Promise in New Cancer Treatments, for Patients and Investors

Morningstar’s equity analysts find the U.S. market overall somewhat overvalued, but there are pockets of opportunity for long-term investors. Pharmaceuticals are one of those areas, and some key players in the sector are fortifying their moats with emerging immuno-oncology drugs, as discussed in a recent white paper from Morningstar Research Services.

To explore these opportunities, I spoke with co-author Damien Conover, director of pharmaceutical research. Our conversation took place June 1 and has been edited for length and clarity.

Laura Lallos: What prompted your recent report on immuno-oncology drugs? Conover: There are two factors driving our research on immuno-oncology. The ability to innovate new drugs to offset products losing patent protection is really a core element to the wide economic moats for large-cap pharmaceutical and biotechnology firms. When we think about the next generation of products, immuno-oncology drugs are very transformative, with a lot of pricing power, and will likely result in a lot of cash flow for these pharmaceutical firms, helping them to offset some of the patent losses.

The other piece is that a lot of data is coming out rapidly in immuno-oncology, such as at the American Society of Clinical Oncology meeting in early June. We’re trying to help set the stage for investors to appreciate the potential for these drugs to not only drive cash flows but reaffirm our wide economic moat ratings for a lot of the firms we cover.

Dr. Tanguy Seiwert from the University of Chicago recently joined us on a call where he talked about how he’s using these immuno-oncology drugs in practice. We came away feeling that these drugs are going to be used very rapidly and will prolong patients’ lives. That will encourage more prescribing of these drugs; they are going to be very important to patients and from the perspective of generating cash flows.

What advantages do these drugs have over older-generation chemotherapy treatments? Conover: Chemotherapy is the core bedrock for most cancers, but it is a blunt instrument. It kills the cancer, but it kills a lot of other living parts of the body around it, and it can have a lot of side effects. And it typically doesn't have a very good long-term survival rate.

The new oncology drugs try to be more precise with the drug treatment, and they allow the body to work like it’s supposed to. Generally, when people develop some sort of tumor, the body will recognize it and T cells will knock it out. With cancer, the tumor cell will start to evade the T cells. These new oncology drugs make the tumor more visible to the T cells, enabling the body to act like it should. That should lead to much better long-term outcomes, and so far, it is, especially for certain types of patients.

Pricing power is key to pharmaceutical moats, and the possibility of legislative price limits poses a threat, as do secular trends such as supply chain consolidation. Are immuno-oncology drugs better able to withstand such threats? Conover: Because of the innovation that they offer and the complexity of the treatment—meaning it's hard to substitute some products based on how these labels are being developed for each drug individually—it's very unlikely you're going to see a massive amount of pricing pressure for immuno-oncology drugs.

There’s more pricing pressure for drugs in areas where there’s less innovation. Any generic drug that hasn’t felt pricing pressure yet will likely feel it. But in the innovative drug space, where there is less interchangeability, that’s where pricing power is probably going to hold up.

In your recent report, you projected overall immuno-oncology drug sales of $28 billion by 2021, which is significantly higher than the consensus. What are other analysts missing?

Conover: The main reason why we're more bullish is that we're more comfortable ascribing higher penetration of these drugs into key markets. Right now, we are making projections based off limited amount of data, phase 1 and phase 2 data, some phase 3 data. Some folks in the investment community would like to see the totality of data before they go to a higher number. But we think the survival benefit, particularly in non-small cell lung cancer but also in a lot of other indications, enables us to get to that higher sales number.

There’s been a lot of focus on non-small cell lung cancer, which is the largest indication for cancer. There are a lot of patients getting this disease and not a lot of treatment options, and this is a big piece of that overall $28 billion that we’re projecting by 2021. But the other piece here is that the consensus is not as bullish on other indications, whether it be renal cancer, melanoma, head and neck, because they’re smaller. But when you add them up they become very large. They represent in totality more than the non-small cell lung cancer market.

I understand that these drugs are narrowly targeted, so that a drug for lung cancer would not necessarily be applied to head and neck. Conover: Cancer used to be just cancer, and one chemotherapy would likely work for all, or at least partially work for a lot of cancer. What we've subsequently found is cancer can be broken down by parts of the body and then can be further broken down by biomarkers. Typically speaking, when these drugs work for a type of cancer with a certain type of biomarker, that can sometimes translate into a benefit for other cancers with a similar biomarker. However, that's not always the case. There is some variability of response rate across the different types of cancer, and certain cancers can be very different.

We’re also going to see different types of trial design that might enable different ways to cut up the market even further. For example, with non-small cell lung cancer, some studies focus on certain biomarkers, some studies on others. It’s very likely we’re going to see room for a lot of different drugs within similar cancers because of the way the trial design works, and then that might lead physicians to use one drug in one way and another drug in a different way, for the same type of cancer.

To turn to specific investment opportunities, Roche RHHBY is on your best ideas list. Why is this name undervalued?

Conover:

With Roche, there are a couple of key dynamics going on. First off, they were one of the first companies to launch biologic drugs, and so now they’re one of the first companies to face potential biosimilar competition. There’s concern in the investment community that the biosimilars will take a lot of market share from Roche’s older biologics, drugs like Herceptin and Rituxan. We also think the biosimilars are going to take some market share. But we think people are underappreciating Roche’s next-generation drugs, and one of the important pillars there are immuno-oncology drugs. We believe that Roche’s Tecentriq is well positioned— probably not as well positioned as Bristol’s or Merck’s immuno-oncology drugs, but nevertheless reasonably well positioned.

This will help drive some of the growth that we’re anticipating for Roche. Roche is a pretty diversified company. It’s not a pure play on immuno-oncology, which represents close to 10% of total sales by 2021, by our estimate— not an overly dominant piece of the overall sales, but nevertheless an important contributor.

You also singled out Bristol-Myers Squibb BMY in your report.

Conover:

Bristol is more of a pure play on immuno-oncology. We are bullish on immuno-oncology, so it makes sense that Bristol might be undervalued. We expect almost half of the sales by 2021 for Bristol will come from immuno-oncology drugs.

One thing we like about Bristol relative to some of the other players is that it has a first-mover advantage into a lot of cancers. That helps establish market share, helps create a moat within the immuno-oncology space. Typically speaking, the first mover to a particular therapeutic area within cancer will dominate the market share. A drug that’s approved second or third to market tends to get a very small slice of the overall market share, even if the efficacy or the side effects look a tad better. Doctors get comfortable with the medicine and don’t want to switch, and you have longer clinical data, which helps reinforce its positioning.

Bristol had a setback with the CheckMate-026 trial. What were the lessons there? Conover: That was a major setback. Bristol's study did not statistically beat the standard of care for first-line non-small cell lung cancer therapy. We believe that's largely due to the design makeup of the trial. Had this study been properly stratified with the information that we know now based on tumor mutational burden and other factors, we think it's very likely the drug would have worked. It was reaffirming to hear Dr. Seiwert agree with the assessment that Opdivo— the drug that failed in CheckMate-026—is a very effective drug.

If you look at Opdivo’s performance in almost all the other studies, we’re seeing positive outcomes, especially in the second-line lung cancer setting. That gives us confidence that the drug will eventually work in the first-line setting, in combination with another drug of theirs that should enable them to get a slice of that large non-small cell lung cancer market.

Do immuno-oncology drugs require different approaches to trials? Conover: Trial design is critical for drug development for immuno-oncology, and it's early days here. There have been theories about immuno-oncology for close to 100 years, but they weren't put into effect because we haven't been able to design the right type of drugs. About eight years ago, we really saw the first emergence of immuno-oncology drugs working, and we've seen more since, but we're very early in this process.

Immuno-oncology drugs don’t work for everybody, but they work for a very large portion of the patient population. To correctly define that patient population is still a bit hard because the scientific community hasn’t been able to find the best biomarkers that will enable them to run studies to gain the efficacy needed to show statistical improvement. But we’re much further along now versus a little over two years ago, when Bristol first set up that study that eventually failed. Firms are taking a bit of a risk developing phase 3 studies without a full information set, because they want to be first to market. You increase the risk of failure. But these drugs are so strong that there is a little bit of a safety net there, because the drugs typically work.

Merck MRK has a significant market share in these drugs, but you noted it is not as good a value at the moment.

Conover:

Merck is probably going to get the lion’s share of the immuno-oncology market. They already are first to market in first-line non-small cell lung cancer, which again is the most important market out there from size, and so that should enable them to get a dominant share of the overall immuno-oncology bucket. But the stock has really run up to close to our fair value now. There are some other things going on. By 2021, we project immuno-oncology sales to represent about 20% of their overall sales, so they are not as focused as Bristol. And Merck has a patent exposure that we think somewhat offsets the potential in immuno-oncology.

We also looked at

Are there any companies you cover that are directly threatened by immuno-oncology? Conover: Immuno-oncology drugs are going to displace mostly older chemotherapy drugs mostly sold by generic firms. The margins aren't very high, so it shouldn't be overly detrimental, but the generic market might have a little bit of a setback there. There are some branded products that will likely feel some pressure, and Roche has some of those drugs. It's likely some of them will still be used in combination, but there also would likely be some displacement there.

Outside of immuno-oncology, what are other significant opportunities for Big Pharma and biotech right now? Conover: There's other innovation within oncology. We're seeing major innovation within the CDK 4/6 class of drugs, a new wave of drugs for breast cancer. We think Pfizer is best positioned within that class, and we also think Pfizer is undervalued. A big piece of that is due to the strength that we think Ibrance, their CDK 4/6, will have in the market.

The other waves of improvement we’re seeing are in immunology, in areas like psoriasis, rheumatoid arthritis, Crohn’s disease, ulcerative colitis. There are major advancements there. Within the next five to 10 years, neurology probably will be the next wave, but the science needs to get a little bit further along before we see major advancements there.

In one of your reports earlier this year, you noted that HIV drugs and multiple sclerosis drugs enjoy significant pricing power. Conover: The strongest pricing power tends to be in oncology and immunology, but there are other areas that also have reasonable strength of pricing power, and a couple of those are multiple sclerosis and HIV. With multiple sclerosis, there's a fair bit of complexity of treatment, and that complexity, both in sequencing drugs and tailoring drugs to individuals, has made the drugs less interchangeable. In the HIV landscape, there is a lot of concern about sequencing as well, because doctors want to avoid any sort of viral resistance, and that also enables some stronger pricing power.

Diabetes drugs, on the other hand, is an area where we’ve seen a lot of pricing pressure. Insulins are very interchangeable. Companies are being pressured by the large payers to lower their price. This will probably spread to some of the oral diabetes medicines as well.

Are there policy changes on the horizon that might affect pharmaceutical pricing power?

Conover: Within the healthcare reform that is being discussed in Washington, there are not a lot of changes to drug regulations. A lot of those reforms have to do more with insurance and hospitals. The most probable near-term reform that could impact the drug industry involves dual-eligible patients—patients who are eligible both for Medicare and Medicaid. If there is a change so that they are reimbursed under Medicaid pricing instead of Medicare, that would be significant because Medicare drug prices can be close to 30% higher than Medicaid. That would probably hurt large biotech and large pharmaceutical firms' earnings by close to 5% in aggregate, so that could be a major hit. But we think there is less than a 50% likelihood of that happening.

How would you classify the prospects for the industry overall?

Conover: We're anticipating large-cap pharmaceutical firms growing close to 5% annually over the next five years. That growth, combined with an average dividend yield of close to 3.5% to 4%, gives you a reasonable return with the likelihood of a little bit of capital appreciation, as we see the large-cap pharmaceutical stocks as modestly undervalued. They aren't steeply undervalued, but we like these firms, especially relative to the valuations outside of healthcare, because in aggregate, Morningstar considers the market to be slightly overvalued.

This article originally appeared in the August/September 2017 issue of Morningstar magazine.