June 22, 2016 – Excerpt from Q2 2016 letter to IMA’s clients
Purchase of Amgen: First we need to explain a peculiar difference between pharmaceutical and biotechnology companies. A simplistic explanation would point to the sciences they pursue – chemistry vs. biology.
Pharmaceutical companies work with chemical compounds (some of which are derived from plants). Biotechnology companies rely on biology since they are trying to duplicate or change the functioning of living cells. Biotechnology firms rely heavily on advances in genetic research.
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This difference in the fundamental building block of their research – living organism vs. chemical compound – has a profound impact on the economics of their respective businesses. In theory, pharmaceutical and biotechnology companies receive the same patent protection under US law. They are granted 20 years of exclusivity, after which their compound becomes fair game to any competitor that can prove to the FDA that their copy is the same (bioequivalent) as the original (branded) drug.
Here is an example of what happens to a simple chemical drug after its patent expires: Today a one-month supply of Pfizer’s Lipitor (branded drug) will cost a consumer $212. However, a generic copy will cost only $10.50 a month. Lipitor used to be the highest-grossing pharmaceutical – its sales in the US peaked in 2009 at $11 billion. After its patent expired, sales dropped by 84% to $1.9 billion in 2015.
Generic chemical drugs are considered to be a perfect copies with the same active ingredients as the originals – a pharmacist is able to substitute Lipitor script with a generic at will (unless the doctor specifies no switch to a generic – some people may be allergic to an inactive ingredient in a generic, e.g. coloring). As you a consumer you won’t even know or care which you receive (unless you’re the one paying for it).
Now enter biopharmaceuticals. After patent exclusivity expires, a biotech firm’s drug also becomes fair game for others to make copies (they are called bio-similar). However, biopharmaceuticals are based on living organisms, and the copy-maker has to prove that this is an equally efficacious copy by conducting clinical trials that may cost hundreds of millions of dollars.
The copy cannot be worse and – just as importantly – cannot be better than the original. If it is better, then the firm may have to undertake even more extensive and far costlier clinical trials.
Unlike plain-vanilla generic drugs, bio-similars are not perfect copies, and thus they are treated by doctors and pharmacists as similar but different drugs. Because their development costs are very high due to the need for clinical trials, they are only 15-20% cheaper than the drugs they are trying to replicate. Also, pharmacists cannot arbitrarily substitute script of an original drug with a bio-similar drug.
Usually, when a bio-similar becomes available, existing patients continue to take the original drug and the bio-similar is introduced only to some new patients. Therefore, patent expiration may lead to a deceleration of growth, maybe even a slow decline, but not a collapse of sales.
This chemistry vs. biology dynamic makes a portfolio of bio-pharmaceutical companies much more valuable than a portfolio of plain-vanilla pharmaceutical companies that have drugs with similar expirations.
Amgen is one of the largest biotechnology companies in the world. Though some of its major drugs are rolling off of patent protection, for the aforementioned reasons the negative impact on overall sales will not be significant. In addition, Amgen has over 30 drugs in various stages of development. Amgen trades at about 12 times next-year earnings which will likely to grow at a high single or maybe even low double-digit rate. It also pays a 2.5% dividend that it will likely raise in the future.
As with other pharmaceutical companies, there is a significant tailwind for Amgen, as aging baby boomers are consuming more and more drugs. The company has as a net cash balance sheet (its cash reserves exceed its debt liability).
Over the next few months political discourse will reach a boiling point as we get closer to a very divisive presidential election. Pharmaceutical companies will be demonized – we’ve seen it many times before. However, cooler heads will prevail, since even politicians and their relatives get sick, and they want Amgen, Gilead Sciences, and Allergan to invest tens of billions in new drugs. We look at the next few months as an opportunity to increase our positions in stocks we already own and take positions in new ones if see a politically driven sell-off.
It is important to note that we are taking smaller than usual positions in pharma stocks. Each of these companies derives a significant portion of its sales come from just a handful products. Current depressed valuations in the pharmaceutical sector have given us an opportunity to take a basket approach (more stocks, smaller positions sizes) to this sector – reducing the risk of a black swan hitting an individual company, without sacrificing overall returns.
Article by Vitaliy N. Katsenelson, CFA – Contrarian Edge
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley). His books were translated into eight languages. Forbes Magazine called him “The new Benjamin Graham”.