Expert Financial Analysis and Reporting

Introduction

The biotechnology stocks have gone through a correction over the last few days that has shaken investor confidence. Traders are saying that the party that these stocks have enjoyed over the last two years is over and it is time to take profits and move on. In this note, I address this concern against the backdrop of my investment style that is long term oriented. As always, my opinion is just my own and I try to address the issues in a way that will help you reach your own independent judgment. After all, it is your money.

Concern about Pricing Power Was the Catalyst for the Correction

Pricing power for new drugs and price increases on older drugs have been important factors in allowing big biotechnology stocks to exhibit strong relative growth in earnings over the last decade or more. There has been a significant correction in stock prices over the past few days with the catalyst appearing to be questioning by some politicians about drug prices and specifically with a focus on Gilead’s (GILD) new HCV drug Sovaldi which sells at about $84,000 for 12 weeks of therapy. Alexion’s (ALXN) orphan drug Soliris which sells at $400,000 per year was also singled out for its price.

There are three components of drug pricing which draw critics’ attention. The first is the price at which a new drug is introduced as in the case of Sovaldi. The situation with Sovaldi is made more acute because it could potentially be used in hundreds of thousands of patients instead of thousands for new cancer drugs and handfuls of patients as is the case with Soliris. The second is price increases on older drugs. For example in 2013, I estimate that the prices of older drugs with little unit volume growth like Epogen, Rituxan, Herceptin, Aranesp, Avastin and Viread increased US prices by 3% to 6%, which of course is over and above the rate of inflation. This is a trend that has been going on for some time, more than a decade. The third component is that the introduction of a new drug in a category does not trigger off a round of price competition. Instead the inevitably higher price of the new drug creates a pricing umbrella that results in significant price increases in older drugs in the category. An example is that the introduction of Biogen’s new drug for multiple sclerosis Tecfidera, was met with a 16% price increase in Avonex and 34% in Rebif; these are older drugs in that category.

From a macro-economic standpoint, the pricing behavior as described above has not caused a dramatic impact on drug expenditures by Medicare and managed care. This is in part because of the large number of recent patent expirations on small molecule drugs which at their peak had enormous sales levels; Lipitor is a prime example as sales in the US plunged from $5.0 billion in 2011 before the patent expiration to $432 million in 2013 after the expiration. These patent expirations have had a major dampening factor on the overall increase in drug expenditures. Moreover, generic drugs account for around 80% of prescriptions in the US and their prices are decreasing at about 2% per year.

It is also not the case that drug companies can set the price of a new product at any level they want. Managed care has enormous power in controlling the adoption of new drugs. We have moved more and more toward outcomes based medicines in which the marketer of a new drug must persuade a skeptical managed care payor that the price of a new drug provides significant cost savings over and above its cost. Otherwise, a new drug will not get broad reimbursement.

I think that managed care finds it difficult to say no to breakthrough drugs like Sovaldi because it is truly an effective therapy (close to a cure) for hepatitis C. Even at $84,000 for a course of treatment this drug is cost effective given the morbidity and mortality linked to long term hepatitis C infections. Also, managed care has difficulty saying no to orphan drugs like Soliris where there previously was no effective therapy and without therapy the patient faces death or extreme morbidity.

Managed care also has difficulty saying no to new cancer drugs. Here we are seeing drugs like Zytiga and Xtandi being priced at $60,000 per year for providing the benefit of a 4.5 month improvement in median overall survival. There have been other drugs introduced at this price that have even lesser increases in median overall survival. Key opinion leaders view a 4.5 month increase in median overall survival as a significant advance. However, it is common practice in cancer therapy to use multiple drugs in combination. If it is the case that two or more of these are new, patented drugs are combined the price of therapy can be over $100,000 or higher per year.

The price of prescription drugs has been a consistent issue for the 30+ years I have been covering the biopharma industry. It is a periodic target for politicians and editorial columnists. This periodically has caused great angst among investors, but has never resulted in the industry failing to grow. There have been winners and losers, but the industry as a whole has found a way to grow.

Of course, investors worry that some type of new pricing restriction could arise that would negatively change the balance of pricing power in the industry. This is always a possibility, but I think that in the current political environment for healthcare where Obamacare is under a great challenge that there is not the political will to put widespread, restrictive price controls on the drug industry. I see managed care as continuing to be the policeman on prices through the remainder of the Obama administration.

In terms of investment approach, I think that those companies that will do well in the future are those that have done well in the past. Companies with innovative new products will be able to charge prices commensurate to their value like Sovaldi and Soliris. There may be some vulnerability to the level of price increases taken on older drugs as described above, but I doubt that it will be in the form of actual price controls but more in terms of self-restraint by manufacturers or tighter restrictions from managed care if this issue flairs up among politicians and in the newspapers.

What about an investment approach in this environment? For the most part, SmithOnStocks focuses on breakthrough drugs being developed by small companies. The larger companies are more bureaucratic and slow moving so that many of the breakthrough drugs are developed by small companies, which are then bought by larger companies. If you go through the list of companies followed by SmithOnStocks most fall in this category. I see no risk to their ability to command high drug prices if they are successful in their drug development efforts.

I am uncomfortable with the pricing practices of some of the larger companies in raising prices at a 5% or so rate on older products that have little unit growth and also the pricing behavior that raises prices dramatically on older drugs when a new product enters the market. I am also skittish on oncology drugs; perhaps hundreds of small companies and all of the large have cancer programs. Most of these programs feature drugs that offer the potential of only limited increases in median overall survival. Hence, I tend to shy away from oncology. An exception is Northwest Biotherapeutics (NWBO) whose DCVax-L may extend survival by years in glioblastoma. Another exception is the checkpoint inhibitors like Bristol-Myers Squibb's (BMY) nivolumab and Merck's (MRK) lambrolizumab which also promise increased survival in a number of cancers.

The Biotechnology Correction is Not Just About Drug Prices

The catalyst for the market correction was the pricing issue, but there are also market related factors. The biotechnology industry had a fabulous 2013 in which the biotechnology index increased 70% and this followed a 24% increase in 2012. Biogen Idec’s (BIIB) stock price increased 100% in 2013 and 32% in 2012. Gilead’s (GILD) price increased 108% in 2013 and 63% in 2012. These stock price increases were far in excess of underlying EPS growth and history teaches that this doesn’t go on for a long period of time. There is certainly froth in biotechnology stocks. Additional evidence of froth is that there 37 biotech IPOs last year.

There are a lot of investors who believe that stocks that do well in one year will do poorly in the next. This has worked out well historically as shown by the “dogs of the Dow” approach to investing. This would suggest underperformance by biotechnology in 2014.

I am just a biotechnology geek and make no claims to being either an economist or market strategist, but let me take a crack at what the market as a whole may do in 2014. I think that most economists are looking at 2.5% to 3.0% growth in GNP for the US. Most believe that the Federal Reserve is not going to be forced to put on the brakes in a meaningful way. Hence, I don’t see a recession or meaningful monetary restraint potential on the horizon. This argues for the market indexes continuing to increase.

Many investors have remained on the sidelines since the market crash so that Americans are not over-invested in the stock market. This argues against a market crash as these investors might finally buy on weakness rather than sell on strength.

I am also persuaded by the argument as to where an investor should put money if they take it out of the stock market. I can only see interest rates trending up over time so I don’t want to be in debt securities. I get no return for putting my money in cash. Commodity prices in this low inflation environment offer little promise. I do think that real estate is a good investment, but few investors want to take the liquidity risk of putting all their money into real estate. By default, investors can either choose to invest in stocks or put their money under their pillow

So how do I think biotechnology stocks will do in 2014. I can’t state with certainty what will happen nor do I think anyone else can. I have watched CNBC pretty constantly over the last six years since the market crash and am persuaded that while lots of people think they can predict price trends for the stock market as a whole or an industry segment, none that I am aware of can do so in the short term. There are just too many unconstrained, uncontrolled variables.

Predicting the long term trend is much easier. If you believe as I do that the US economy and the world economy will continue to innovate and grow, the stock market will go up. At least this is what has happened for the last several centuries. There may be fluctuations but the trend is up. The stock market is a winner’s game and if you want to find someone who recognized this and capitalized on it, you need only look at Warren Buffet.

My Life Experience Affects my Judgment

One final note I would like to add comes from my own personal investing experience. I was the first analyst covering Amgen while I was at SmithBarney when it brought the company public over 30 years ago. We executed the IPO at a price of about $18 and the stock quickly plummeted to $4 or so. At that time, there was controversy as to whether biotechnology was anything more than a manufacturing tool and lacked promise for product development; both investors and the drug industry shared this belief. Of course, Amgen (AMGN) proved to be a great company and over the last 30 years has increased from an adjusted price of about $0.25 to the current price of $122. (My calculations are a little rough, but the magnitude is correct.) In still another life lesson learned at SmithBarney I recommended Marion Laboratories for over 8 years in a row as the price increased from $1 to $48.

Like everyone else, there was a time in my life in which I thought that I was smarter than everyone else and I tried to trade stocks. I failed and I think that the reason was that humans have a tendency to want to be comfortable and do what all the other (smart) people are doing. The result is that when all of us smart people were very comfortable with our analyses on where a stock was going; it was totally or more than totally reflected in the stock price. My experience in trading has been that if you carefully analyze and have high conviction in your view that leads you to an investment decision, you will more likely than not make money doing exactly the opposite of what your analysis suggests. I want to emphasize that this applies to short term trading and not long term investing.

I came to the conclusion that the basic human tendency is to buy high and sell low in the short term. One way to avoid this trap is to be a long term investor. Even if you are right on the short term direction of a stock and manage to sell it before it corrects, it is very difficult to determine when to get back in. The result is that you may never catch a ride on a stock like Amgen or Marion Laboratories. This is not to say that you should never sell a stock. We all know that there are frequent failures in biotechnology and sometimes we have to shrug our shoulders and move on. However, as long as your positive perception of the fundamentals remains unchanged, it is more risky to trade in and out than to stay the course.

My Investment View

My sense is that the big biotechnology stocks will not duplicate the outstanding performances of 2012 and 2013; this is not a heroic assumption as the gains in those years aren’t sustainable for more than a short time. I would not be surprised to see this group underperform in 2014, but this is pretty much the consensus expectation. I don’t see a wholesale slaughter as I don’t see other industry groups that will have markedly better sales and EPS growth and therefore a markedly more compelling investment case. We seem to be in a slow sustained recovery that doesn’t lend itself to big EPS gains from less technology driven sectors.

I think that poor performance of the large companies could put a damper on smaller stocks if investors reduce market weightings in biotechnology. On the other hand, it can also be hypothesized that money will be shifted from the large to the small biotechnology companies. I think that the smaller biotechnology companies as a whole will experience lesser returns in 2014 and could even lag the market. However, I think that those companies that hit significant clinical milestones can still have extraordinary gains and this is my focus.

Based on these ramblings, you can probably guess that I am not changing my position on any of the companies that I follow because of the recent sharp correction in biotechnology or the potential for a more substantial correction. I will continue with my emphasis on emerging biotechnology companies with exciting new products. As an aside, there are a lot of such prospects as scientific advances seem to be advancing at an exponential rate and this underlies growth in biotechnology. My bottom line is steady as she goes.