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Let’s have a look at 3 pharmaceutical giants that may encounter some troubles in coming years.
By Alexander J. Poulos and Brian Nelson, CFA
Established companies in the pharmaceuticals industry (XLV) generally offer an appealing blend of high profit margins, a relatively recession-resistant nature of commercialized products, and a flourishing drug pipeline. In many ways, companies in the industry can be viewed as largely defensive, with a resilient revenue profile and profit stream helping to power a steadily-growing dividend, which remains highly prized in the current income-starved environment.
In addition to a focus on balance sheet health and the timing of future free cash flow generation, when it comes to pharmaceutical entities, we also analyze the length and validity of drug patent lives to gain a full view of the opportunity offered by each company. We think this makes sense as cash cows won’t last forever and must be replaced by the next up-and-coming breakthrough. Not only are there risks to the duration of the patent exclusivity period, but some pharma giants are also heavily exposed to just a handful of key blockbusters, sometimes just one.
The Patent Cliff
At Valuentum, we’re always looking for valuation outliers, or those stocks that fall outside our fair value estimate range. The pharma group is an industry that we watch very closely because we very much like the fundamental backdrop across the space. There are subtle nuances that we pay very close attention to in pharma, however.
Similar to the pitfalls of using earnings-multiple analysis indiscriminately across cyclical companies regardless of where we are in the economic cycle, investors can encounter trouble in the pharma space by just relying on earnings-multiple analysis. At first blush, this statement may seem incompatible with the durable character of the margin profile of many pharma entities as they generally are remarkably consistent through the course of the economic cycle. This isn’t always guaranteed, however.
In fact, the most vital component of the durability of a pharma entity’s free cash flow stream, in our view, rests in the length of patent life that remains on key drugs. Many industry observers know that patent protection prevents rivals from entering the market with their own drug and crushing margins and profits as a result. The stronger and longer the patent protection, the better.
A recent example of some of the troubles pharma entities can sometimes encounter happened with the patent exclusivity loss of Eli Lilly’s (LLY) key product Zyprexa. Zyprexa is generally used to treat psychotic conditions including schizophrenia and bipolar disorder. In 2010, for example, Lilly generated over $5 billion in sales from Zyprexa, the last full year of patent protection, but revenue from the drug fell to just shy of $1 billion during 2015.
The loss of Zyprexa patent protection led to Lilly posting a sharp drop in overall revenue, even though the company’s share price still caught an updraft with the broad market advance, mostly on hopes of its blossoming pipeline. In any case, however, the loss of patent protection on Zyprexa, or the “dreaded patent cliff,” was a leading cause of Lilly’s top-line troubles in recent years.
To gain a firm understanding of the various patent dynamics, additional insight is gleaned from the competitive position of each product in its respective therapeutic class. Sometimes, even if a patent is rock solid, others are still able to circumvent it, hurting the patent holder. For example, Gilead (GILD) continues to dominate the market for a hep-C cure, but Merck’s (MRK) newly-approved competitive product has truncated its long-term opportunity, in our view, even though Gilead’s Solvadi/Harvoni remains patent-protected.
Abbvie
AbbVie (ABBV) falls in the category of a risky pharmaceutical company due to its overreliance on a single product, Humira. Abbvie derived over 60% of its annual revenue in 2015 from Humira, the top selling biologic in the world. Abbvie has skillfully increased the drug’s addressable market by expanding Humira’s label to include a host of inflammatory disease states. The demand for these treatments continues to grow, but significant competition has entered which could hamper Humira’s potential going forward. A recent example is the entrance of Eli Lilly’s Taltz and Novartis’ (NVS) Cosentyx for the indication of plaque psoriasis. As each company ramps up promotional activities, both will be looking to steal share from Humira. Cosentyx is also indicated for Rheumatoid Arthritis and Ankylosing Spondylitis, adding additional pressure to Humira’s long-term opportunity.
The largest unknown that continues to plague the share price of AbbVie is the fate of the patent covering Humira. The European patent is set to expire in 2018, thus opening the door for a biosimilar challenger to steal market share. We expect the biosimilar market to follow closely in the footsteps of the traditional generic medication market with a steep drop in margins as multiple players battle for market share. The supposed complexity of producing a biosimilar does not seem to be a daunting task and traditional manufacturers such as Amgen (AMGN), Novartis, Pfizer (PFE) and Eli Lilly are all-too-willing to create biosimilar products. The move on Amgen’s and Eli Lilly’s part is a notable departure from their traditional roles, as neither has an existing generic division unlike Novartis with its Sandoz unit and Pfizer with its Greenstone division.
Further complicating matters is the recent expiration of the composition of matter patent covering Humira in the US. The expiration of this patent is the basis of the ongoing biosimilar challenges, with Amgen leading the charge in an effort to steal share from AbbVie. The management team of AbbVie believes it has adequate patent protection covering Humira well into 2022, a view that may not hold. While it is impossible to handicap the exact timing of the loss of patent exclusivity of Humira, 2017 may be the last full year of Humira protected sales. The combination of an expected decline in European revenue in 2018 coupled with an increase in competition and the unknown status of the Humira patent in the US leave AbbVie extremely vulnerable in the coming years.
Amgen
We include Amgen on this short list of 3 as the company has left its original roots of a biotech behind and has transformed into a stable, big pharma-esque company with weak revenue growth prospects, unfortunately. Amgen’s most promising molecule remains the recently-approved Repatha for the treatment of heterozygous familial hypercholesterolemia. Amgen is locked in an acrimonious patent dispute battle with Regeneron Pharmaceuticals (REGN) and its partner Sanofi (SNY) over the validity of their competing product Praluent.
Amgen believes the duo has infringed on its patent and that the product should be removed from the market. The company won a recent judgment, which is being appealed, but the most likely outcome may be a settlement where the duo of Regeneron/Sanofi pays a royalty based on sales of Praluent. The treatment remains very expensive, and removing a competitor from the market would give Amgen enormous power over payers, placing an additional strain on national budgets.
Thus far, neither product has gained much traction in the marketplace, however, with sales of Repatha totaling $40 million in the third quarter. The crucial event for the future sales growth of Repatha is the conclusion of the Fourier trial with a data read expected in the first quarter of 2017. The trial is projected to show clear evidence of the effectiveness in Repatha. If all goes well, this information should allow Amgen to expand the pool of eligible patients and loosen the restrictions payers have placed on the treatment. The success of Repatha is crucial for Amgen as the company’s legacy portfolio continues to decline.
At the moment, Amgen’s top-selling product is Enbrel, with a similar label as Abbvie’s Humira. The effect of new competition has begun to make significant inroads into Enbrel sales. Sales of the product were down slightly in the most recently-reported quarter with an increase in net selling price helping to offset a loss of volume. To compound matters, management expects little benefit from an increase in selling price as competition intensifies and the PBM’s drive a harder bargain.
Amgen’s second-leading product is Neulasta, which narrowly avoided a biosimilar challenge by Novartis. Novartis’ Sandoz unit expects to correct the deficiencies stated by the FDA and refile shortly. The US patent for Neulasta lapsed in 2015 with the European patent scheduled to expire in late 2017. Amgen is trying to migrate as many patients over to their Onbody system in a bit of lifecycle management. With its top products undergoing revenue declines, Repatha remains Amgen best shot at avoiding steep top-line headwinds.
Instructive to the potential devastating effects of a biosimilar challenge, sales of Amgen’s Neupogen plummeted 42% in the most recent quarter as a result of stiff competition from Sandoz coupled with a decrease in demand for the therapy. In essence, Amgen lost volume as a competitor undercut them in price and stole market share. Such is the world of big pharma sometimes.
Eli Lilly
Lilly makes the list as the company continues to struggle to grow revenue meaningfully. The star of Lilly’s clinical pipeline was Solanezumab for the treatment of Alzheimer’s disease. The product failed to meet its clinical endpoint, however, with Lilly deciding to bypass submitting the product to the FDA for approval. The loss of this product is quite the blow to Lilly as the pharma giant continues to grapple to produce a viable treatment for Alzheimer’s disease.
The loss is even more disappointing as Lilly faces near-term patent challenges of its treatment for erectile dysfunction Cialis and Strattera. The loss of Cialis will have the largest impact with sales of the drug totaling $2.3 billion in 2015. As the generic industry aggressively looks to produce its own version of the product, we expect sales dynamics to mirror the losses seen in Zyprexa.
That said, Lilly is not sitting idly by as it is aggressively looking to expand its revenue base with innovative co-marketing deals and new products from its lab. Diabetes remains an area of notable strength for Eli Lilly as the company has an extensive lineup of insulins along with oral dosage form treatments.
In addition, Lilly’s Basalgar a biosimilar to top-selling Lantus is expected to aggressively take share from Sanofi’s flagship product. Usually, we would be excited by this development, but the recent reimbursement dynamics in the diabetes market give us reason for pause. The PBM’s are playing a game of hardball, which is hurting margins.
With nearly $2.6 billion in revenue at risk due to a biosimilar challenge in 2018 coupled with the pricing pressure in the Diabetes market, Lilly may not be able to adequately replace the expected revenue losses, which may inevitably pressure earnings.
Those are the three. Please let us know if you have any questions!
Disclosure: Alexander J. Poulos is long Regeneron and Novartis.