Drug Pricing Power Transcends Politics

We don’t expect any significant fair value estimate changes in the drug group based on Democratic presidential candidate Hillary Clinton’s disclosed drug pricing plan targeting unjustified price increases for older drugs. While passage of the plan in Congress would be very uncertain, if the plan were to take shape, we expect less innovative generic drugs and older branded drugs to be the focus of price controls. Further, we believe the core element of patent protection supporting drug prices is still intact, supporting our moat ratings in the pharmaceutical and biotechnology industries. Our moat ratings and valuations reflect our skeptical outlook on less innovative companies and their weaker prospects for pricing power, including our no-moat and negative trend ratings for

Parts of Clinton’s proposed plan would face low chances of passage in Congress or tough implementation. In response to unjustifiable price increases for older drugs, Clinton proposes increasing supply of competitive drugs and issuing penalties, which generally go against Republican support of market driven forces. Further, if drug prices increase too much, Clinton also supports drug importation, which is generally supported by Republicans but difficult to implement through the FDA.

Less innovative drugs would face the brunt of Clinton’s proposed plan. We believe smaller generic drugs with less natural competition and old branded drugs pushing for gains through pricing before generic competition would feel the most price pressure under this plan. However, most drug companies don’t derive much valuation from these drugs, and most large diversified generic drug manufacturers continue to face significant competition and pricing pressure.

On a broader note, the recently introduced drug plan reinforces Clinton’s message of lowering healthcare costs, but we don’t expect major changes in drug pricing power, especially for innovative drugs.

However, we believe the most likely negative legislative impact to the group is giving Medicaid rebates to Medicare patients that qualify for Medicaid, which could reduce industry earnings by 5%, but we still only assign a 30% chance of this legislation passing.

Within this highly politically charged environment,

Robust Drug Portfolios Give Companies Their Shot Allergan (previously called Actavis) has utilized acquisitions to transform into a major pharmaceutical contender. Management's decision to sell its generics and distribution segments to Teva looks prescient and will deleverage the balance sheet with ample cash to pursue more acquisitions. Even though Allergan's planned merger with Pfizer fell apart due to tax inversion rules released by the U.S. Department of the Treasury, the company still looks well-positioned for long-term growth. We think Allergan's diverse portfolio of defensible products, broad pipeline, and future potential acquisitions will sustain healthy earnings growth. Although large deals may sporadically continue, we expect Allergan will remain focused on expanding its branded pipeline and salesforce productivity through small acquisitions and licensing partnerships.

We think Roche's drug portfolio and industry-leading diagnostics conspire to create sustainable competitive advantages. As the market leader in both biotech and diagnostics, this Swiss healthcare giant is in a unique position to guide global health care into a safer, more personalized, and more cost-effective endeavor.

In Roche's pharmaceutical division, blockbuster cancer biologics acquired with Genentech--including Avastin, Rituxan, and Herceptin--continue to grow quickly as they gain market share in approved indications and garner widened approval in new indications and emerging markets. Strong information sharing continues between Genentech and Roche researchers, boosting research and development productivity and personalized medicine offerings that take advantage of Roche's diagnostic arm. For example, BRAF inhibitor Zelboraf, approved in melanoma in 2011, is among the first drugs tested in biomarker-selected patients from the start.

Roche's biologics focus and innovative pipeline are key to the firm's ability to maintain its wide moat and continue to achieve growth as current blockbusters mature. Three fourths of Roche's top pharmaceutical sales are from biologics, which provides a buffer against traditional generic competition. With the launch of Perjeta in 2012 and Kadcyla in 2013, Roche is in a strong position to continue expanding its breast cancer franchise beyond Herceptin, regardless of biosimilars (which we expect as early as 2017 in Europe and 2019 in the U.S.). Gazyva, now approved in CLL and NHL, could also extend the longevity of the Rituxan franchise. Avastin's lung cancer sales are vulnerable to competition from new therapies Opdivo and Keytruda, but Roche's own immuno-oncology drug Tecentriq is launching in 2016.

Sanofi's wide lineup of branded drugs and vaccines and robust pipeline create strong cash flows and a wide economic moat. Growth of existing products and new product launches should help offset weakening pricing in the insulin market.

Sanofi's existing product line boasts several top-tier drugs, including long-acting insulin Lantus. The drug's ability to work well for an entire day sets Lantus apart from other insulins. Further, given the complexity in marketing and manufacturing insulin, we don't expect major generic competition following the drug's 2015 patent loss. However, increasing branded competition and a deteriorating pricing environment will likely lead to sales declines for Lantus over the long term. Offsetting the Lantus weakness, Sanofi's vaccines, consumer products, and animal health treatments should continue to post growth as these products are less susceptible to patent losses.

Sanofi has compiled a robust group of late-stage pipeline products that complement its existing lineup and should help mitigate patent losses. We expect continued strength in the multiple sclerosis area with potential blockbusters Aubagio and Lemtrada emerging from the late-stage pipeline. In addition, diabetes drug Lyxumia looks to be a strong complement to the company's well-entrenched diabetes franchise.