Drug Stocks Pay A Price

1/2/2017


The worst-performing sector index in the S&P 1500 in 2016 was health care, down more than 3% through Dec. 28, the only sector in the red for the year. We can blame most of that weakness on the biotechnology and pharmaceutical indexes, down 13% and 5%, respectively.

What ails drug stocks? The sector's bears point to increased competition, plus consumer and political backlash against the group. But these negatives flow into the single biggest fear Wall Street has for the drug makers — the loss of pricing power.

Interestingly, based on list prices for branded drugs, the pricing environment remains robust. Invoice (or list) prices on drugs have posted roughly double-digit percentage increases in each of the last five years, including a 14% increase in 2014 and a 12% increase in 2015.

However, the rise in list prices doesn't tell the whole story. Growth in net prices — what insurers and employers actually pay for drugs — has decelerated sharply over the last four years. According to research conducted by QuintilesIMS Institute, net price growth for branded drugs in 2015 was just 2.8%, less than a third of the growth rate in 2012. The research firm expects net prices to rise 2% to 5% annually going forward.

If recent growth in net prices is barely above the inflation rate, why all the hue and cry? First, prices are still going up, and no one wants to pay higher prices for anything, especially something as essential as medications. Second, and perhaps most relevant to the public outcry against drug prices, consumers are footing a bigger part of the cost of their medications. According to the Kaiser Family Foundation, the average insurance deductible for people with employer-provided health coverage rose to $1,077 in 2015 from $303 in 2006. With people paying more out of pocket for their drugs, price sensitivity becomes more acute.

Drug companies counter with a number of rebuttals, not the least of which is the increasing cost to bring drugs to market. According to the Tufts Center for the Study of Drug Development, the estimated cost to develop a new drug is nearly $2.6 billion, up from around $800 million in 2003. Factor in post-approval research and development costs of nearly $400 million, and the amount approaches $3 billion.

Pharmaceutical companies defend their pricing schemes, especially on older drugs, saying revenues from existing drugs help fund innovation. Still, with support for generics and biosimilars growing, pressure on drug prices probably won't dissipate anytime soon. According to QuintilesIMS Institute, generics that entered the market between 2002 and 2014 reduced the price of medicines 51% in the first year following the loss of exclusivity and 57% in the second year.

Certainly, the pressure on drug companies to hold the line on price increases makes the landscape riskier for companies that rely on price increases on legacy drugs to boost profit and revenue. One positive is that stocks in the sector already reflect a lot of these fears and trade at valuations significantly below historical levels.

One such company is Biogen ($289; BIIB), which has benefited from the ability to increase prices on some products, most notably Avonex, a treatment for multiple sclerosis. While unit volume for Avonex has declined every year in the past 10, U.S. sales of the drug have roughly doubled to $2 billion annually.

The expected decline in pricing power for drugs like Avonex places a big emphasis on the company's new-product pipeline. Fortunately, Biogen has some attractive drugs in testing, including a potential game-changer to treat Alzheimer's that is in phase 3 clinical trials.

To be sure, a number of companies — most recently Eli Lilly ($73; LLY) — have stumbled in their path to bring an Alzheimer's treatment to market. Biogen rated Buy and Long-Term Buy, is reviewed in more detail on page 6.


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