Top Biotech Resolutions for 2017

Battered by bad news, beaten-up biopharma has some work to do to restore investor confidence in 2017.

The industry remains under scrutiny because of pricing decisions, pipeline failures, and profit concerns. What can top stocks like Gilead Sciences (GILD 0.07%) and Valeant Pharmaceuticals (BHC 0.35%) do to win back investors?

In this episode of The Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes is joined by Todd Campbell to offer up some resolutions they'd like biotech's C-suite to stick to in 2017. Could these ideas get the industry back on track? Listen in to find out.

A full transcript follows the video.

This podcast was recorded on Jan. 4, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every single day. I'm your host, Kristine Harjes, and it is January 4th, 2017, meaning it's our first Healthcare episode of the new year. Healthcare contributor Todd Campbell is joining me via Skype. How's it going, Todd?

Todd Campbell: Hi, Kristine! How are you?

Harjes: I'm great. Welcome to January!

Campbell: Yeah, Happy New Year!

Harjes: Thanks! It's my birthday month, I'm excited.

Campbell: Exciting!

Harjes: So, we are jumping the gun a little bit this week and talking resolutions. I say we're jumping the gun because next week we'll actually get to our individual financial resolutions across the entire Industry Focus team. But Todd and I thought it would be fun to do this first show on resolutions that we hope healthcare companies are making in 2017. 2016 was a pretty brutal year to be a shareholder in many healthcare companies. The biotech sector as measured by the IBB was down 18%. There were plenty of individual companies as well across the entire healthcare spectrum that bled even worse than that. So, it's a new year. Todd, do you think they're going to turn around?

Campbell: Listen, I'm an optimist at heart.

Harjes: Tough sector for that.

Campbell: Yeah. Let's hope that a lot of the damage had been done, and some of these biotech companies make some smart moves and get a little bit more successful. We saw a lot of surprising disappointments last year, and hopefully we won't get a repeat this year. I'm sure we're going to address some of those resolutions, but before we get into that, I'm going to put you on the spot.

Harjes: Oh, boy.

Campbell: Do you have any personal resolutions for this year?

Harjes: I have financial resolutions for sure. Those I'm going to save for the next show. I don't have any non-financial ones specifically. Do you?

Campbell: Well, my goal would be, like many Americans, once we get up into middle age -- God, I hate saying "middle age." But starting to put on a few pounds more than I'd like to have. So I'm going to try and drop a couple pounds.

Harjes: Yeah, that's the holidays. All right, good for you. Best of luck with it.

Campbell: Well, I figure it's healthcare-oriented.

Harjes: Yeah, that's pretty related, I would say. All right, great. Let's get to giving some of these companies some advice. Hopefully we have a couple executives listening in, trying to see what Kristine Harjes and Todd Campbell would like them to do in 2017. 

Campbell: Hey, as we've seen in the past, that wouldn't shock me.

Harjes: (laughs) You never know. The first company we want to talk about, and this one couldn't possibly be a surprise to any of our regular listeners, Gilead Sciences. What do you think they need to resolve to do in 2017?

Campbell: Gilead Sciences needs to lose a little weight, too.

Harjes: (laughs) Yeah! That's a good way of putting it. This is a pretty bloated company, if you're talking about cash. They have $32 billion just sitting there in cash and equivalents, and it's been weighing them down.

Campbell: Oh, boy. They have so much money on the balance sheet, and it's almost like investors are, "Do you even know what you want to do with it?" They've said over and over, quarter after quarter, "We want to put it to work, we want to buy smart, we want to acquire companies at the right price." But we've also, at the same time, seen a lot of high-profile deals get gone that could have reignited investor enthusiasm last year. Gilead Sciences has struggled a bit over the last 12 months -- declining sales because of lower unit volume growth for hepatitis C and some price competition. They could use some positive news here in 2017 that helps show investors, "This is our path forward to growth."

Harjes: Yeah. I give this company a lot of credit, and I do trust their management team a ton, but some time in 2017, they're going to have to pull the trigger.

Campbell: You would think so. They've been pretty smart about raising money and padding that balance sheet at cheap rates. They have the dividend that they're paying out to people, you could argue, wouldn't that money be better off used somewhere else? But right now, they're not using that money for anything, so, yeah, give it back in a dividend.

Harjes: Right, that or those share buybacks. They've been very generous about those.

Campbell: They did $10 billion worth of share buybacks in the first three quarters of the year, but that's slowed down dramatically. In Q3, they only bought back about $1 billion, and a lot of people thought it was maybe a sign that they were getting ready to make a push and do a deal. I don't know. There's no question that M&A valuation has gotten off the charts crazy. Medivation went for about 14 times sales. I've seen some studies that say we're now in the mid to high double digits. There's a deal out there right now that's being theoretically negotiated for Actelion between Johnson & Johnson, Actelion, and Sanofi, and that could be at a multiple of 14-15 times sales. So, I understand that these deals are pricey now. But at the same time, you have a company like Pfizer, who also has a ton of cash out there, and they gave investors a pathway toward their growth. They made a big splash with biosimilars, which could be a big market over the course of the next decade. We'll call it, for lack of a better term, generic drugs biologics. It's a new thing we've talked about in the past on the show. And then, of course, with buying the leading prostate cancer drug, they showed that they're committed to growing in cancer. So, I think Gilead needs to make some of those same kind of moves to show investors, "This is how we're going to grow over the course of the next five or ten years."

Harjes: Right. And speaking of cancer, they did give us a little bit of a clue recently. I forget if the news came out this morning or not, but it was within the last couple of days. They just hired a new senior vice president of hematology and oncology. This is somebody named Alessandro Riva, who comes from Novartis, where he was the head of oncology. This suggests to me that that's what they're looking to do -- beef up their oncology unit. It's not done well in the past, but I think they're going to be persistent about it. If I had to guess, I would say that is the field in which we'll see the acquisition made when and if it comes.

Campbell: Right. I absolutely agree with you. They're obviously committing to it. Zydelig has not been a success for them since its launch. We'll see. Maybe we should start making a list of possible targets in cancer.

Harjes: That would be a fun show, who Gilead could buy.

Campbell: Absolutely.

Harjes: Let's move on to another company. This is an even more troubled company over the past year than Gilead Sciences -- Valeant Pharmaceuticals, which is a company that is down 85% over the past year. What do they need to do?

Campbell: Something.

Harjes: (laughs) Anything?

Campbell: (laughs) Anything. Valeant is a struggling company. It had this wonderful business model that everybody was walking to years ago, where you buy a drug or acquire a company, you reprice that drug higher, and then you relaunch it with a brand-new marketing campaign. They chose to go that route and forgo internal development of candidates. They're one of the drugmakers that invests very little historically, relative to peers, in their own internal R&D pipeline. So, now they've run into a situation where they're incredibly heavily indebted, they've run afoul of regulators on some of their past practices for sales and marketing, and that's cast a long shadow over them. How is this company going to go from all of the struggles it's been enduring and be able to show investors, "This is how we're going to succeed in the future?" They're doing some things right, but there's still a lot of question marks out there that I think they need to resolve to put those question marks behind them, and show investors, "This is where we're going to be in the next three years, five years, 10 years."

Harjes: Right. They have a couple of different ways that they could go about trying to turn themselves around. I do think we need a little bit more guidance on what exactly that will be. One thing that many investors have speculated is that they could sell part of the company, in particular, one name that comes up, the Bausch + Lomb subsidiary of Valeant, which makes up roughly half of their revenue. This is a company that they acquired back in 2013 for $8.7 billion. Back then, it was generating $3.3 billion in annual revenue. This unit is now generating $4.6 billion annualized, based on Q3 earnings. So, in theory, that could make it worth around $12 billion, although everybody knows that Valeant is under pricing pressure and under all sorts of scrutiny, so I'm not sure what they would even be able to get for this unit at this point. It's such an interesting contrast to the Actelion bidding that you mentioned earlier with J&J, where the pricing is just going up and up and getting inflated. I think Valeant is the complete opposite right here.

Campbell: Right. They're just not in a power position. They don't have the bargaining power. Frankly, Bausch + Lomb is the crown jewel of their organization. It's the only one of their three segments that posted year-over-year growth in the Q3. My fear would be, you get rid of that unit, and you're left with the other stuff, to be diplomatic. These other parts of the business that aren't nearly as attractive. So yeah, if they go out, and they might get $12 billion, you're still stuck with $20 billion of debt on the balance sheet, and now you have two slow-growing or no-growing parts of the business that are left. It's almost like they need to rebrand themselves, get rid of the Valeant name, take the Bausch + Lomb name, and toss the other parts of the business to whoever will take it, say, "Take it off our hands and take some debt with you."

Harjes: Yeah, trim the fat. I could see that, too.

Campbell: It's going to be a very interesting year for them. The other thing I'd like to see them do, Kristine, and I know you and I follow this stock, quarter after quarter after quarter, they've continued to cut their estimates, where they think they're going to earn. You can't continue to do that and restore confidence.

Harjes: Yeah, those are diametrically opposed.

Campbell: Right. You have to rip the band-aid off. We have new management there, that should encourage some people. That's good news. But you have to rip the Band-Aid off, you have to lowball those estimates for 2017, and then overdeliver. If they can do that, I think you restore some confidence. People start to get a little bit more enthusiastic. You cut some of that SG&A expense. Their SG&A as a percentage of revenue is about 27%. To put that in perspective, that's like 5% higher than J&J. That's double what Gilead Sciences is. They have to do a better job, if the sales are going to decline, of keeping up on cutting the SG&A.

Harjes: That actually sounds extremely New Year's resolution-y. Make a fairly small goal and knock that one out of the park, as opposed to saying, "I'm going to lose 20 pounds," and when you don't lose it, you immediately give up.

Campbell: Right. If you're working in the right direction, show investors that you are indeed working in that right direction. You can't just say, "Well, sequentially, we're seeing some improvement," and then cut forward guidance. That's not going to do it. You have to say, "Sequentially, we're improving, and look, we're exceeding the guidance we gave you." If they can do that, they don't need to sell these other parts of the business, they have some time. And eventually, the year-over-year comparisons will get easier. As long as creditors are willing to play ball with them, and I think at this point they are, then 2017 could, if they play this right, end up being a transition year.

Harjes: And that's how you build back up the confidence. OK, Todd, let's get rolling with another company that we think should have a pretty firm resolution.

Campbell: You know what? I'm going to throw the entire biotech industry into this one. I think biotech needs to take a really hard look -- biopharma, we'll say -- at the way they're pricing their drugs. They need to focus on innovation, and stop focusing on growth through price increases. Setting arbitrary, "We're not going to increase our prices more than 10%," and going right up to 9.9% --

Harjes: You're calling out Brent Saunders, aren't you?

Campbell: A little bit. Allergan was at the forefront of saying, "We need to self-regulate on pricing, and we're going to commit to our consumers that we're not going to raise our prices more than double-digit rates." Sure enough, the reports from different Wall Street analysts who tracked the pricing show that he did, indeed, come underneath that double-digit rate, but 9.5%? Consider the optics here, people. If inflation is 3%, and you're going at about 9% to come underneath 10%, I feel like that doesn't do a whole heck of a lot to encourage the average person who's reading this news flow and saying, "Great, I guess it's less than 50%, and it's less than 20%, but come on."

Harjes: To be fair, if you look at the industry as a whole -- and I don't think this is an excuse for Allergan -- relative to the broader industry, a 9.5% increase is actually not that much. The average price of a brand-name drug increased 16.2% in 2015. Those are the latest numbers we have from the Express Scripts Drug Trend Report. These prices have also increased almost 100% since 2011. One-third of branded drugs increased their price by more than 20% in 2015. Which is just crazy. And it's very indicative of this industry, where prices are inelastic. Can you imagine the price of a Chipotle bowl going up 10% every single year? It wouldn't happen.

Campbell: Yeah, it wouldn't. You make a fair point. It's the right direction, and it shows that there's a social consciousness, a social contract out there, to try and contain these increases. I think a lot of people are looking at it and saying, "But what's behind those increases? Did the cost to produce these drugs really increase 10%, and you're passing that cost on? Or did the cost to produce those drugs increase 4% and you're padding profit by an extra 5%?" I think it's a fair question to ask. I think we have to move beyond this. We have to focus on innovation. We have to focus on how these drug companies are improving the lives of consumers and patients. And I don't know whether or not we're going to be able to do that in 2017.

Harjes: But at its heart, that is what this sector is about. That's why I love it. I'm sure you're the same way.

Campbell: Oh, absolutely. It's fascinating. We see the phenomenal work that's getting done by companies, which actually is a nice segue into another one that I have. Let's resolve to stop hyping early stage phase 1 results.

Harjes: Ooh, this is a good one.

Campbell: Right? Let's stop going out there and saying, "Hey, we have this great phase 1 success story!" In a bid to being able to do an equity offering, getting people convinced that this is going to be the next drug that's going to revolutionize Alzheimer's or whatever. Let's focus more on phase 3 drug successes and growth for drugs that are already on the market, tied to unit volume, not pricing.

Harjes: Yeah. The responsibility for this one has got to fall both on the companies themselves for producing the hype, but also on investors. You can't blame people for being excited about new, innovative drugs. But once you actually translate that into the financial markets, and you get these bloated valuations for very, very early stage companies, you get the volatility and the heartbreak that we've seen in a company like, say, Anavex. You mentioned Alzheimer's. This is a company that was taking a completely different approach to Alzheimer's. They had great phase 1 data, and then all of the sudden, phase 2A, nope, there was a slight deterioration, actually, in the patients' mental abilities, and the stock plunged 50%.

Campbell: Yeah. As investors, we need to hold these companies accountable by not buying shares based on phase 1 data. Kristine, you and I have talked about it before -- 90% of drugs fail in clinical trials. 90%! So, the likelihood of a phase 1 success translating into an FDA-approved drug that's going to be a billion-dollar blockbuster? Small. Very small.

Harjes: Yeah. And maybe, if there wasn't so much hype about early stage candidates, you would find the larger companies like Gilead better-able to make early stage acquisitions, because the prices wouldn't be as bloated. It's all related.

Campbell: And, theoretically, they might have a greater level of experience that allows them to recognize failures earlier on. So, yeah. I think, we can hold them accountable, but they should also be holding themselves accountable, and they should resolve to do that this year.

Harjes: Right. Speaking of experience, I think we have time for one more resolution. This one I'm going to give to manufacturing issues. Across the entire industry, we need to stop having drugs rejected by the FDA because of manufacturing issues. If you have a drug that works and is safe, it needs to be able to get the patients without being blocked by your facility not being up to par.

Campbell: Yeah. There were a host of them last year, Kristine, that we talked about, where the FDA said, "No, we're going to push back on this because we have some questions about how these drugs are going to be manufactured." I don't want to say it's ridiculous, but come on. We've been making biologics for a long time. A lot of these monoclonal antibodies, etc., they've been produced for a long time. For me, I struggle to understand how it is that large companies -- I'm going to call out Sanofi and Regeneron on this one -- how they're having some problems with their manufacturing that's causing delays in approval.

Harjes: Right. The Sanofi-Regeneron story, that one was a heartbreaker. Back in October of 2016, they received a complete response letter, a CRL, which is basically a thumbs down from the FDA, for a rheumatoid arthritis drug, because of manufacturing issues in one of the Sanofi facilities in France. This was where the drug was filled and finished -- the very last step of the process. Interestingly, the active ingredient isn't even made there. It's manufactured by Regeneron all the way over in New York. But just because of this one last step in the process that the FDA had some sort of issues with the facility, all of the sudden, they need to refile and fix these problems before it can actually get to patients.

Campbell: Right. This was a drug that could have gotten approval in late September or early October. It could potentially be a $1 billion drug for rheumatoid arthritis. It showed really good responses versus Humira. And now you're wondering, what happens in March? We have another drug coming up that is also getting filled in, finished at that same facility. Will that get approved, or will it get delayed?

Harjes: Yeah. I think this would be a really good resolution for not just Regeneron and Sanofi particularly, but across the board, because we have seen it happen too many times in the past year.

All right, well, I think we're about out of time. Todd, thank you so much for helping me come up with this list. Hopefully, some ears that can actually make these resolutions happen will be listening in on us. Folks listening, if you have any questions for us or just want to say hello, maybe give us some ideas for resolutions of our own, email us. Our email address is [email protected]. We also have a Twitter account, the handle is @MFIndustryFocus. As always, people on the program may have interests in the stocks that they talk about, and 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, have a Happy New Year and Fool on!