Inoculated Against Uncertainty

Inflation, the threat of recession, and the ongoing war in Ukraine have created an extremely uncertain environment for investors. In a recent report, Morningstar’s director of healthcare research Damien Conover and healthcare strategist Karen Andersen explained how the stocks of the big biopharmaceutical companies offer protection against these mounting macro headwinds. I recently sat down with Andersen to discuss opportunities and risks in the sector.

While these companies can price their drugs to withstand inflation, they do face another price risk—that their prices are unjustifiably high and may not be sustainable. Morningstar and Morningstar Sustainalytics have enhanced their analysis of this key environmental, social, and governance risk by incorporating cost-effectiveness analysis from the Institute for Clinical and Economic Review. Andersen explained how Morningstar’s new capsule system uses ICER’s benchmark information to assess U.S. drug pricing risk.

I spoke with Andersen on June 14, 2022, and our discussion reflects conditions and valuations as of that date. It has been edited for length and clarity.

Laura Lallos: What makes these biopharma companies less sensitive to inflation?

Andersen: There are two sides to this, the pricing side and the cost side. On pricing, the big biopharmas see most of their revenue from branded drugs. These are typically drugs that are patent-protected and usually have some differentiation and significant pricing power. So, passing through inflated costs shouldn’t be a problem. One caveat to that is that drug pricing is kind of a headline risk right now. Any price increases that stand out as much higher than inflation would probably raise eyebrows.

On the cost side, the cost of goods sold of the actual pills or injectable medicines is a small percentage of sales on average, somewhere around 10% of sales. The industry can absorb any increased cost for the raw materials. As for costs that are tied to wages, anything that’s reflected more in research and development or operating costs, the industry can run cost-saving programs or trim salesforces where needed.

Lallos: It sounds like the war in Ukraine is not a significant factor for these companies.

Andersen: I’d say that’s true for most. Several companies have commented on the percentage of sales that they get from Ukraine and Russia, and it’s typically less than 1%. Most of these firms are very global, and these countries tend to have lower income per capita and a less developed pharma industry, which makes them a smaller piece of the pie. The one impact some companies have noted is on clinical trial enrollment. There are a lot of clinical trials that enroll in these countries, so drug firms are scrambling a bit to boost enrollment at other trial sites so that pipeline programs don’t get too delayed.

Lallos: How protected are these companies in the event of a recession?

Andersen: We’ve found over the decades that demand for prescription drugs is relatively inelastic, so less sensitive to changes in the economy, which makes Big Biopharma a pretty defensive industry. For example, in 2009, these firms posted steady growth that was in line with prior years and the years that followed, despite a recession and the 2% decline in gross domestic product that year.

Lallos: So, COVID-19 was a rare event?

Andersen: COVID was a little special in that it did have a significant impact on healthcare utilization. It was down by roughly a third. The hospital system was overwhelmed and stretched, and individuals were a lot less likely to seek care for anything that wasn’t of utmost urgency. Patients delayed elective procedures, and we even saw a significant decline in diagnosis for a lot of different diseases, from HIV to multiple sclerosis to cancer. That spills over into demand for prescription drugs.

But now we’ve got vaccines and treatments, and a high percentage of the country has either been vaccinated or infected. So, utilization rates have already rebounded a lot. We estimate they’re probably about 10% below pre-COVID levels. This is a potential growth tailwind for this industry as we head into the second half of the year.

Lallos: You mentioned the headline risk of raising prices too much. What is the policy risk?

Andersen: U.S. policy changes have been a background risk and an overhang on industry multiples since around 2015. That’s when the industry first started seeing headlines about the cost of some new medicines, and Hillary Clinton announced potential policy changes that could affect drug prices. Previously suggested reforms ranged from things like price control—setting prices at levels that mirror other developed markets, which could cut some prices in half—to smaller efforts that would have reduced out-of-pocket costs for seniors. The last real attempt was the Build Back Better Act, which passed the House in late 2021 but stumbled in the Senate earlier this year. Democrats are trying to pass a pared-down version of the bill through the reconciliation process this summer, and if drug policy changes remain similar to the Build Back Better Act, that could lead to mid-single-digit pressure on U.S.-branded drug sales, on average.

But getting consensus even among just Democrats has been really difficult. And as we’re heading into another election season, I’d note that Republicans tend to favor policy reform that would probably have only a low-single-digit impact on U.S. sales for these biopharma firms.

Lallos: These are multinational companies, but U.S. policy has a tremendous impact. Why is that?

Andersen: It’s two things: population and prices. The U.S. might be only 5% of the world’s population, but it’s about a fourth of the developed world’s population. Then add the fact that prices in the U.S. can be, as I mentioned, close to double the prices in other developed markets—and drug firms can increase prices annually in the U.S. So, there’s a huge discrepancy in price and higher profitability for these drugs in the U.S. We estimate the U.S. accounts for almost half of Big Biopharma profits.

Lallos: Morningstar is using information from ICER to evaluate pricing risk. What is ICER?

Andersen: ICER is an independent private organization that looks at the cost-effectiveness of drugs. It is getting a lot of attention from drug companies and from payers who look to their analysis for advice.

ICER tends to focus on drugs or therapeutic areas where there’s been some recent innovation, and there might be questions on how the drugs should be priced. Based on the efficacy and the safety data from clinical trials, they determine a threshold for a fair price. They’re trying to determine how much a drug can extend life or improve quality of life and then use an accepted benchmark to come up with the highest price. In the U.S., the benchmark is roughly $150,000. That’s a common threshold for what we’d be willing to pay for an extra year of life.

Lallos: How is ICER’s analysis factored into Morningstar’s new capsule system?

Andersen: The capsule system is a way to assess ESG risk that’s tied to U.S. drug pricing. It combines ICER’s cost-effectiveness analysis, recent net drug price increases that are estimated by Morningstar and by ICER, and then Morningstar’s own forecast for 2025 U.S. drug sales. We focus on the top five bestselling drugs in our forecast to determine the final capsule scores for each firm, ranging from 1 to 5.

Lallos: Can you explain the relationship between cost-effectiveness and ESG risk?

Andersen: We’re trying to isolate firms that aren’t pricing their drugs fairly—either current prices, which are tied to cost-effectiveness, or price changes, which may be unsupported price increases. Firms that don’t score well in the capsule system tend to have higher exposure to a material ESG issue in the Sustainalytics methodology, access to basic services. Depending on how the firm’s exposure to this issue differs from average for other reasons beyond the capsule system, and depending on their management score, that could have bigger implications for the firm’s overall ESG Risk Rating.

Lallos: Which ESG header does this issue land within?

Andersen: We put it under the S. In general, for biopharma, the risks that we see are more social. It includes product governance: Are they selling drugs that are, in fact, safe in the long term? And access to basic services, which is where we put pricing issues. For Morningstar, for the purposes of our valuation models, the most impactful issue is are they pricing drugs fairly in large markets, and is that something that’s going to hold back access or create high out-of-pocket costs for Americans?

Lallos: So, this capsule system factors into the Morningstar Uncertainty Rating as well as the Sustainalytics ESG Risk Rating?

Andersen: That’s right. The Uncertainty Rating is the key area where it makes sense to incorporate the long-term risk of crackdowns on drugs that aren’t cost-effective. If a capsule score is less than 4, we consider that a red flag and a potential reason to raise our Uncertainty Rating for one of these firms. We raised our Uncertainty Ratings for three firms—AbbVie ABBV, Amgen AMGN, and Vertex Pharmaceuticals VRTX—to High from Medium.

Vertex stands out as the worst performer. Its cystic fibrosis drugs are extremely innovative, but they’re priced at multiples of what ICER thinks they’re worth. And Vertex is very heavily reliant on those drugs for its profitability. For Amgen and AbbVie, the culprit is immunology therapies. There are a lot of drugs for diseases like arthritis, psoriasis, and asthma that tend to be overpriced, I think partly because insurers feel the need to cover a wide range of products, so they have less negotiating leverage. Amgen has an older arthritis drug, Enbrel, and a newer asthma drug, Tezspire, that both look overpriced. AbbVie has one of the most famous overpriced drugs, Humira.

Lallos: What companies look good by this measure?

Andersen: The capsule system confirmed our past ESG research for some top scorers. Companies like Sanofi SNY and BioMarin Pharmaceutical BMRN have done well in past reports, and they did well here. Sanofi gets a lot of its sales and profits from Dupixent, which is priced very appropriately in atopic dermatitis. BioMarin has a hemophilia gene therapy that isn’t yet approved, so technically not priced yet, but ICER believes that this drug could be worth as much as $2.5 million. BioMarin has echoed that it intends to price it around that level. Roctavian is an example of a treatment that can be given one time, and a patient may not need any treatments for another six or more years. That can be very cost-effective in a market where annual treatment can cost $600,000.

Lallos: How are valuations for these companies as of mid-June?

Andersen: As of June 13, the median price/fair value estimate of the 18 names in the report was 0.93, implying that the group was slightly undervalued. There are some companies that are more undervalued and some that are even slightly overvalued right now. The largest, most diversified names with strong dividends tend to be more fairly valued or even overvalued. More concentrated biotechs that maybe don’t have quite as strong a moat, maybe don’t yet pay a dividend—those tend to be more undervalued.

Lallos: What names may offer significant upside today?

Andersen: GlaxoSmithKline GSK is one that we like. Glaxo is criticized for having a weaker growth outlook than its peers and a weaker pipeline, but we think that the HIV and the respiratory products will perform better than expected.

Roche RHHBY is starting to move past a big headwind that it saw from biosimilar competition to some of its older cancer drugs. We think that’s going to make the continuing growth of its newer drugs stand out, and that will be more evident as we move through this year. It has very innovative drugs in hemophilia, multiple sclerosis, and oncology, and they’re continuing to grow very strongly year to year. And Roche has a lot of innovation in the pipeline as well.

Among companies leaning more toward biotech, Gilead GILD also looks undervalued. It has a dominant HIV portfolio that it is continuing to refresh and a very novel cell therapy in blood cancer that’s being used in more and more patients. Also, Gilead has invested a lot in their oncology pipeline. I think this is going to be a key year for learning more about its ability to compete with the more established oncology companies.

The highest-risk name would be Biogen BIIB. It also looks the most undervalued. Biogen just had a terrible year. It had approval of Alzheimer’s drug Aduhelm, but that was followed by a lot of controversy, losing Medicare reimbursement, and almost no sales of the drug. At the same time, Biogen was going through patent expiration for one of its big multiple sclerosis drugs. It’s been a very difficult time for the company. But at recent prices, Biogen shares don’t incorporate any value for its pipeline, which still has a lot of mid- to late-stage programs for neurodegenerative diseases and other types of neurology programs in areas like depression and stroke. Some of these tend to be higher-risk programs, but we still see Biogen as a leader in neurology research.

Lallos: Putting aside valuation, for somebody who has a watchlist of best-in-class companies, what are the top names that should be on that list?

Andersen: Although it’s undervalued, I would put Roche there because it’s one of our favorite names. It has one of the widest moats in Big Biopharma, and it’s an innovative combination of new drugs and diagnostics. Eli Lilly LLY and AstraZeneca AZN also stand out. These are companies where everything is going right in terms of their portfolios and pipelines.

Lilly has a very strong established diabetes portfolio and immunology and oncology drugs that are growing really well. Probably the most exciting thing going on right now is it just got approval for a new diabetes drug, Mounjaro, which also just saw amazing data in obesity. That opens the door to a future use of this drug in an area that hasn’t seen a lot of effective therapies or very good reimbursement in the past, and I think that that’s about to change.

AstraZeneca is a similar story but a slightly different focus. It has a lot of oncology drugs and rare-disease drugs. One oncology drug, Enhertu, was just highlighted at a major cancer conference in early June. Enhertu looks like it’s going to be a very effective drug for a large percentage of breast cancer patients. AstraZeneca also recently acquired Alexion, which gives it a lot of exposure to next-generation rare-disease drugs.

Lallos: Any final thoughts for investors interested in this area?

Andersen: The way the market’s behaving now, there are certainly names where there’s still a lot of opportunity for growth and that investors have shied away from. It could be a good time to get into some of these more innovative biotech names.