Are the Dividends of Biopharma Stocks at Risk?

Key Takeaways

• The Inflation Reduction Act was really the first major new legislation in a long time that impacts almost all pharmaceutical firms.
• This new legislation reduced our fair values by about 2%.
• We don't anticipate any dividend cuts for the large biopharma industry.
• Why AstraZeneca and GlaxoSmithKline are our stock picks.

David Harrell: Hi, I'm David Harrell with Morningstar Investment Management. I'm here once again with Damien Conover, who leads the team of healthcare analysts for Morningstar Equity Research.

Damien, welcome back.

Damien Conover: David, it's great to be here.

Harrell: So I wanted to ask you about a recent report from your team. Morningstar Equity Research has reduced its fair value estimates for a number of biopharma firms in response to the Inflation Reduction Act that was just signed into the law. Can you give us a quick overview of the law and how it's affecting your fair value estimates within this industry?

Conover: Yeah, it's a great question. The Inflation Reduction Act was really the first major new legislation in a long time that impacts the large pharmaceutical firms—well, really, almost all pharmaceutical firms.

And what it does is it really aims to reduce the ability for pharmaceutical firms to increase prices over inflation for a key demographic, the Medicare patient population. So, when you think about pharmaceutical firms, sometimes they make headlines for increasing prices too quickly. This law is going to largely keep that in check, as well as implement some changes to negotiations for drugs that have been on the market for a very long period of time. Those two dynamics should reduce some of the spending by the U.S. government. And then, beyond that, there's a little bit of change too in how seniors will pay for drugs, really limiting their out-of-pocket pay. So, it does have a lot of impact on the way drugs are purchased and some of the pricing dynamics for a lot of different pharmaceutical firms.

Harrell: Okay. So, this change though, it's going to have some impact on earnings and that's why it's causing these changes in fair value estimates, correct?

Conover: Yeah, exactly. In aggregate, this new legislation reduced our fair values by about 2%. So, it's not a huge impact, but it is meaningful. We did reduce on average about 2%, some firms a little bit more if they have more exposure to Medicare patients and a little bit less for others. So, in aggregate, a moderate impact that we think a lot of firms will be able to navigate around. It shouldn't be a huge falloff on value, but a modest headwind.

Harrell: Okay. So, relatively small changes across the board?

Conover: Correct. Yeah, not a huge impact.

Harrell: Now, when we spoke back in December, you explained why the wide-moat firms within the biopharma industry had been such reliable dividend payers and that we had seen so few dividend cuts over the past decade. Looking at the impact of this legislation, are there any firms where you see this perhaps impacting the dividend and causing a reduction?

Conover: Yeah. It's a great question. So, in aggregate, no. The quick answer is no. So, this will be a new legislation that will hurt some of the cash flows, but the cash flows will be only moderately hit. And to your point earlier on, the ability of these firms to pay the dividend is very, very strong and that largely has to do with this huge portfolio of drugs. So, even though some drugs will be losing exclusivity, new drugs will be launching, and that portfolio of diversification really enables strong dividend support. So, we don't anticipate any dividend cuts for the large biopharma industry.

Harrell: Okay. And what about just growth rate in dividends? Is that going to be affected in any way?

Conover: Potentially, the dividend growth might be a tad bit slower. I mean, keep in mind, we're talking about a valuation impact of only about 2%. So, it could be a very moderate pressure on the growth of the dividends. We still anticipate this group will grow earnings at over 5% annually over the next five years, and that dividend growth will probably at least keep up with that.

Harrell: What about investor reaction to the law? Have you seen anything in terms of driving prices that might create more buying opportunities? I know when we look at healthcare as a sector, it was down for the second quarter, down for the year to date, but healthcare has held up better than the overall U.S. equity market in 2022.

Conover: Yeah. It's a great question because when you think about valuations for biopharma, they've been compressed for quite some time. There's been a lot of dialogue really over the last five years about concerns over major policy change for drug pricing in the United States. Keep in mind, the United States is the most important market for drug firms because of the ability to price high and have a lot of profits. So, this concern has really compressed valuations much lower than the historical average for this group.

Harrell: Okay.

Conover: Now that we've seen this legislation pass—and it doesn't look overly detrimental to the valuations—we think it's a great opportunity for investors to look at this group as we see the entire group as undervalued right now.

Harrell: Looking at the overall industry right now, can you share a few of your current picks, firms that are providing a decent dividend yield right now, but also look the most attractive from a valuation standpoint to you?

Conover: Yeah. It's a great question, because when we think about large biopharma firms, there's really two pieces to total return: You have the capital appreciation and the dividend yield. So, two names we like right now. The first one is AstraZeneca AZN. Its dividend yield is a little over 3%. We think it's a very secure dividend. And what we think the market underappreciates about this firm is the growth potential, both of currently marketed products with very few patent losses over the next five years, and importantly, a really strong pipeline, one of the best pipelines in the entire industry. Those two dynamics really to us show that the firm is undervalued relative to the market expectations with the current stock price.

Harrell: It's no patent cliff and strong pipeline right now?

Conover: Absolutely. Yeah. So, Astra is really one of the faster-growing firms out there and probably not getting enough credit for that growth potential.

Harrell: Okay. And you had said another name?

Conover: The second name is GSK GSK, so previously known as GlaxoSmithKline. This is a firm that it looks like it's been really hurt by concerns over litigation around an old drug called Zantac. This is a heartburn medicine. It's been out there forever. But recently, the amount of cases against GSK tying this drug to cancer has caused a massive decline in the market capitalization of the firm. We think that's way overdone. We do expect likely payouts, but nowhere near the amount of market capitalization that's been lost by this company. Beyond that, fundamentally, GSK looks very well positioned for nice steady growth, much higher than what the current stock price reflects.

Harrell: Now, GSK did have a corporate restructuring fairly recently and I believe that did affect the dividend rate of the firm.

Conover: Correct. So, when you think about the dividend yield right now for GSK, you want to be thinking of it as a little bit over 3%. If you think about GSK before the divestment of Haleon, the consumer products group, the yield was a bit higher, and that had to do with some of the yield coming from the consumer group. But following the divestment, there was a reallocation of that dividend. And GSK going forward is going to be paying a smaller dividend because some of the rest of the dividend is going to be paid by folks who own Haleon and them having that dividend.

Harrell: Got it. Damien, thanks again for sharing your insight. It's been great having you back.

Conover: Yeah, great to be here. Thanks for all the great questions.

Harrell: I'm David Harrell for Morningstar Investment Management. Thanks for watching. We'll see you again next month.

Watch Dividend Stock Deep Dive: Banks and Capital Allocation for more from this series. Watch 3 Dividend Stocks for October 2022 for more from David Harrell.