XPH - XPH: Revenue Challenges Ahead For U.S. Pharmaceuticals

2023-04-04 23:52:36 ET

Summary

• XPH gives you exposure to a broad-based cut of the US Pharmaceuticals sector.
• Patent expirations are a major headwind affecting many companies in the industry.
• Focus on orphan drug development leads to riskier revenue streams.
• Overall, XPH is unlikely to generate alpha over the S&P 500.

Introduction

Recently, I published an article on Johnson & Johnson ( JNJ ). Analyzing that company got me more curious about the overall pharmaceutical sector as I realized that many players were facing sectoral patent expiration headwinds. In this piece, I do a deeper dive on the SPDR S&P Pharmaceuticals ETF ( XPH ), which is a product that gives exposure to a broad-based cut of the US Pharmaceuticals sector. My assessment is that XPH ETF and the US Pharmaceuticals sector is unlikely to generate alpha vs. the S&P 500.

ETF Exposure Mix

Top 10 Holdings

The top 10 holdings include Jazz Pharmaceuticals ( JAZZ ), Eli Lilly ( LLY ), Royalty Pharma ( RPRX ), Axsome Therapeutics ( AXSM ), Bristol Myers Squibb ( BMY ), Organon & Co. ( OGN ), Pfizer ( PFE ), Zoetis ( ZTS ), Johnson & Johnson and Merck & Co. ( MRK )

The top 10 holdings make up only 43.3% of the overall index. And the weights of the top 10 holdings are rather evenly distributed. This leads to a well-diversified index that makes it a suitable candidate for broad pharmaceuticals factor exposure without idiosyncratic exposures to company factor risks.

Thesis

From a fundamentals perspective, I lack bullish enthusiasm on XPH due to 2 key reasons:

1. Patent expirations are a major headwind
2. Focus on orphan drug development leads to riskier revenue streams

Patent expirations are a major headwind

Over the next 6 years, the US pharmaceutical industry is facing significant patent expiration headwinds. Some industry experts forecast a loss of $200 billion in revenues over 2022 - 2030. For context, the 2022 industry revenue for brand name pharmaceutical manufacturers is $239 billion . According to ZS Associates, the top 10 pharmaceutical manufacturers combined have more than 46% of their revenues at risk during 2022 - 2030.

The table below shows my analysis of various pharmaceutical companies' drug-aggregated exposures to patent expirations, also known as loss of exclusivity ((LOE)):

The revenue numbers in the table above are a tad old as they are based on 2021, but the analysis is still useful for directional movements and context.

The bolded companies' rows above indicate the companies which are in XPH's portfolio. Note that all these companies are in the top 10 list of XPH's portfolio, aggregating to a total weight of 21.4%.

In my previous article covering JNJ, I determined a median revenue loss per drug of 28% . Assuming the same here, I estimate a total revenue loss impact of $67.5 billion. Counting only the companies for which XPH has exposure, this amounts to a $37.6 billion. This is much smaller than the $200 billion impact quoted earlier because this is not an exhaustive list.

Overall, the key message is that many pharmaceutical companies are facing major revenue headwinds as they lose patent protection. And XPH has meaningful exposure to many of these names. The challenge these pharmaceutical companies face now is replacement of these revenue losses.

Focus on orphan drug development leads to riskier revenue streams

A need to replace loss of exclusivity affected drugs amid increased competitive intensity and rising R&D costs have led many pharmaceutical companies to pivot focus into niche, lucrative areas in rare disease treatment also known as orphan drug development . For example, in 2020, Sanofi acquired Principia Biopharma, a company that specializes in therapies for rare autoimmune and inflammatory diseases. The following table shows how many pharmaceutical companies in XPH are expected to have an increased revenue share from orphan drugs over the next 4 years:

Orphan drug development has higher barriers to entry due to multi-million dollar and multi-year development pipelines. Commercialized orphan drugs are 4.7x more expensive, with unit patient costs of $147,000 compared to $31,000. However, their clinical trials' probability of success is also much lower ; 13.6% for orphan drugs vs 20.9% for all drugs.

Due to these characteristics, I believe these revenue replacement efforts of pharmaceutical companies into orphan drug development leads to a less predictable and riskier revenue stream, thus reducing the quality of revenues. Note that these rare disease imply a smaller and limited total addressable market, which would also lead to a higher revenue concentration profile.

A nuanced verdict

I think many of the companies in XPH representing the US pharmaceutical sector are moving toward a bit of a 'do-or-die' situation as a large portion of revenue streams are at risk of erosion due to looming patent expirations over the next few years. To address this, large pharma companies - including key names in XPH's top 10 holdings - are focusing on rare disease treatments (aka orphan drug development), benefiting from scale-based barriers to entry. However, this revenue stream is more risky as the chances of successful commercialization is lower and the target user base is more concentrated. I believe this is likely to erode the quality of revenues for the companies in XPH.

Due to these headwinds, I am skeptical about XPH's alpha potential vs the S&P 500 ( SPY ) ( SPX ). I would need to see a powerful sector-wide catalyst to become bullish on a relative basis vs the S&P 500.

For this reason, I rate XPH a 'Sell'. But I do note that my 'sell' here is relative to the market index. In other words, it is a relative sell; on absolute terms, XPH may still give absolute returns if the market goes up. Hence, think of this 'sell' as a sell XPH and buy the S&P 500 kind of view to maximize total shareholder return.

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