Big Pharma, Wide Moats

Pricing pressure is weighing on pharmaceutical and biopharmaceutical companies, but Morningstar's analysts are optimistic that the major players will continue to support their wide moats, as they explain in a recent Healthcare Observer featuring Morningstar's annual drug pipeline report. Firms that can develop innovative drugs for critical needs can protect themselves as existing drugs lose patent protection. Meanwhile, this environment is ripe for large-scale consolidation.

I spoke with co-author Damien Conover about opportunities for the industry and investors. Conover, CFA, is director of healthcare equity research with Morningstar Research Services. Our conversation took place on Feb. 19, and valuation data is as of that date. The discussion has been edited for length and clarity.

Laura Lallos: Is it fair to say that Big Pharma and biotech are the best areas to find wide moats in healthcare?

Conover: I think so. What's interesting about the healthcare sector is that the majority of the market capitalization is in these largecap pharmaceutical and biotechnology stocks, and we consider a lot of these firms to have wide economic moats. We believe these firms will be able to develop the next generation of medicine to offset older medicines that are losing patent protection. That's the key driver.

Lallos: At the same time, these companies face some challenges. Why don’t they have the pricing power they used to?

Conover: Over the last decade and a half, we've seen a consolidation of the payers in the United States, and the U.S. is one of the most important markets. There are three key pharmacy benefit managers left now, and they are able to negotiate strongly on price.

The payers have pushed drug firms to go deeper into their pipelines and development strategies to bring out the next generation of drugs. Drugs that are just slight enhancements— perhaps with easier dosing requirements or with slight efficacy or side effect improvements— may be valued by the patient and physician communities, but the payer community will not ascribe much value to these things. This is one thing that’s driving pricing pressure in the pharmaceutical landscape.

The other piece is on the regulatory side in the U.S. The system we have can put a lot of price pressure on the patient. Most drugs are covered by insurance, but patients who have high-deductible plans end up having to pay out of pocket until their insurance kicks in, and most of these payments are done on the drug’s list gross price, not the net price that the drug firm negotiates with these pharmacy benefit managers. Hence, we see the media and politicians focused on this piece of the payment, rather than the net price. This convoluted payment system has led to politicians wanting to control drug prices, when in actuality, net drug prices have only been going up very modestly in the U.S., below medical inflation. Drugs are under pricing pressure partly because of this convoluted system.

Lallos: You note that European firms are more diversified across industries, while U.S. firms are diversifying their drug lineups.

Conover:

Excluding

In Europe, there is still concern about the volatility that comes with being very focused in drug development. Generally speaking, the culture is to be more diversified, to have more stable returns. In the U.S., they want stable returns, but are OK with a little more volatility of cash flows. That being said, European drug firms are moving at a slower pace to a more focused drug development structure.

Lallos: Why are firms increasingly focusing on drugs for critical medical needs?

Conover: This is a way for drug firms to fight back against drug pricing pressure. They are starting to focus on areas of unmet medical need like oncology and immunology, involving diseases that can be lethal or highly debilitating. The scientific innovation is there now to develop drugs to treat them.

These drugs have important advantages. First, the FDA and other global regulators are less concerned about small side effects because of the severity of the disease they’re treating. Further, the pricing power for drugs that treat severe diseases is much stronger than for drugs that offer only incremental advancements in treating something minor. Also, the launch trajectories of drugs that treat unmet medical needs are much higher. The payer community feels like they need to reimburse these at pretty high prices.

Lallos: It sounds like consolidation is another promising theme right now.

Conover: These firms are always doing small tuck-in acquisitions, those between $500 million to about $8 billion. That's because a lot of the innovation in drug development happens in smaller biotech firms or small spinouts from universities. Big Pharma and biotechnology firms want to develop their pipelines externally, and they'll make these smaller acquisitions.

But what is potentially transformative is massive consolidation, very large firms buying very large firms. To kick the year off, we saw Bristol- Myers make a bid for

At the top of our list is

Beyond BioMarin, some larger firms are potential targets—

Lallos: So, Bristol itself is a likely target.

Conover:

A lot of times you see smaller firms make acquisitions and then get acquired, and then the acquirer is acquired. Bristol gets Celgene, and they get a really interesting pipeline; the valuation still looks attractive to us. Now, once you get to Bristol’s size there are fewer firms that can make that acquisition.

Lallos: Some companies that have a number of potential catalysts for valuation change, such as AbbVie, Novartis NVS, and Roche RHHBY. What are the themes here?

Conover: Each of those firms has drugs coming to the market that address areas of unmet medical need, in oncology, immunology, or rare diseases. The drug treatments for each of those areas are transformative. We anticipate these firms' portfolios shifting even more toward these areas over the next year or two, which should not only generate great drugs for patients, but likely lead to some margin expansion. Not only are these drugs strong on pricing power, they also tend not to need as large of a salesforce because they're going after smaller patient populations.

These catalysts should have multiple impacts. They should drive faster approval and stronger pricing power and improve margins. All of this should help these firms not only offset patent losses but grow the overall business as well. AbbVie is the one exception; it has a lot of patent exposure for the next five years, which is going to be more difficult for it to offset. It does have a good pipeline, but AbbVie has a narrow moat, while most of its peers have wide moats.

Lallos: How is Morningstar’s outlook different from the consensus?

Conover: When thinking about stock investments, it's important to know where you are different and why you are different. With pipelines, it's important to think about the potential for these new drugs.

One area where I’d consider us more bullish is immuno-oncology drugs. We anticipate the drugs in the immuno-oncology landscape to sell about $35 billion annually by 2022, versus consensus of $30 billion. The main reason why we’re different is we believe the efficacy that we’ve seen so far will continue in other cancers. We’ve seen excellent clinical data in non-small-cell lung cancer and melanoma. There are a lot more cancers being studied right now, and we believe there will be strong efficacy rates there, too.

It’s not just oncology. The investment community is less bullish on rare-disease drugs than we are, because the patient populations are small and it’s sometimes difficult to see the launch and trajectory going as well as we do in certain cases.

Pain management is another area where we’re different. There are many patients trying to manage their pain through opioids, with a lot of side effects. A new generation of drugs— nerve growth factor drugs—can treat pain incredibly effectively. One of these is tanezumab, which is in joint development with Eli Lilly and Pfizer. We think this drug has blockbuster potential, partly because there are no other treatment options out there and partly because the efficacy so great.

Why isn’t the rest of the investment community as bullish as we are? There are side effects. This drug potentially works too well: Patients may not get the signal that they need to be careful on their hips and knee joints, and they may walk and exercise a bit too much. There’s also potential for some rapidly progressing problems within the joint. But that is very limited in its incidence, and we think that limited incident rate relative to other treatment options will push the regulatory agencies to approve drugs like these. And we anticipate them to be quite large.

Lallos: Do these drugs avoid the concerns with opioids that regulators are worried about?

Conover: Absolutely. You don't see the addiction that comes with opioids. These drugs are biologics, which means they're going to be much more carefully monitored. They won't have the same abuse potential. That's a huge reason why these drugs are likely to get to the market.

Lallos: Does the increasing use of medical marijuana limit the prospects of drugs like these?

Conover: Medical marijuana would bring in another treatment option, particularly for mild to moderate pain. But it's harder to see marijuana being as effective for more severe pain, as with cancer, low-back pain, or osteoarthritis, which is where these NGF drugs would be focused.

Lallos: Where is Morningstar more bearish than the consensus?

Conover: It is more drug-specific, but several share a theme of increasing competition. Amgen's Enbrel is a good example there, as is Eli Lilly's Trulicity. In Enbrel's case, we think biosimilars will place greater pressure on this drug than what the investment community thinks. Trulicity is a new type of way to treat diabetes, but there's a competitor coming out that we think will be more damaging than what the market thinks. Most of the cases where we're more bearish tend to be where there's more branded competition coming out, or where we think that generic drugs will cause more damage than what the market's anticipated.

Lallos: You highlight several opportunities in the Observer. We’ve talked about Bristol and BioMarin; can you touch on Roche and Biogen?

Conover: Roche is a company that is very focused in areas of unmet medical need, and they moved their strategic direction almost a decade before any other pharmaceutical firm. Their pipeline is focused in oncology and immunology, and not in primary care, which is an area where it's much more difficult to get drugs approved and pricing isn't as good. This, I think, is underappreciated. We think as these drugs come to the market and as the launch trajectories go up, the stock price will go up as well. It's a focused cancer play, but Roche also has drugs in other areas of unmet medical need, like hemophilia and multiple sclerosis. These are devastating diseases that Roche is bringing transformative medicines to, and we don't think the market has fully appreciated that transformation.

Biogen is a similar story in a different therapeutic category, neurology. Neurology is definitely an area of unmet medical need, but the problem is the scientific advancement isn’t as far along as it is in oncology and immunology. The scientific community just doesn’t understand the brain quite as well yet and hasn’t figured out ways to delay or cure diseases like Alzheimer’s and Parkinson’s. However, Biogen is the best-positioned firm for neurology and has some of the most interesting medicines to treat some of these diseases.

Lallos: What should investors be watching for?

Conover: Concerns about further pressure on drug prices are weighing on the group. What we're going to likely see over the next few months is Congress talking about potential reforms that won't hurt the drug companies' pricing power. They might shift the way things are paid for and the pricing transparency within the drug pricing channels, but they shouldn't affect what the drug companies get paid. As these laws evolve, we should start to see valuations increase.

Beyond that, there are some drug studies and launch trajectories of new drugs, particularly in immuno-oncology, that should get valuations higher. We think Roche’s immuno-oncology platform in particular will show further strength. Biogen will likely have good data in its neurology platform. BioMarin has a whole host of smaller drugs going after rare diseases; we think the data to come out will bode well.

The strategic shifts that these firms have made over the last decade will start to bear fruit over the next two to three years. These are like big ocean liners; it takes time to turn. They’ve now shifted in the direction of unmet medical needs, and these ocean liners are now all going in the right direction. Innovation should be much stronger, and pricing pressure should come off these names and lead to overall valuation expansion for the group.

This article originally appeared in the Summer 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.