Is Biopharma Immune to Brexit Fallout?

A global downturn in stock prices last week resulting from the U.K. vote to leave the European Union spared no one. Even healthcare, which is typically considered a safe haven, tumbled.

Brexit's impact on healthcare stocks is complex, but in this clip from The Motley Fool's Industry Focus: Healthcare, analyst Kristine Harjes and contributor Todd Campbell take up the challenge of explaining it. From the Brexit's impact on U.K. pharmaceutical giants GlaxoSmithKline (GSK 1.60%) and AstraZeneca (AZN 1.03%) to its potential affect on the U.K.'s medical research labs, they've got you covered with profit-friendly insight.

A full transcript follows the video.

This podcast was recorded on June 29, 2016. 

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's June 29. I'm your host, Kristine Harjes. Healthcare contributor Todd Campbell is calling in to Fool HQ in Alexandria, Va., via Skype. Welcome to the show, Todd!

Todd Campbell: It's a pleasure to be here, Kristine!

Harjes: Today, we are talking about Brexit, specifically as it relates to healthcare. We're going to do a quick recap of what's gone down in the markets the past week or so and talk about how to think about these currency fluctuations, and how the EU may have to completely rethink its drug approval process, as well as what all this means for healthcare companies and investors.

As some examples, we'll touch on a couple major U.K.-based companies. We'll give an example of a U.S.-based company that does a lot of business in Europe, because it's all connected. Sounds like we've got a lot to cover, Todd.

Campbell: Wait a minute. Is there some news going on globally that maybe our listeners would be interested in?

Harjes: In case you missed it, there's something going on here.

Campbell: Yeah, I think it really took a lot of people by surprise. You've got Britain deciding that they want to leave the European Union. While a lot of people, they discussed the pros and cons leading up to this referendum vote last week, it was widely thought, or expected by most industry participants, that Britain would come down on the side of remaining in the EU, not exiting.

Harjes: I know it.

Campbell: As investors have seen, when things tend to surprise industry participants, markets tend to shudder a little bit.

Harjes: It absolutely took us by surprise here in HQ. The editorial department did a little survey to see who could get the closest to the specific number, percentage-wise, of people that would vote to remain. The only people that had it correctly predicted that they would vote to leave were the people that misunderstood the question and thought it was being asked in reverse.

Campbell: That is crazy!

Harjes: Absolutely nobody. This is a team of 12, 13 people. None of us saw this coming.

Campbell: I know you were all glued too to the monitors paying attention to the vote. It's a very intriguing, interesting thing that's going on globally. It has broad spread, widespread implications for global trade. We've spent the last seven or eight decades advocating for free markets to boost economic activity. Now we've got a situation where people are saying, "Maybe that's not the best plan."

Harjes: Yeah, the common opinion among economists was that this would be bad for the economy at large. The question that I want to dig into is, why does this impact the stock market and economics at all?

Campbell: The main reason that you're seeing stock markets globally react to this is because of the worry of contagion effect, which is that you've got Britain -- which is a big part of the EU -- separating.

What happens now as far as Britain's GBP? Will it go up, or will it go down? Generally speaking, most independent economists, the International Monetary Fund, these people that have crunched the numbers believe that you'll see a decline in wages, a decline in production as a result. You could see tariffs and trade wars depending on how they negotiate an exit -- things that would be a detriment to economic growth within that country.

Because it's such a big part of the European economy, therefore, it could cause a recession in Europe. Since the U.S. trades a lot with Europe, that could have a negative impact on multinationals that do business overseas.

Harjes: You could see, looking across the broader market, that all of the major indices were down on this news. How, specifically, did healthcare fare?

Campbell: What's interesting to me, and I think that investors need to remember, that typically in times of trouble, investors seek out defensive areas of the market. One of the most defensive areas of the market is healthcare. If you need healthcare, you're probably not going to focus too, too much about how much money is in your wallet. You're still going to get that.

There's an inelastic relationship to the economy that provides a little bit of insulation to healthcare stocks. That's especially true in European markets, where you have a single-payer system. Theoretically, the impact on each individual patient's wallet is even smaller.

Healthcare stocks, however, didn't climb in the wake of Brexit. They declined. There are a number of different reasons for that. If you look at companies specifically, you had GlaxoSmithKline trade down about 2.9% since the vote. You got AstraZeneca down 1%. You've got biotech stocks overall down much more than that, down 4%. You've got pharmaceutical companies down much more than that, down 2.9%. Healthcare stocks, which are typically viewed as defensive, they still fell.

Harjes: You mentioned GlaxoSmithKline and AstraZeneca. These are U.K.-based companies. Both of their leaders had come out previously saying that they don't think that this is a good idea for Britain to leave. Glaxo's CEO, Sir Andrew Witty, said earlier this year that, and this is a quote, "Europe has gone from 27 fragmented, independent, not-talking-to-each-other regulatory authorities in the healthcare space to one. That's a big deal!"

AstraZeneca, meanwhile, their CEO said, and another quote, "Britain would be better off staying within the E.U. than outside of it." These guys make their points pretty clear. They're not going to be happy now.

Campbell: As CEOs in publicly traded companies, what they're really saying is when they say that Britain would be better off, they're saying, "Our company would be better off, too."

I think that broadly speaking, if you look at the people who wanted to remain in the EU -- the scientific community, including people who are involved in healthcare research and development overwhelmingly wanted to remain in the EU both for the advantages, such as free trade, but also because there's been a big push over the last decade, to turn London into a healthcare powerhouse of innovation on par with, say, Boston in the United States.

Harjes: Yeah, London has absolutely been a hub for a couple of reasons. There's enormous research presence there. That's something that we'll talk about a little bit later in the episode. Another really interesting part of this story is that the EMA, the European Medicines Agency, is based in London.

Campbell: To talk a little bit about this, because there are some implications of the Brexit that are going to impact patient care, or potentially could impact patient care.

One of them is the fact that the United Kingdom relies upon the EMA to vet drugs that could be used in U.K. patients. The EMA is charged with either approving or rejecting drug approvals. That's one of the reasons GlaxoSmithKline and AstraZeneca want to remain. It's one single regulatory body. They don't want to have to --

Harjes: For the whole EU.

Campbell: -- go ahead and pitch this to three different bodies.

Harjes: They cover the entire EU in one single marketing authorization application. Now they're going to have to leave. They can't continue to be based in London if they're not part of the EU anymore.

Campbell: The EMA is probably going to end up somewhere in France, or in Germany. Sweden would like to have it. Everybody is trying to figure how they can have it. There's a big infrastructure in London, in science, and in healthcare regulation. Hundreds of scientists from all around Europe, including areas that could theoretically -- it could be harder for them to travel to and from.

There's all sorts of implications that could come because of this. Obviously, the U.K. has some infrastructure on its own. It's got a body that negotiates prices directly with drugmakers. It's got another body that's responsible for making sure that manufacturing that occurs in their country is done appropriately.

Theoretically, they could choose to set up a system similar to the FDA here in the United States, or they could just do what Norway does and say, "OK, we're independent. We're not in the EU, but we're still going to cut a deal with you to be able to rely on the EMA to vet the drugs."

Harjes: Yep, those are the two options that they're faced with now. They could go the Norway route. That would be letting it stay largely the way it is now. The other option here, that you mentioned, is if you had an agency like the Medicines and Healthcare Products Regulatory Agency take over, that would probably make drug approval a heck of a lot more costly and time-consuming.

Of course, this regulatory body also does a lot of work underlying many of the EMA reviews, particularly when it comes to patient safety. If you look at it from the perspective of the EMA, they probably don't want to lose the work that the U.K. does, either.

Campbell: It's going to be very interesting to see how the negotiations play out on this. One of the key tenets of the European Union is the freedom of movement of both goods and people. Brexit was about the restriction of the movement of goods and people. I'm very curious to see how this shakes out. We don't know.

You hinted, or you said actually, that one of the concerns that CEO Witty and these other companies have is that if I have to go out now and I have to apply for approval in multiple countries, independent, no longer using the EMA, that's going to increase my costs, make my drugs less profitable. I also now have to consider if I'm manufacturing drugs in the U.K. and I want to distribute them throughout the EU, what things change now in regard to that? Am I going to have delays in getting product from say, the U.K. to Germany? Am I going to have to worry about additional border regulatory restrictions on the movement of goods that could also impede my profitability?

Of course, then there's a currency component to this. If the currency in the U.K., or the euro, falls, versus other areas of the world, then that could take a short term toll on revenue and profitability as well.

Harjes: Let's take another look at currency. I know that the financials crew covered it on Monday's episode of Industry Focus. It's worth reiterating some points that relate specifically to healthcare. Something that I want to emphasize is that currency is a consideration that is really largely focused on the short term.

Look at, for example, Johnson & Johnson and their struggles all last year fighting currency headlines. Every single time you hear The Motley Fool and anybody with a long-term perspective cover this company, it's like, "Guys, you can't look at this at face value. You have to strip away the effects of the currency, because these things go up and they go down and it doesn't really impact the underlying business." That being said, it could be a pretty strong tailwind for these U.K. companies, in the short term, at least.

Campbell: It depends a lot on how they report their currencies. A company like GlaxoSmithKline, which reports in pounds, could see a big benefit. It produces a lot more product in the U.K. than it generates in revenue in the U.K. As a result, if you look at their Q1 results, both on the top and bottom line, I think the top line had a 3% tailwind because of exchange rates. The bottom line had a 6% tailwind because of exchange rates.

That was because of converting the weak pound to a strong dollar. Since the pound has weakened even more since then, I think investors could probably say, "Well, the tailwind in currency is probably going to continue for them."

On the other side, however, you've got AstraZeneca. They reported, back at the end of the Q1, that they were going to face a 2% headwind because of currency exchange. You have to look at each individual company independently when you're considering the currency exchange impact.

You and I have talked about this a lot on this show previously. The things you want to consider in evaluating biopharma stocks is product, pipeline, and profitability. You'll notice currency is not one of those three. Yes, you do not want to use currency as the dominant reason for buying or selling a stock.

However, it can be helpful to know. You can guarantee, or at least I would bet that during these upcoming conference calls, management of these biopharma companies are going to be talking a lot more of the potential headwinds or tailwinds because of this currency conversion issue.

Harjes: This is not something that's limited to just companies that are based in the U.K. Almost every single U.S.-based company has some business in the E.U. One example of a company that has a lot of European revenue coming in would be Celgene. This is the company that has a ton of currency hedges in place. They're using options to try to minimize their risk. It's going to be a really important part of their business.

By the way, I mentioned options. It got me thinking in the back of my head about how this is a complex topic that has a lot of misunderstandings around it. I just want to throw it out there that The Motley Fool actually has a free Options University course.

Reach out! Feel free to reach out to us via email, Twitter -- [email protected] is the email address to get the link. You'll have to enter an email address when you get it as it is an emailed series. It's a really fantastic way to learn from the pros, in a very accessible way, how to use options from an individual-investor standpoint, which might be a little bit different than the way Celgene does it, but it could help you understand Celgene's use, too.

Campbell: All of these companies, it's important to know that all of these companies, if they're doing business globally, they're hedging some of that exposure. However, because no one has a crystal ball, oftentimes trying to hedge it, you can't hedge it perfectly. That's how you end up with companies reporting both currency adjusted and operational results in their quarterly numbers.

Companies like Celgene do get a lot of business from Europe. Think about this for a second. The United States spends the most on medicine. That's typically where companies like Celgene focus initially. "Let's get approval by the FDA so we can launch our drugs here in the United States."

However, Japan and Europe are also major consumers of drugs. Those are significant markets for Celgene. It gets about 37% of the revenue for its top selling drug, Revlimid, from markets outside of the U.S. As a result, it does face some currency headwinds when it converts that other money back into dollars.

Last quarter, or I should say last year, it was about a 2% drag that they had to deal with because of the strong dollar. Who knows what it'll be now. You'll want to watch for their conference call and listen to management and figure out what they think that might mean for guidance for the rest of the year.

Harjes: This is, fortunately, something that companies are very transparent about. It's not terribly difficult to try to figure out the underlying business movements, whether they're going up or down without the effects of currency involved. It's certainly something that, going forward, we're going to hear about in these earning calls.

Todd, we talked about the drugmakers. We talked about the approval process. Let's take it and rewind a little bit and go back to research. This is the last element of this story that I want to touch on. I think it's actually the most interesting.

The U.K. is a research hub. They either receive a ton of funding from larger E.U. research projects. They actually receive more research money than they give to these funds. About 16% of the 4 billion U.K. life-sciences money that they spend on research annually comes from these EU grants. There's this huge question and concern now within the research industry. What's going to happen to that money?

Campbell: EU member countries can participate in something called Horizon 2020. Horizon 2020 is a major research initiative worth 80 billion euros from over a 10-year period that runs through 2020. Last fall alone they came out and said that we're going to spend or invest 16 billion euros in research throughout the E.U. That's a ton of money that is now put in jeopardy by the decision to Brexit.

It's going to be very interesting for Glaxo, and AstraZeneca, and companies that are located over in the U.K. that obviously have very deep ties to the universities doing research there to see what happens to those plans to turn, again, London into this big innovation hub for medicine.

Harjes: I saw a couple of really interesting quotes from some leaders of the industry, particularly on the research side and the science side. Stephen Hawking said that Brexit would be a disaster for U.K. science. That is not a good sign right there.

However, I will also read one more quote. This is from Steve Bates. He's the CEO of the Bioindustry Association, which is a British life-sciences trade organization. He says, at first he goes: "The future structure of medicine regulation in Europe is now thrown into question." He goes on. This is a really foolish point of view right here, but he just says, "We've just got to keep on and carry on bioteching," which is just such a lovely British way of putting that.

He's right. This will all be a gradual shift over the next two-plus years. There's really no set date that the British government is going to invoke this Article 50, which would trigger the entire process of negotiation. It is something that, as always, we want to have a long-term mindset about.

Todd, thank you so much for helping me tell this story and dig a little bit deeper into Brexit and particularly the healthcare side of it today. We are almost out of time.

Before we go, I would like to remind everyone that you can find past episodes of Industry Focus and all of The Motley Fool's podcasts online at podcasts.fool.com. We've also got a listener survey that we would really love your help with. It'll only take a minute. You can do it anonymously. It will help us serve you better. If you could please help us out, we would really appreciate it. Again, the survey's online at podcasts.fool.com.

As always, people on the program may have interest in the stocks that they talk about. The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. For Todd Campbell, I'm Kristine Harjes. Thanks for listening, and Fool on!