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Winners and Losers in the Drug-Pricing War

Matthew Coffina, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. There's been a lot of talk about drug pricing recently. I'm joined today by Matt Coffina--he's the editor of Morningstar StockInvestor newsletter--for his outlook on drug pricing and who he thinks some of the winners and losers are going to be.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's talk about why drug pricing has come to the forefront of discussion recently. Is it a political issue? Is it a true economic issue? Why are we talking so much about drug prices?

Coffina: The United States has always been an unusual market for pharmaceutical companies. Most other developed markets have very strict regulation about drug pricing, and the government is usually the main insurer. So, they can really dictate prices to pharmaceutical companies. In the U.S., it's much more of a free-for-all, and the drug companies have a lot of latitude in setting their prices. The main counteracting force is the pharmacy benefit managers. In order to get included in an insurance plan and to get included in a formulary, you need to usually offer concessions to the pharmacy benefit manager in the form of rebates. That's really how they hold down pricing.

The reason, I think, it's coming to the fore right now is that we've seen relatively rapid growth, especially in specialty drugs that meet high unmet medical needs. Things like new hepatitis C and cancer drugs are coming to market, and they are tending to come to market at very high prices. In the case of some cancer drugs, they can cost more than $100,000 a year. Then, we've also seen some very aggressive players like Valeant Pharmaceuticals (VRX) and Turing Pharmaceuticals--a much smaller company that's been in the headlines--that have really started to take advantage of that market power that they've had all along. But more mature and developed pharmaceutical companies like Novartis (NVS) and Johnson & Johnson (JNJ), I think, have been somewhat more responsible historically. They didn't want to attract negative political attention. They didn't want a reputation for jacking up prices on life-saving drugs. So, they take their price increases 10% or 15% a year, but they're not trying to raise prices 500% from one year to the next. Now, we've seen some more-aggressive companies come in and take those kinds of actions, and that's attracted some political backlash.

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Glaser: So, what's your outlook here? Do you think that there will be a push beyond just the [pharmacy benefit managers] for drug prices to drop in the coming years?

Coffina: It's hard to say. There aren't a lot of tools at policymakers' disposal right now. You could try to regulate drug prices at the federal level; you could have Medicare negotiate drug prices. But that's really a political third rail--it's like gun control. Nobody really wants to get involved in that fight; it's pretty much a political nonstarter. So, I would be surprised if we see any kind of serious legislative efforts to regulate drug prices. But you never know.

Barring that, I'd say it's really up to the pharmacy benefit managers to flex their bargaining muscle. This base is pretty consolidated in the U.S.--Express Scripts (ESRX), CVS Health (CVS), and UnitedHealth (UNH) are really the three dominant companies. They control 20% to 30% of the patient population each, so they can really have a lot of say over which drugs people are using. But the caveat is that they need to have some kind of competitive alternative. So, if you have two or three drugs in a class, you can play them off one another; you can say, "I'm only going to include one in the formulary--who's willing to give me the best price?" If you only have one drug, and it's truly unique and treats a condition better than any other drug on the market, then there is not much the PBM can do. They basically just have to take the pricing that they are offered.

Glaser: Looking at the investment implications, do you think the PBMs are in the best position? Is that where you see the most value?

Coffina: We own Express Scripts in the Hare portfolio. It's actually one of our largest positions, and I do see a lot of opportunity there. First of all, Express Scripts trades at a very reasonable price. It trades for about 16 times trailing earnings and about 14 times forward earnings. It has this natural growth tailwind from growth in pharmaceutical spending. That should last for decades as the population ages and expansions in insurance coverage increase spending on drugs.

CVS Health also, I think, is a very high-quality company. With UnitedHealth, you are dealing with managed-care organization; the pharmacy-benefit-management business is a much smaller part of the whole, so I wouldn't buy United as a bet on pharmacy benefit management. But I think Express Scripts and CVS are both going to benefit from this trend in the long run as their services become more necessary than ever to employers and insurance companies trying to rein in their drug costs. PBMs are really the only companies out there offering any kind of tool to be able to do that.

Glaser: We talked about Valeant briefly earlier. What's your outlook for these more-aggressive players? Are they more likely to feel some pain?

Coffina: Valeant is definitely backing away from their former policy of driving organic growth primarily through price increases. They attracted a lot of backlash; they also got into a situation with a specialty pharmacy they had been using that was doing some sketchy business practices. The CEO is actually in the hospital right now with severe pneumonia, so that's adding to the uncertainty and the complexity around Valeant. But I think for a company like that which hasn't historically invested in research and development and whose product lineup isn't particularly innovative--they have a lot of older drugs, off-patent drugs--they have relied on these price increases for organic growth historically. I think it's going to be very difficult for them to grow organically.

At the same time, their shares have come down quite a bit, so it's much harder to grow through acquisition as well. They are already highly leveraged, so they can't take on much incremental debt. I think our analyst still thinks Valeant is undervalued, but the uncertainty surrounding that valuation is very, very high right now. As far as I'm concerned, I'd probably rather have a company that is showing innovation in its drug pipeline and has been investing in R&D. Some stocks that we like would be Bristol-Myers (BMY), Amgen (AMGN), and Biogen (BIIB). These are companies that do have innovative pipelines and do have potential for organic growth based on actually solving our healthcare problems versus just trying to raise prices on old drugs.

Glaser: Matt, thanks for your thoughts today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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