Janus Henderson: Navigating the drug pricing debate

When the Trump administration introduced a ‘blueprint’ to lower drug prices in May, the pharmaceutical industry breathed a sigh of relief. The proposal excluded recommendations such as allowing the government to negotiate drug prices directly with manufacturers or importing lower-cost prescription drugs from abroad, each of which could have caused significant disruption.

But the reprieve did not last long. In late June, Amazon.com announced it was buying PillPack, a mail-order pharmacy licenced to ship prescriptions in 49 states. Less than two weeks later, Pfizer raised prices on dozens of drugs – only to backtrack and postpone the hikes after President Trump criticised the move in a sharply worded tweet. Since then, other companies have also delayed price increases or even lowered prices.

In short, scrutiny over drug pricing continues, with the potential to intensify as we approach the US midterm elections. However, we think any potential reforms could take years to implement, and the impact for most companies should be moderate. Meanwhile, innovation within the sector remains high, leading to transformational therapies. With that in mind, we believe investors should be mindful of these key trends going forward.

Improving multiples

Given the uncertainty around drug pricing, biotechnology and pharmaceutical stocks have lagged the MSCI World Health Care Index, falling 1.0% and 2.2% respectively during the first half of 2018, while the benchmark gained 1.9%. However, we believe the underperformance has helped make valuations within these categories more attractive, especially in light of continued innovation.

Indeed, in April, late-stage clinical trial data showed that one lead immuno-oncology drug, in combination with chemotherapy, cut the risk of death for patients with advanced non-small cell lung cancer by 51%. We feel this represents a revolutionary advance for the leading cause of cancer death in the world. It also demonstrates both the clinical and commercial potential of these drugs, which harness the body’s immune system to attack and kill cancer cells. Immuno-oncology agents reached US$10 billion in sales in 2017, and we expect the number could exceed US$15 billion this year, with the potential to go much higher in the future.

A focus on value

The market could start to appreciate this innovation as the focus on value within the healthcare system intensifies. Last month, the US Food and Drug Administration (FDA) released guidance about how manufacturers can appropriately communicate a drug’s efficacy when negotiating so-called value-based contracts with payers. These contracts aim to tie reimbursement decisions to the overall treatments, an approach that is gaining ground in the US and select other countries. As Scott Gottleib, FDA commissioner, said in an adjoining statement: “Prices should be able to adjust to reflect the value in how medicines are prescribed and the outcomes they deliver, to control rising spending and reduce the burden of drug costs for consumers.” Companies whose therapies improve upon the current standard of care may have wider latitude to price attractively and secure reimbursement. For others, the stakes are rising.

Supply chain pressures

Members of the drug supply chain – distributors, pharmacy benefit managers and pharmacies – may also start to feel pricing pressure. Rebates and discounts paid by drug makers to the supply chain are often pointed to as one reason for rising drug prices. The discounts are calculated as a percentage of a drug’s list price, so the higher the price, the fatter the payout.

Trump’s blueprint proposes changing the incentive structure for rebates, including passing on some of the financial benefit directly to consumers. If regulators fail to make an impact, Amazon could eventually achieve a similar goal with its entry into drug distribution. As Amazon’s CEO, Jeff Bezos, famously quipped, “Your margin is my opportunity”. Either way, we expect that the supply chain could get squeezed. The market seems to agree: for the first half of the year healthcare distributors, as a sub-sector, declined by almost 10%.

The recent divergence in performance between innovators and the drug supply chain could continue in healthcare, underscoring why we think it is critical for investors to focus on fundamentals and understand the nuances when approaching the sector.