Drug companies are already dealing with patent cliffs, where multiple drugs are going off patent at the same time, cutting into revenue. They don't need any more cliffs to fall off.
Unfortunately, they're not immune to the fiscal cliff. The sector is usually resistant to macro issues -- people get sick even in a recession -- but decisions the government makes, or doesn't make, will ultimately affect health care companies' revenue.
Falling off the cliff
The worst option for the economy in general is also the worst case for health care companies dependent on the Food and Drug Administration for their future revenue.
Many years ago, the industry worked out a deal with the FDA where companies contributed user fees as part of the Prescription Drug User Fee Act in exchange for faster decisions on the marketing applications for drugs. The FDA hired more staff and set goals -- referred to as PDUFA dates -- and review times decreased. Everyone was happy. Or at least happier.
So, the FDA is insulated from budget cuts? According to Regulatory Focus, that doesn't seem to be the case. The across-the-board 8%-cut in budgets will hit the entire FDA budget. The agency will have to lay off employees, which will likely result in delays in approvals of drugs. Even the threat of layoffs or furloughs could have an effect on productivity today. Navidea Biopharmaceuticals (NYSEMKT:NAVB), MAP Pharmaceuticals (NASDAQ:MAPP), NuPathe (UNKNOWN:PATH.DL), and others have drugs under review that could potentially be delayed.
Ironically, the drug companies will still have to pay their user fee; the FDA just won't be able to use the extra cash, since it's caught up in some sort of limbo invented by politicians who thought forced cuts were the best way to solve the problem.
In theory, cuts to Medicare and Medicaid in some form or another should hurt the industry. In reality, changes in spending by the government-run programs don't have that much impact. As Merck's (NYSE:MRK) CEO Ken Frazier points out in this editorial, cuts in Medicare just get shifted to the private sector.
With the exception of companies like Gilead Sciences (NASDAQ:GILD), which sells a lot of its HIV medication to Medicaid patients, most companies will be able to make up for losses from government agencies with price hikes elsewhere. The buck has to come from somewhere; gross margins on drugs are high, but after you subtract out the high cost of R&D, pharmaceutical companies' net profit isn't all that high. If they don't shift the cost, they'll be out of business, and private insurers are willing to pick up the tab because they don't have much incentive to hold prices down; the insurers just pass the cost onto their members.
In fact, since Medicare pays the lowest rate available, if the age where seniors become eligible for Medicare is increased to 66 or 67 -- an idea some lawmakers have floated around -- the cut could have a positive effect on companies with drugs that treat the elderly. That assumes, of course, that seniors would remain on private insurance and don't just let their insurance lapse between when they retire and when they start Medicare. Obamacare should take care of that, at least in theory.
Looking a little more long term, the industry should really fear potential cuts in government-sponsored research at the National Institute of Health and elsewhere. The billions of dollars spent to do research at academic labs result in discoveries that eventually lead to drugs.
Drugmakers are in the business of drug development; relatively little basic research goes on in industry labs. For instance, a drugmaker might design a drug to inhibit a protein that causes a disease, but the discovery of that protein and how it functions in the cell was likely done in an academic lab.
If the NIH budget gets slashed, there will be a roadblock to developing new drugs a few years down the line.
The best solution
The path the health care industry is on, with increases in health care costs grossly outpacing general inflation, is unsustainable. Not just for a government trying to balance its budget, but for Americans in general.
The long-term solution -- I doubt this will get worked out before sequestration kicks in -- is a move toward value-based pricing. A drug that works and prevents future medical spending down the line should be priced higher than a drug that doesn't. How many tests are run that produce no real value?
There's been a little push on that front; Medicare, for instance, has tried some things like kickbacks for doctors who are able to reduce spending. But we have a long way to go.
It's a complicated issue in large part because Americans don't have the same coverage over their entire lives. So, an insurance company might be reluctant to spend money now on a procedure that will save money later when the patient might no longer be a member.
Universal coverage would solve the problem, but it isn't politically viable. One hope is that Obamacare's requirement to mandate coverage for all people will make it easier to require and encourage preventative treatments that decrease overall health care spending over the life of the patient.
Fool contributor Brian Orelli has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.