What's Ahead for Healthcare in 2017?

Two of healthcare's biggest stories this year could end up being the planned launch of two new gene-sequencing machines from Illumina, Inc. (ILMN 2.40%), and the potential approval of Kite Pharma's (NASDAQ: KITE) chimeric antigen receptor T-cell therapy. Are you prepared for the potential opportunity associated with these two stories? In this episode of The Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes is joined by contributor Todd Campbell to explain why these companies could be smart investments.

Also, the two offer up insight into UnitedHealth Group's (UNH -1.98%) recent earnings report, and they provide investors a preview of Johnson & Johnson's (JNJ 0.82%) fourth-quarter earnings next week.

A full transcript follows the video.

This podcast was recorded on Jan. 18, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Kristine Harjes, and it is Jan. 18, 2017. I have healthcare contributor, Todd Campbell, calling into Fool HQ in Alexandria, Virginia. How's the last week been, Todd?

Todd Campbell: Hi, Kristine! Happy Wednesday!

Harjes: Thank you! Happy Wednesday, indeed!

Campbell: Do you ski, Kristine?

Harjes: I do! I was just on a ski trip last weekend.

Campbell: Oh! So was I!

Harjes: Really?!

Campbell: And we both emerged unscathed! 

Harjes: [laughs] Yeah, no big bone breakages to report, just a little bruised.

Campbell: Excellent! Yeah, in New Hampshire, it's not really skiing, it's more like sledding on ice-filled mountains. [laughs]

Harjes: Hey, at least you guys probably have real snow. It was all fake snow in Maryland.

Campbell: Ugh, I would have taken fake snow, to tell you the truth. It was pretty skied off, it was tough conditions. I don't know about you -- well, I'm a lot older -- but for my knees, Ibuprofen was my friend. [laughs]

Harjes: Yeah, I feel that. Very cool. I did not know we had that in common from this past weekend. So, the meat of today's show, we have a lot of different things that we're going to cover. We have some big-picture takeaways from a very important healthcare conference that is wrapping up, and we also have a little bit of earnings news to touch on. But, let's get started first with some takeaways from the J.P. Morgan Healthcare Conference. Todd, do you want to start with why J.P. Morgan matters?

Campbell: It's the grandaddy conference. Everybody looks to early January to watch this conference and look at the presentations that come out. It's a great opportunity for the executives at different companies to tout their performance in the past year, to point investors in a certain direction for what could happen this year. So, every year, there's a tremendous amount of attention that gets focused on it. We've put out a lot of coverage on The Motley Fool that listeners can go out and track down if they're interested in individual companies. But, there were a couple specific takeaways coming out of J.P. Morgan. Two things that I think are happening this year are pretty transformative.

Harjes: Right. I would say, the very top of my list for big advances that were announced, and I would even go so far as to say that this company was the winner of the conference, was Illumina. Their stock jumped 17% after they had their J.P. Morgan presentation, because they had so many cool things to report.

Campbell: It was pretty much a perfect storm. The stock had fallen a lot last year. There had been some weakness in Europe early in the year, and some weakness in the U.S. in Q3. As a result, investors were getting a little bit nervous that maybe the double-digit growth, that they have gotten used to over the past few years, was coming to an end. So, you have them walking away from the stock going into J.P. Morgan. And then sure enough, at the conference, they come out with this bombshell, "Hey, we're rolling out two completely transformative new gene sequencing machines that could significantly," I think, "advance this entire movement toward personalized medicine," which is medicine that is based on each individual's genetic code.

Harjes: And Illumina is completely at the front of this market. They dominate the gene-sequencing market.

Campbell: Yeah, they pioneered it, right, Kristine?

Harjes: Exactly. But, they do kind of need a little bit of a kick in the pants to get them moving again, particularly with their high-end instruments. There are many who think this new line of sequencers could totally reenergize them. I think the most exciting part about the NovaSeq 5000 and 6000 that they announced is that this system could eventually allow researchers to sequence an entire genome for under $100.

Campbell: Wow.

Harjes: Yeah, that's incredible. To put that in a little bit of context, when the HiSeq X machine was announced in 2010, it could do it for $1,000, and that was incredible. So, to take that down by another factor of 10 to $100 or less, that opens up so many possibilities for gene sequencing.

Campbell: Right. 20 years ago, this was tens and tens of thousands of dollars that it would cost to do this, and you were getting very top-line surface genetic data. Now, you're talking about a pathway, for the first time, to get us below, consistently, that $1,000 mark, potentially drive it all the way down to $100. But in addition to that, to be able to do it with more accuracy and more speed than ever before. They're able to use deep sequencing technology to get even greater understanding of the connection between our genetic code and disease. That could be very transformative long-term. But even in the short term, it could help kick-start Illumina back to where they were going, maybe 10% year over year, coming out of Q3. Maybe they get closer back toward that 15% to 20% mark that people have gotten used to in the past.

Harjes: Right. This is a very exciting company to watch. I think the NovaSeq machines are the most intriguing thing to watch right this second, but this is a company with a lot of intrigue around it. They have very strong strategic partnerships, they just announced three more at J.P. Morgan, with Bio-Rad Laboratories, Philips for data analytics and oncology, and also even IBM with Watson for standardizing and simplifying genomic data interpretation. Plenty to watch out for here. We've also talked on the show a little bit about some of their moonshot programs like Grail and Helix. If these don't sound familiar to listeners who are just starting to listen to the show, definitely go back and try to find those episodes. If you can't, shoot me an email at [email protected], and I will send them right over to you. But, yes, tons to be excited about with Illumina.

Campbell: Yeah. And again, I think the big takeaway for investors is to go back and say, what has happened in the past when the cost of gene sequencing has fallen? And like you mentioned, the HiSeq X Ten when that launched, it caused a wave of growth, a surge of research and activity, and, of course, resulting demand for the consumables that are higher margin that Illumina sells. So, as the price comes down, more overall research activity, which could open up all sorts of doors further on. This is one of my top stocks, I think, for 2017.

Harjes: You know, the more I look into it, the more I agree. It's kind of pricey stock. But I'll also add to what you were talking about, about more research. With the 21st Century Cures Act, that was another $4.8 billion to the NIH over 10 years for more programs that involve this sort of sequencing.

Campbell: Right. And some of that money is going to be heading toward developing next-generation cancer drugs, which segues into my other big takeaway out of JPM.

Harjes: Which was?

Campbell: Which was the fact that CAR-T is most likely going to become a reality either later this year or early next year.

Harjes: Quick refresher on CAR-T?

Campbell: OK, we're talking about removing the T cells from a patient's body, re-engineering them so that they can find cancer cells, bind to them, and destroy them. There's all sorts of reasons why cancer cells can evade detection by the T cells. What these researchers have discovered is that you can actually program the T cell to find these proteins that are expressed primarily by cancer cells. One of the most advanced -- there's an application that's already under way for its approval -- is Kite Pharma's KTE-C19 which, if approved, will be sold as Axi-Cell, and that is targeting non-Hodgkin lymphomas that haven't responded or have come back after prior treatment.

Harjes: And, as you mentioned, it is pending approval in this indication, which is super exciting. At J.P. Morgan, they presented their roadmap to commercialization, which was also very impressive. They have a manufacturing facility that's in full operation. This is really important, for the FDA to see that you're actually able to make your drug and have it be up to standards every single time. They have a commercial facility that's close to the LAX airport. They're prepared to produce right off the bat 4,000-plus treatments for patients every year.

Campbell: Right. If we do a little back-of-the-napkin math there, Kristine, we don't know what price they would set this up. It's a complex, brand-new class of drugs. But we do know that most cancer drugs that have launched over the course of the last few years have launched with six-figure price tags. So, let's just assume that it runs somewhere in that range of $100,000 to 200,000. If you look at 4,000 patients, and you go by $100,000, that's $400 million. If you go by $200,000, that's $800 million. So, this has a nine-figure potential, just within the early indications that it's seeking approval for now. And, of course, Kite has all sorts of research going on further back that could theoretically expand the use of CAR-T into other indications that could also generate, eventually, money. But as we always discuss, right, Kristine, you don't want to get the cart too far in front of the horses. This drug has not been approved. We have seen manufacturing problems delay or result in complete response letters from the FDA. So, there's still some hurdles that need to be overcome before investors can be confident that this drug is going to be starting to generate meaningful revenue for the company. But, coming out of JPM, I really do feel like there's a really good shot that this becomes a reality. Science fiction just becomes science.

Harjes: We've been watching CAR-T technology for a long time, and to this point, it's been sort of disappointing. There have been a lot of hiccups with safety profiles and different companies not meeting the expectations they had set out for themselves. But it does look, like you say, coming out of this conference, that Kite is about to make it a reality, which is pretty cool.

Last year, we covered this conference on our Jan. 20 episode. If you want to go back and find out more about what was going on in this conference, maybe save it for tomorrow, Throwback Thursday. You can also check out the full roundup of Motley Fool coverage. We have a list of all of the articles that we've written about this conference on fool.com, just search for "Motley Fool 2017 J.P. Morgan Healthcare Conference Roundup," that should bring you right there.

All right, Todd. Are you ready for earnings season?

Campbell: I'm about as ready as I'm going to get.

Harjes: Good, because even if you're not ready, it's ready for you. [laughs]

Campbell: Here it comes! It's coming on fast.

Harjes: It is. UnitedHealth Group reported on Tuesday Morning, yesterday morning.

Campbell: Yeah. This is one of those companies that we're going to be laser-focused on in 2017 for a lot of different reasons, some industry-oriented and some stock-specific, and of course, some political.

Harjes: Absolutely. It's the biggest health insurer in the United States, so it definitely is a company to watch if you're interested in this changing healthcare landscape in America.

Campbell: Yeah. As the largest U.S. health insurance player, UnitedHealth made a lot of news last year when they came out and said, "Guess what, we're losing a boatload of money in selling our insurance plans on the Obamacare Affordable Care Act exchanges, so in 2017, we're going to back substantially away from that program." That kicked off a whole lot of activity within the industry, with a number of other insurers saying, "Yeah, we're losing money too, maybe we're going to walk it back, too." Now, with the election of Donald Trump in November and plans to repeal and replace, the health insurance market is going through a major transition over the course of the next 12 to 18 months, as all of the people who have been covered on the Affordable Care Act now have to seek out coverage through some other venue. What will that venue look look like? How will UnitedHealth profit from whatever change occurs? All of that is going to have to be carefully watched over the course of the next year.

Harjes: Absolutely. Management does expect that they'll post 2017 revenue between $197 billion to $199 billion. This is a humongous company. That would work out to the growth rate of about 6.5% to 7.5%, compared to the finish of 2016. That's still pretty solid growth. In particular, I would say watch out for the Optum segment. The way that this company works is they have the health insurer, which is the UnitedHealthcare insurance segment, and then they also have the Optum part, which has a whole bunch of different things involved in it. It has their pharmacy benefits manager, Optum Rx, data analytics, whole bunch of stuff going on in Optum, and it's been growing like a weed. Interestingly, in Q4, revenue from the insurance segment jumped over 15%. Meanwhile, the Optum revenue actually only inched upwards by a little over 1%.

Campbell: Yeah. There's a couple things that investors are going to have to remember here to keep it weighed as they're comparing year-over-year comparisons over the coming quarters. One of them is going to be, what is the impact of the drawdown, or exiting, these other markets in the individual marketplace? How will that affect revenue? It's almost like, when you're looking at insurers, because they're so big and the margins are so thin, it's less important what their top line is doing than it is what their bottom line is doing. If you look at the Q4 numbers, UnitedHealth's top line grew 9% to $47 billion, which is amazing. But maybe more important is to look at the adjusted EPS number for the quarter, which was up 50% to $2.11. The same thing with the 2016 full-year numbers, you had revenue surge. A lot of that was because of marketplace plans it turned out they were losing money on. So, revenue for the full year was $184 billion, up 18%. That sounds great, but they were losing money on some of that growth. So, when you're looking at that 2017 forecast, and you say, "Yeah, but revenue is only going to grow 6.5% this year, versus last year, and last year grew much faster," you have to remember that that revenue growth is going to be more profitable revenue growth than it was in 2016. 

Harjes: Yes, absolutely. If you look at their earnings guidance, they're guiding for 15% to 19% bottom line growth.

Campbell: Right, very hard to argue with a stodgy, old, big insurer that can grow earnings by double-digit percentages. That's pretty compelling.

Harjes: Not bad, not bad. All right. We also wanted to talk about Johnson & Johnson, which is another one of our favorite healthcare stocks to talk about, because they are very large and also very interesting. They will report earnings on Jan. 24. Do you want to do a quick refresher, first, on Q3 earnings, before we talk about what to look for?

Campbell: Absolutely. J&J has three big businesses. They have the consumer business, think Listerine and Aveeno, that kind of stuff. Then, they have the Goliath pharmaceutical business, which markets a lot of top-selling drugs. Then, they have a medical device unit, which is involved in things like hip replacements and cardiovascular treatment surgery, that kind of thing. The majority of the bulk of their growth historically over the last five years or so has come from that pharmaceutical unit, and has specifically come from U.S. sales within that pharmaceutical unit. In Q3, sales grew 4% to $17.8 billion overall, across everything, but without a doubt the pharmaceutical was the shining star that quarter. Sales were up 9% to $8.4 billion in the quarter. So, as we look forward and say, "How did they do in Q4?" we're going to want to see, did the pharmaceutical growth rate accelerate, or did it deccelerate? Because, again, that's a big driver of what's going to happen with J&J in 2017.

Harjes: Yep, I totally agree. Sometimes I go back and forth about, "Do I give the pharmaceutical segment of J&J too much attention?" I mean, I hardly ever think about the consumer segment, and I'm not sure if that's just because I love biotech and drug development and that's what I cover, or because if, when you look at these numbers, it just is what investors need to keep an eye on.

Campbell: Yeah. Consumers is a $3.3-billion-per-quarter business, where pharmaceuticals is an $8.4 billion business. And consumer is established. You're always going to get single-digit growth. You're not going to get the wild swings from either patent expiration causing sales to decline, or new competition, which we'll talk about in a second, or new drug launches. Those are the things that are going to move the needle up or down, higher or lower, for J&J in 2017.

Harjes: Exactly. For me, the No. 1 thing that I'm looking for in their pharmaceutical segment is what happens with Remicade, which is a treatment for rheumatoid arthritis, and a biosimilar, meaning a generic version of a biologic complex drug called Inflectra, which was developed by Celltrion and licensed by Pfizer, hit the shelves at the market in November of this past year. So, Remicade is this very important drug to Johnson & Johnson. And now, all of the sudden, you have this off-brand generic biosimilar competitor coming in. And we don't yet know what's going to happen to it. We have some hints. We know that in the E.U., where Merck actually is the one that markets Remicade, they have seen a little bit of a drop because of the introduction of a biosimilar over there.

In the first nine months of 2016, European Remicade revenue dropped 30% compared to 2015's first nine months. That itself is kind of an interesting number, 30%. That's actually not that much compared to, normally, generic competition will eat away 80% to 90% or even more of a brand-name drug. The reason for that is that biosimilars are not your average generic. They don't sell for as much of a discount because they're really tricky to make. And, they're not exact duplicates. It's not a chemical that you can make another one of and know it's the exact same thing. With a biosimilar, you still have some principles of brand loyalty, where somebody might be a little bit skeptical of them. They're new, there are questions around them. Meanwhile, they only sell for about a 15% discount, in the case of Inflectra.

Campbell: Yeah. So, you have a situation where J&J is trying to calm the fears regarding the potential to Remicade. Remember, Remicade is roughly 20% of their pharmaceutical revenue. $1.783 billion in Q3 alone. So, this is a very important drug. If you look at the conference call from Q3 and you listen to what management was saying, they were saying, "Remember, Inflectra," which is Pfizer's biosimilar, "there's no interchangeability there. It's not like you can walk into the pharmacy and say, 'My doctor wrote a script for Remicade, can you give me Inflectra instead?' It has to be written for Inflectra specifically."

So, initially, at least out of the gate, there's about 30% of Remicade patients that don't respond well to Remicade. Those patients will probably go pretty quickly over to Inflectra. There's also, of course, some patients that will want the price difference. It depends on how the insurers play this out. You have average wholesale prices, and those don't tell the whole story, because Johnson & Johnson could go back to these big insurers, like UnitedHealth, and say, "We'll cut you a deal, we'll undercut Inflectra if you continue to reimburse Remicade at a more favorable part on your drug formula."

Harjes: Yes, absolutely. We are sort of running out of time, but one more thing that I wanted to say about Johnson & Johnson that I'll be looking for particularly in their earnings conference call is any sort of commentary on M&A -- mergers and acquisitions. There is $41 billion of cash on this company's balance sheet, which is a lot. And they want to be making moves with it. They're in talks with a company called Actelion, so we still have our eye on that. And, I'll be curious to see what else they plan on doing with their cash.

Todd, before we sign off, anything else that you're looking for in J&J's earnings?

Campbell: Yeah, let's give our listeners a couple numbers to jot down on a little Post-It note or whatever to stick on their monitor --

Harjes: Please don't do this while you're driving.

Campbell: [laughs] Right, good point. Do it later if you're driving, OK?

Harjes: [laughs] Just memorize them.

Campbell: The guidance for 2016 was for $71.5 billion to $72.2 billion. So, you want to see if they come in the high end of that $71.5 billion to $72.2 billion. They were also guiding for $6.68 to $6.73 in adjusted EPS. So, again, where are they falling? Now, analysts right now are at $72 billion and $6.71, right in the middle. So, obviously, if we come in ahead of those numbers, the stock could rally, and if we come in below, then maybe there's an opportunity for long-term investors to buy the stock on sale. We'll have to see how that rolls out.

Harjes: And, of course, for long-term investors, management expectations matter more than analyst expectations. You want to see that the company has a good handle on its own earnings.

Campbell: Absolutely.

Harjes: That will do it for this Healthcare episode. Thanks so much, Todd!

As I mentioned earlier in the show, you can always email the team with any comments or questions at [email protected]. And, if you're feeling extra generous, leave us a review on iTunes, please! 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. Fool on!