HQH - Biopharma Bounce-Back: From Policy Pains To Profitable Plains

2023-09-08 00:03:09 ET

Summary

• The recent IRA list of 10 drug publications is not expected to have a significant impact on big pharma stocks in the near term.
• The legal challenges by big pharma companies against the IRA may derail the implementation of the drug pricing reforms.
• Investors can consider diversified biotech indexes or healthcare-focused ETFs for exposure to the biopharma sector.
• We reiterate our buy rating around the biotech sector, worst has been priced in and we believe it is time to increase exposure to the biopharma sector.
• XBI and IBB are the broad biopharma ETFs that we recommend, and HQH is for investors who are looking for an actively managed income fund.

The recent IRA list of 10 drug publications should have a limited near-term impact

The Biden Administration's recent release of a list of ten drugs signifies its commitment to the Inflation Reduction Act ((IRA)) drug pricing reforms ahead of the 2024 elections. Following the recent release detailing the ten drugs earmarked for negotiation through the IRA in 2026, we've reviewed our stance on the broader impact of drug price negotiations.

While the White House and various Democratic party members have lauded this as the dawn of a new phase in drug pricing, the practical implications for the market are nuanced in our view. These drugs account for nearly 20-30% of gross Part D spending . However, the actual net spending might be significantly less due to existing hefty discounts on many of these drugs. Despite these events, it's vital to note that these newly negotiated prices won't come into effect until 2026, after the upcoming election. Furthermore, we believe that if Republicans take over, there is a good chance they will revert the plan, although, we admit that the tail risk of government intervention is likely here to stay.

The drugs on the list include blood thinners, diabetes medications, and a cancer drug. Each carries its own challenges for CMS negotiations. For instance, drugs like Eliquis and Xarelto already have substantial discounts, and it remains to be seen how CMS will handle their negotiations. Meanwhile, in the diabetes category, medications such as Januvia are set to face significant price cuts due to their prolonged monopoly in the market.

We believe most drugs, including prominent ones like Eliquis and Imbruvica, were anticipated by the market to be part of the negotiation, and around 2026, we see the aforementioned drugs being minor contributors to revenue and EPS, and there shouldn't be substantial alterations to the general perception around big pharma stocks in 2H 2023. In our view, the biggest uncertainty remains around the degree of discount, which CMS has not provided yet, and we are closely watch for upcoming updates around the negotiation. Furthermore, we believe the neutral price action post the release of the list may indicate the bottom is in for the big pharma stocks as the worst has already been priced in.

Stepping back, we believe that the continuous innovation in the sector and the launch of novel therapy will add positive impetus to stock performance.

Big pharma companies initiated a lawsuit against the US government; the IRA may get derailed

Companies such as Merck , Johnson & Johnson, Bristol-Myers Squibb, and Astellas Pharma, in alliance with trade groups PhRMA and the US Chamber of Commerce, are involved in the legal challenges. Their foundational arguments stem from perceived violations of the First, Fifth, and Eighth Amendments.

One of their principal contentions is against the Fifth amendment's prohibition of illegal seizure of private property. By mandating that prices be set significantly below market rates, they argue that the government unduly interferes with their profits without adequate compensation, effectively compromising their financial interests. Additionally, the First amendment is invoked, asserting that the government's prescription of what constitutes "fair market values" curtails the companies' free speech. Moreover, the imposed penalties for non-compliance, which can skyrocket to an extraordinary 1900% of daily U.S. revenues for the selected drugs, are viewed as excessively punitive, leading to Eighth Amendment challenges. Though some legal experts and analysts feel the litigation might be premature, as tangible harm from the policy is yet to be realized, the strategic selection of litigation geographies, like Texas with its precedent in the Obamacare lawsuit, could potentially facilitate a pathway to the Supreme Court. Coupled with the upcoming 2024 elections, public sentiment could influence the IRA's trajectory. Importantly, we believe the hefty penalties alone may sway public opinion towards viewing them as overbearing, possibly hindering drug innovation. In light of these factors, there exists a substantial possibility that the pharmaceutical companies may succeed in their legal pursuits against the IRA.

XBI, IBB, and HQH are our top-picks

For investors who may not possess the acumen to select individual stocks, we recommend considering a diversified biotech index such as the iShares Nasdaq Biotechnology ETF, SPDR S&P Biotech ETF ( XBI ), First Trust NYSE Arca Biotechnology Index Fund ( FBT ), or the VanEck Vectors Biotech ETF ( BBH ). It's notable that within these, XBI leans more towards mid-cap firms, some of which could be speculative, for instance, BHVN , CYTK , and TPTX. In contrast, IBB encompasses more stable big pharma and healthcare services companies, including Amgen ( AMGN ), Gilead ( GILD ), ( BIIB ), Regeneron ( REGN ), IQVIA ( IQV ), Vertex ( VRTX ), and Illumina ( ILMN ) - these have multiple approved candidates and robust cash flows and can be more defensive.

Consequently, should the market rally, XBI might yield a higher return, though with a corresponding higher downward risk. We also favor firms like Lonza (LZAGY) (LZAGF) (LONN), Samsung Biologics, and WuXi Biologics (WXXWY) (if investors are willing to stomach China risk) which underpin biotech/pharma R&D without the inherent clinical trial risks (they are factories that produce biopharmaceutical products at a large scale for clinical trials or for commercial usage). For those seeking safer avenues, Royalty Pharma ( RPRX ) offers the potential for steady, non-correlated dividends, ideal for those looking to sidestep market volatility. For high-risk-taking investors, Direxion Daily S&P Biotech Bull 3X Shares ( LABU ) is an option, although, we do not recommend it considering the high degree of risk and tracking error that can come with the ETF.

Additionally, Tekla Healthcare Investors (NYSE: HQH ) is a prime candidate for income investment or people who seek actively managed funds managed by Tekla Capital Management-seasoned experts in healthcare investments with multiple decades of track record. Around 73% of HQH's portfolio is allocated to biotech and pharmaceuticals, featuring leading global biopharma brands. Notably, the fund has consistently distributed significant returns to its shareholders. HQH currently offers an enticing 15% discount on its Net Asset Value ((NAV)) and boasts a forward yield of 8.9%.

Risks

The biopharma sector's investment landscape is currently witnessing significant dynamism. The Biden Administration's commitment to the Inflation Reduction Act ((IRA)) signals looming drug pricing reforms, targeting 10 key drugs accounting for a sizable chunk of Part D spending. While pricing changes won't take effect until 2026, the selection of drugs for negotiation largely aligns with market expectations, possibly indicating that major stock price shocks have been absorbed. However, the sector faces considerable legal uncertainties, as big pharma companies challenge the IRA, citing constitutional infringements. Their success in courtrooms could destabilize the IRA's future. Investors should consider diversified biotech indexes for balanced exposure, with the understanding that legal outcomes and policy shifts will heavily influence the sector's trajectory.

Conclusion

The biopharma sector is poised for a bullish run, particularly in 2H 2023. Despite the Biden Administration's commitment to the Inflation Reduction Act (IRA) and the unveiling of a list of ten drugs for pricing negotiations under the IRA, the sector's response remains relatively neutral. These drug price negotiations, targeting a significant chunk of Part D spending, won't materialize until 2026. The market already anticipated most drugs on the list, thus, the muted price reaction suggests that the worst might be behind for big pharma stocks. Key pharmaceutical firms challenging the IRA on constitutional grounds may see success, casting uncertainty on the IRA's future. Meanwhile, historical data showcases biopharma stocks' resilience during stagflation periods, indicating a potential buying opportunity given the recent drop in stocks after the White House's drug price cap announcement. As the U.S. economy slows down, healthcare remains non-discretionary, offering an inflation hedge (as patients still use drugs when they get sick during recessions). XBI and IBB are the broad passively managed biopharma ETFs that we recommend for investors who are going after total-return, and we recommend HQH for investors who are looking for an actively managed income fund.

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