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2017 will undoubtedly go down as one of the most fabulous years for the stock market, and while we continue to warn of the dangers associated with the market continuing to trade at lofty valuations, we are intrigued by the outlook for big cap pharma and biotech in the near term. Changes in the US tax laws will likely have a profound impact on the industry.

By Alexader J. Poulos

Big Cap Pharma

We view the big cap pharma sector as ripe for a change in its operating structure as the current environment may pave the way for a wholesale shift. We’re not ignoring the frothy existing prices of the equity markets these days, but the big cap pharma industry still offers opportunities.

One key issue plaguing pharma heavyweights such as Dividend Growth Newsletter idea Novartis (NVS) is a large concentration in slower growth lines of business outside of the core biotech/pharmaceutical products we have come to expect. For example, Novartis derives nearly a third of its quarterly earnings from the Alcon eye care division and Sandoz, its generic drug division. The lack of meaningful growth from these businesses masks the stellar growth of Novartis’ oncology portfolio and new star-molecule Cosentyx for inflammatory diseases.

A similar phenomenon is playing out at Shire Plc (SHPG) as its equity price came under enormous pressure in 2017 as its key hemophilia division is being disrupted by a new entity in Roche’s (RHHBY) Hemlimbra, as detailed in a recent post, “Roche’s Hemlimbra Looks Very Promising.” The drop in demand in its hemophilia unit coupled with the lack of growth in its ADHD unit has capped the upside for Shire while obscuring the strong growth from its rare drug platform.

The venerable Eli Lilly (LLY) is operating under similar constraints as the expected loss of patent coverage for Cialis, one of its top-selling products, will put a lid on growth, thus masking the promising suite of recently-approved molecules in Eli Lilly’s product lineup. To combat the lack of top-line growth, the management team at Lilly has signaled a willingness to seek strategic alternatives for its animal health division.

These developments may seem independent and uncorrelated, but we have chosen to highlight them as they illustrate big pharma players’ willingness to disrupt traditional business models in search of improved growth potential. Strong growth in the pharma/biotech area invariably comes from bringing forth a new or more successful treatment for various disease states, but the challenge is the difficulty in developing a string of multi-billion dollar hits.

Bristol-Myers and AbbVie as a Template

We believe the recent willingness of big pharma management teams to dispose of non-core divisions is an attempt to emulate the uber-successful moves undertaken by Bristol-Myers (BMY) and the original Abbott Laboratories (ABT). Bristol-Myers was facing a relatively bleak product future as its top-selling product Plavix was facing the loss of patent protection thus blowing a massive hole in Bristol’s annual revenue. The innovative management team decided to refocus the company into a “BioPharma” by spinning off its nutrition division Mead Johnson to shareholders. The transaction occurred in 2009 where existing Bristol shareholders could exchange $1 in BMY for $1.11 worth of Mead Johnson stock thus valuing Mead at ~$7.3 billion dollars. Mead was recently acquired in 2017 by Reckitt Benckiser for $16.7 billion dollars--a return of over 200% for those who exchanged shares in 2009!

Abbott underwent a radical transformation in early 2013 as it split itself into two companies with Abbott remaining a medical device and nutrition company, while the drug discovery unit would become a stand-alone entity under the corporate structure currently known as AbbVie (ABBV). AbbVie has thoroughly outperformed the market since its initial debut fueled by the continued growth of Humira, the top-selling inflammatory disease treatment.

We believe the results delivered by Bristol and Abbott are noted by big pharma management teams--dare we say they are looked upon with envy. The recent changes in the tax law structure have brought a degree of clarity that had been lacking regarding policy impacts on major investments, which may have prevented more aggressive M&A activity in 2017 as heavyweights such as serial acquirer Pfizer (PFE) remained notoriously coy.

Pfizer has signaled it is willing to dispatch its consumer goods division with popular but slow growth products such as Advil. We view this as an incremental step towards a much more significant transformation--keep in mind Pfizer in recent years attempted to acquire AstraZeneca (AZN) in a tax-inversion deal and more recently went after Allergan (AGN). AbbVie was also very interested in a tax inversion with overtures towards Shire that fell through.

We believe a strong wind of change will rip through the traditional pharma sector with a dispatching of non-core assets to fund the acquisition of growth molecules in order to transform into the BioPharma model put forth by Bristol. In this scenario, a new blockbuster molecule will have an outsized impact on revenue and ultimately the share price.

Large Cap Biotech

The biotech industry is poised to be a significant beneficiary of the tax law change as 2018 could shape up to become the “Year of the Takeout” as we suspect big pharma players will open up the checkbook to acquire recently-approved or promising phase 3 molecules to round out their product portfolios.

We have written many skeptical articles on the prospects of Amgen (AMGN) as the decay in revenue from its top-selling products continues to plague top-line growth. This could change quickly should management deploy cash held overseas to fund the acquisition of promising molecules with meaningful sales potential, most notably in the area of oncology, where it has been lacking.

The prudent deployment of cash in M&A remains a core portion of our thesis in highlighting Gilead Sciences (GILD) in the Dividend Growth Newsletter portfolio. We were able to highlight Gilead in anticipation of a major splash--the takeout of Kite Pharma to gain the pole position in the revolutionary CAR-T treatment. It is not a coincidence that both Novartis and Gilead are listed among our top pharma ideas as a primary criterion for addition is the strength of the forward-looking pipeline. In the case of Gilead, we expect additional M&A activity in 2018 as its overseas cash hoard is now largely unlocked.

Feeding Frenzy in Small Cap Biotech

The small-cap biotech space remains one of the most exciting yet volatile sections of the entire stock market. Small cap biotech will often consist of companies that are attempting to bring forth one or two molecules through the rigors of the clinical trial process--hence the heightened risk profile. In essence, if the primary molecule is a success the share price will most likely leap accordingly. Unfortunately, a late-stage failure can torpedo the share price, often rendering the market value of shares nearly equal to the cash held on the books by the company as future free cash flow expectations are crushed.

The coming year may go down as one of the best in recent history for the small-cap biotech sector as a proverbial feeding frenzy will commence aided in large part by the increased willingness by big pharma to refocus the landscape into one with  more pure play research-driven entities. The sweet spot of the sector for deals may be companies that can be had for less than $5 billion based on a plethora of comments from various big pharma CEOs. We will continue to monitor events as they transpire as we believe the ingredients are now in place to radically transform the industry. On that note, we would like to wish all of our members a healthy and prosperous New Year!

Independent Healthcare and Biotech Contributor Alexander J. Poulos is long Gilead Sciences and Allergan.

Biotech ETFs: IBB, XBI, LABU, HQL, FBT, BBH, LABD, PBE, BBC, BBP, UBIO, ZBIO, LABS

Pharma ETFs: XLF, FAS, FAZ, KRE, VFH, KBE, UYG, FNCL, IYF, BTO, IAT, IYG, KBWB, RYF, QABA, KBWR, FXO, SEF, FINU, DPST, RWW, FINZ, WDRW, JHMF, FAZZ, FTXO, FNCF