Fall Gilead
July 17, 2010 
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Buy Or Sell Biotechnology
The tidal wave of changes driven by initiatives from the Obama administration and Congress is causing investors to abandon well thought out strategies. On Thursday, February 26, 2009, the Obama administration released more details of their 2010 budget proposal calling for access to cheaper generic versions of biotechnology drugs as a way to pay for an overhaul of healthcare. Investors reacted to the news by aggressively selling the biotechnology sector, with the S&P SPDR Biotechnology ETF (XBI) falling $5.07 from $51.35 to $46.28 in two days. Is this a sign of further weakness in the sector, or is it a buying opportunity for the biotechnology firms and the generic firms?
Budget Statements and Intentions
President Obama's 2010 budget seeks to accelerate the development of lower cost generic versions of biotechnology drugs by establishing a new regulatory pathway at the Food and Drug Administration. To speed development of generic drugs, the administration's budget requests $20 million in 2013 to create this pathway for FDA approval of generic versions of biologic drugs, which are made from living organisms. This plan, which must be passed by Congress, has key Democratic support. The budget document estimates that $9.2 billion over 10 years could be saved, helping to pay for expanded insurance coverage and improved care.
Henry Waxman, House Energy and Commerce Committee Chairman, said legislation to allow FDA approval of generic biologics "is one of my highest priorities this year." Biologic drugs are more difficult to reproduce than traditional pharmaceuticals. Biologic drugs can cost patients tens of thousands of dollars a year.
Obama's budget seems to back a period "consistent with the principles in the Hatch-Waxman law" for chemical-based drugs. That law provides five years of exclusivity for new medicines, and three years for new formulations of existing drugs, according to Kathleen Jaeger, president of the Generic Pharmaceutical Association, a trade group. There are mentions in the budget proposal that the exclusive period should be seven years.
The biotechnology industry has been pushing for 14 years of exclusivity, indicating that is the time they need to help them recover the investment necessary to develop, test and produce the medicine. According to Jim Greenwood, president of the Biotechnology Industry Organization, the projected savings in Obama's plan appear to be based on Congressional Budget Office calculations that were related to a Senate bill with 12 years of exclusivity.
Another part of Obama's plan prohibits biotech firms from "evergreening" drugs to protect them from competition for extended periods. Ever-greening adjusts the dosage or formulation to extend the patent protection. In addition, they are seeking to prevent drug companies from blocking generic drugs with anti-competitive agreements to keep the cheaper generics off the market.
Getting such legislation passed by the House will be relatively easy. However, the Senate will be more difficult, as the Democrats do not have sufficient votes to override a filibuster. Most likely, there will be some sort of compromise that will preserve much of the exclusivity sought by the biotechnology companies in return for not fighting other initiatives such as ever-greening and blocking generic firms from developing their version of the drugs as the patent expires. Moreover, the request to fund the pathway is 2013, four years away.
According to Mark McCellan, a former Food and Drug Administration commissioner, now with the Brookings Institution, the proposal sets an important starting point; however, there will be proposals for longer exclusivity leading to a negotiated settlement in Congress.
Implications for Generic Drug Manufacturers
According to the Congressional Budget Office, letting generic drug companies manufacture their own versions of medicines produced by biotechnology companies like Genentech Inc. and Amgen Inc. could save $25 billion in the first decade they're on the market. Moreover, the legal pathway opens up the market to generic firms such as Teva Pharmaceuticals Ltd (TEVA), Watson Pharmaceuticals (WPI) and Mylan Inc. (MYL). Generic versions of biologics would be prohibited for periods "consistent with" current limits. This will create additional opportunities for generic drug manufacturers to expand their market.
Manufacturing biologics, which are living proteins, is more difficult and costs more than molecular based drugs. It also requires new manufacturing facilities to be constructed, leading to additional investment by any generic drug manufacturers that wish to produce their own biologics. Instead of building their own facilities, these firms might acquire one or more firms that already have approved biologics manufacturing capability. In any case, the generic drug companies must invest substantial amount of money to be able to manufacture biologics properly.
Should the pathway to FDA approval for generic biologics be passed and begin operation on or after 2013, it will create new opportunities for the generic drug companies. However, this opportunity is four years away, so a lot can happen in the mean time. Investing in generic drug stocks, hoping that they will benefit from the move to generic biologics is a risky venture. The smarter play is to wait to see what happens in the Congress and the market before making a commitment. This does not mean the generic drug companies are not a good investment for other reasons.
Implications for Biotech Sector
The proposal to provide a pathway to the FDA for approval of generic versions of biologics will have a big impact on biotech companies like Amgen, Genentech and Gilead Sciences, as well as traditional drug makers like Merck that have said they want to get into biotech.
According to most analysts, the production of approved biologics is years away. First, the pathway is four years away, at least. Second, the generic firms must request approval to manufacture the drug, showing they know how to handle a living protein, which requires careful handling and a large investment. As a result, the threat from generic biologics is years away.
In addition, the pathway proposal will go through the legislative process where it is likely to face some compromise. Many of the biotech firms are located in democratic districts, so the passage of a law that meets everything the generic firms want is not a sure thing.
On Friday February 27, 2009 Deutsche Bank's biotech sector analyst, Mark Schoenebaum sent out a message to his clients titled: "Mean 2010 Biotech PE Is Now Under 15x !!" The implication is the biotech sector is still a good place to invest and we should not panic. Rather, the sell off represents an opportunity to buy shares at a discount.
James Thomas co-founder of venture firm Thomas, McNerney & Partners believes that the drug industry should gain from health care reform even if there are pressures to lower prices. Drug prices have very high gross margins. Growth for biotech companies is driven more by the number of units sold then by price. Expanding health coverage will boost sales, offsetting price reductions.
The Bottom Line
The recent sell off in the biotechnology sector is an opportunity to buy into the sector rather than a signal to sell. First, the competitive impact of generic biologics is years away. Second, Congress must pass legislation to give the FDA the faster process for generic firms to produce biologic drugs. Like most legislation, there will be a compromise that is different from what was proposed. Of course, there can be no guarantee that the results will be a positive for biotechnology firms.
Third, the sell off is bringing down the share prices on all the biotechnology firms to historically low levels. The good firms are growing revenues at 30% or more, while their PE ratios are falling to 15. The threat from the pathway to the FDA is four years away. In addition, many biotechnology firms based in the U.S. receive half of their revenue from foreign sources, not subject to the U.S. generic pathway threat. For example, Gilead's foreign sales are 42% of antiviral sales, growing at 45%. The company's U.S. sales are 58% of antiviral sales, growing at 30%. Moreover generic drug companies will offer significant investing opportunities as they increase their sales.
The risk to the biotechnology industry is now higher. With higher risk comes the possibility of higher rewards. Look to buy on dips in the price of quality companies in the sector as well as the sector's ETFs. Use proven risk management techniques to lower the down side risk. Capture profits by selling half of the position on any run up in the share price and protecting the rest from any loss.
About the Author
I began investing in high school and have remained active in the markets. A graduate of the US Air Force Academy with an MBA majoring in Finance from the University of Colorado, I continued to invest throughout my career in the US Air Force, Bank of America, Coopers & Lybrand, and working for Ross Perot before retiring at 55. During that time I have gained a very good understanding of what works and what doesn't. I hope to impart that knowledge to others so they can achieve financial independence as well.
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