Therapeutic Costs: With the rise in the amount of orphan drug approvals has come the rise in cost per treatment. A new immunotherapy for cancer can cost as much as $180,000 annually. Gilead’s Harvoni (treatment for Hepatitis C or HCV) is priced at roughly $90,000 for a 12-week course of treatment. Compared to the costs for treating hypertension (roughly $150 per year), these new drugs are placing enormous strain on insurers and patients.
The Rise of PE Biopharma: In the last decade we have seen the creation of what I refer to as private equity biopharma. These are companies engineered to take advantage of the United State’s unique healthcare model that is half for-profit and half not-for-profit. These companies acquire a target that has one or two approved drugs (sometimes branded or under patent protection and sometimes generic), strip the company of all R&D assets, and hike the price of the drug anywhere from 50-800%. An obvious example of this is Valeant but others such as Allergan and Endo Health follow the same model. Price increases are an essential component of these companies’ business model.
PBMs Push Back
Price inflation on some generic drugs and the cost of new specialty drugs has caught the attention of those who have to pay for these medications. These companies pay pharmacy benefit managers (PBMs) to negotiate prices and generate cost savings across the board. The largest PBMs have enormous leverage when negotiating. For instance Express Scripts covers roughly 85 million patients. The largest PBMs have taken steps to rein in these costs and seek out the cheapest option whenever available. In particular, two new trends will impact biopharma the most.
Market-Event Action: Currently PBMs are required to get individual patient approvals to switch to a cheaper version of their prescription. Several PBMs are moving to a more centralized – and quicker – process. Under new market action processes, employers or insurance plans will give Express Scripts advance permission to try to shift patients to cheaper alternative medicines when an old drug jumps suddenly in price. Express Scripts expects to have the market-event process in place by the end of 2016.
Indication-Specific Pricing: In Europe, regulators compare the clinical and cost-effectiveness of new drugs with existing treatments to determine whether a drug qualifies for inclusion in their formulary. The goal is pay an amount based on improving quality and/or length of a patient’s life without substantial side effects. For instance, Genentech’s Tarceva can increase the survival of a metastatic non–small cell lung cancer (NSCLC) patient by roughly 3 months. Treating a patient with pancreatic cancer with the same drug increases survival by less than 2 weeks. Indication-specific pricing would argue that the price should be different for each instance – based on clinical results - rather than one universal price.
Why This Matters
As any investor in Valeant or Gilead can tell you, the ability to drive earnings growth is highly dependent on gaining market share and increasing drug prices. As PBMs begin to reject coverage on some drugs, seek generic alternatives, and begin indication-specific pricing, the impact on Biopharma will be profound. Some companies will be impacted more harshly than others. PE biopharma will face the largest impact as their model is based primarily on price increases. Both market event and indication-specific pricing will likely prove to be catastrophic for these companies. Valeant’s 87% drop in share price reflects these new realities. Endo’s 44% drop in the last week is another example of the investment community grasping the magnitude of these changes. Large biopharma (such as Pfizer and Merck) will face similar pressure but the impact will be far less. That doesn't mean they are out of the woods. Far from it. Market event and indication-specific pricing will slow earnings growth significantly over the next decade. Conversely, if the major PBMs succeed in driving down prices, their revenue from shared cost savings (PBMs take a percentage of savings derived from price decreases) will likely expand significantly over the same time period.
Conclusions
Picking the winners and losers from these trends isn’t as easy as it may seem. Additional actions such as Medicare/Medicaid reimbursement, hospital order sets, and evidence-based medicine could play equally large roles in the future. With so many moving parts it will be vital to fully understand what is a remarkably complex marketplace. Companies that are one-trick ponies (focused on only price increases or having one product in multi-treatment therapy) will pay the highest price. Finding a company that blends new products, significant drug efficacy, and reasonable pricing will likely be your best bet. Companies like Novo Nordisk (I own this in the Nintai Charitable Trust) are well positioned. NVO has roughly 25% of the diabetes market with three of their products in either number one or two market position. Their drugs are highly effective with only one real competitor (Sanofi). The company’s financials are rock solid with no debt and roughly $750M on the balance sheet. Finding companies like NVO will take a significant effort but they are out there. Investors should keep their eye out for companies that thread such a needle. It’s a prescription for a healthier portfolio and adequate returns.
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