News! News! News! Here's What's Happened in Healthcare Last Week

A big-time patent settlement between Merck & Co. (MRK 2.93%) and Bristol-Myers Squibb (BMY -8.51%), Johnson & Johnson's (JNJ -1.15%) fourth quarter earnings report, and Aetna (AET) and Humana's (HUM -1.45%) $37 billion merger bust were among the top stories in healthcare last week. Should you buy any of these stocks?

In this episode of The Motley Fool's Industry Focus: Healthcare podcast, Kristine Harjes and Todd Campbell to explain how these market-moving stories impact your portfolio.

A full transcript follows the video.

This podcast was recorded on Jan. 25, 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's January 25th. Healthcare investor extraordinaire Todd Campbell is skyping in to Fool headquarters. Todd, did you see the big DOW news this morning?

Todd Campbell: Unbelievable. Who would have thought 20 years ago we'd be where we are today, at DOW 20,000?

Harjes: 20,000 as of this morning. I think, if you've been watching it lately, you probably could have seen this coming. The DOW has been rising since the election of Donald Trump to the presidency of the United States. There's been lots of business people appointed to the cabinet, such as the CEO of ExxonMobil, for example. Even this morning, the DOW opened at 19,994. We all know it's just a matter of time.

Campbell: Right, the concept of deregulation and potentially lower corporate tax rates providing some additional tailwinds. But again, like anything, it's the power of compounding. Over time, if the market grows at a 4-6% annual rate, you're going to eclipse these milestones decade after decade after decade. It's a great reminder to investors who look back on the Great Recession and were extremely nervous that the next time we go through one of those hiccups to just take a deep breath and keep focusing on that long-term plan.

Harjes: Absolutely. In honor of the event, I wanted to share a little bit of history about the Dow Jones Industrial Average. What it is, is a price-weighted average of 30 large American publicly traded companies. It is the most well-known index of the United States stock market. It actually dates all the way back to 1896, when a guy named Charles Dow was involved in the creation of it. Todd, here's a little bit of trivia for you. Do you know the only one of the original 12 companies to still be on the index today?

Campbell: Oh, god ... General Electric?

Harjes: Yeah, that's it.

Campbell: (laughs) Oh! Yay!

Harjes: (laughs) I was going to give you the hint that it was the Industrial Average, to see if maybe that would help, but yeah, you got it on your own.

Campbell: That was really tough, I had to really go back in time. I'm old, but I'm not that old.

Harjes: (laughs) Yeah, 1896, not quite. Actually, of the five companies that we plan on talking about today, two of them are actually on this index. We'll be talking a little bit about Merck and Bristol-Myers Squibb and some patent infringement lawsuit business that has gone on with the two of them. We'll also be talking about Johnson & Johnson, touching on their earnings, because we gave you a preview last week, so why not check back in this week? Then, toward the end of the show, we will also talk about two health insurers, Aetna and Humana. So, of those five, the two that are in the index are Merck and, as I'm sure is not surprising, Johnson & Johnson. But, let's kick it off with Merck, and also Bristol-Myers.

Campbell: Some very interesting news here this week, Kristine. Wouldn't you like to be able to add nine figures in revenue with just the stroke of a pen?

Harjes: Yeah, that would be nice. My bank account would love it.

Campbell: That's essentially what's happened here with Bristol-Myers and Merck. Essentially, these two companies have settled a patent dispute, Bristol-Myers coming out on top. Merck has now agreed to give them a pile of money up-front to make up for royalties that they hadn't been paying for infringing on the patent. And, according to the settlement, Merck is going to give Bristol-Myers a healthy 6.5% dividend from here until 2023, and then another 2.5% from 2024 to 2026.

Harjes: And that's specifically on one drug named Opdivo and Keytruda.

Campbell: Yes. Both these drugs work in the same way, they target a protein called the PD-1, which is expressed on T-cells, in which cancer cells sneakily use to evade the immune system's detection.

Harjes: Right. This is a completely novel way of treating cancer, which is why you have Bristol-Myers saying here, "Hey, wait, you have infringed upon the patent that we have." So, this will effectually end all of the patent infringement litigation against Merck's Keytruda, and as you mentioned, Bristol will get a whole pile of money to make up for the past, and then they'll get royalties going forwards. The payments will actually be split 75% to Bristol-Myers and 25% to a company called Ono Pharmaceutical, it's a Japanese partner on the drug. This is still a very hefty sum for Bristol-Myers.

Campbell: Right. They're getting $625 million right up front. Merry Christmas, here's $625 million! Then, if you look at the potential market opportunity for these checkpoint inhibitors, these PD-1 drugs, it's tremendous, it's huge. These are billions and billions dollar drugs. Just out of the gate, assuming no additional growth on Keytruda, you'd be looking at right around $100 million in royalties stream heading toward Bristol.

Harjes: Right, so this is huge news. Most likely, the drug will continue to expand, making it even bigger and bigger news going forward. And that 6.5% royalty will last all the way through the end of 2023.

Campbell: Right. You just mentioned to the ability to expand. A lot of cancers use this PD-1 to escape detection. What they're finding is, as they do more and more trials in different types of cancer, that these drugs are very effective, very high response rates in patients. This was especially interesting, to see them come to this agreement, because in the last year or so, both drugs, Opdivo and Keytruda, they've diverged in what's happened in their clinical trials, with Merck having a lot of success and Bristol-Myers mostly, in my view, because of the way they designed their trials, having less success, especially in lung cancer.

Harjes: Right. This is something we have talked about on a previous episode of Industry Focus, so our long-time listeners will hopefully remember. It basically had to do, as you mentioned, with the trial design, where Opdivo failed its trail in which it was looking at pretty much all levels of PD-1 expression 5% or above as opposed to, when they did the Keytruda study, it was 50% PD-1 expression and above. Of course, it's a drug that works on PD-1, so if you're targeting patients that have a higher expression of it, you're tilting the odds in your favor.

Campbell: Yeah, it's almost like Merck went the safe route, and Bristol-Myers tried to jump the shark.

Harjes: Right, and it backfired.

Campbell: By going the safe route, Merck was able to nab an FDA approval for the use of Keytruda in the first line setting for high-expressing PDL patients. What's really interesting is that they also have recently filed for first line use of Keytruda plus chemotherapy in patients who don't express PD-1, after seeing some pretty solid trials. So, if Bristol-Myers had either designed the trials so that was only high-expressing patients initially, or had combined it with chemotherapy, who knows if Keytruda would have the advantage in lung cancer heading into 2017 versus Opdivo. Obviously, I think that probably made Bristol-Myers a bit more willing to agree to that royalty stream, because they looked at it and said, "Well, if we can't get the first line, and the first line could be worth up to $1 billion, at least maybe we can share in some of Keytruda's success."

Harjes: Absolutely. It is not a bad consolation prize.

Campbell: No, and it's all high-margin money. They're not actually producing anything, they already produced the IP for it.

Harjes: Yep, that's money in the pocket. Let's move on and touch back on Johnson & Johnson earnings, which we did a preview of last week. Todd, what was the report like?

Campbell: Last week, we had talked about a couple different things. One of the things that had jumped out to us, or, one of the things we wanted to make sure everyone was aware of was the potential threat to Johnson & Johnson's best-selling drug Remicade, which is used to treat rheumatoid arthritis. That drug has lost patent protection, and it's now facing a biosimilar that works similarly to it that launched in November. So, we were very curious to see what's going to happen with Remicade's sales. And, sure enough, Johnson & Johnson went from growing almost 10% year over year in the U.S. for Remicade in the third quarter to actually losing ground on Remicade year over year in the fourth quarter. Sales fell 1.7% in the U.S. for Remicade to $1.17 billion, where in Q3, they rose 9.4% to $1.22 billion.

Harjes: Yeah. Before you specified in the U.S., I was actually going to ask you for that clarification, just because there is a good amount of difference here regarding this drug between what's going on internationally versus in the United States. Internationally, the biosimilar has been on the markets in Europe for a while, a long enough time that, as they put it in the earnings report itself, they are continuing to see the impact of biosimilar competition. But, it's in the U.S. that we just recently, at the end of last year, saw the biosimilar come to be approved by the FDA. It was interesting to me, the discrepancy between the numbers that you just reported, where you saw that decline, versus the quote from the earnings call where management said, "We have not observed any significant impact to date," and that was referring to the impact of the biosimilar, Inflectra, on Remicade. 

Campbell: Right. And I think they can probably make that argument by saying, "We haven't necessarily lost any market share." But, remember, in order to protect their market share, they're having to cut the price and offer greater discounts, which, of course, is going to weigh on their ability to generate out sales growth. And even with competing heavily on price, if you go in and listen to that conference call and get all the way to the question and answer section, management did sort of tip their hand and say they could perhaps lose 10-15% in the first year of market share. So, Remicade being Johnson & Johnson's biggest drug, a drug with $4.4 billion run rate in the United States alone, losing market share is going to create a headwind that could keep its sales depressed in 2017. It's not a disaster by any sort. I still think they can grow sales and profit by 3% this year. But, 3% is probably not going to get too many people overly excited about this company.

Harjes: Right. And interestingly, the pharmaceutical segment has historically been what drives this company forward, but in this past quarter, the consumer products segment, that's your Listerine and Band-Aids and things you would buy at CVS, that actually led the way. Their sales were up 3.4%, particularly when you look domestically, sales were up 13% in that unit. 

Campbell: I look at it over the course of a trailing 12-month period for consumer goods, because you just don't know what's happening with people building up wholesale inventories and that type of thing. If you're looking for the full year, sales have declined 1.5% from 2015. So, I think what we'll need to do is watch and see how that plays out over the course of the next few quarters, and see if they're still delivering that kind of growth. If they are, great, that's awesome news. But I think, again, as we talked about, they get the majority of their revenue from the pharmaceutical area. And while they have some intriguing stuff that could help offset some of those headwinds to Remicade, this is going to be an evolving story for 2017, no question.

Harjes: For sure. Anything else that you want to touch on with J&J earnings before we move on to our last story of the day?

Campbell: There was one bright spot that I want to call out, that I think investors should be aware of, and that was the performance of Darzalex, which is their new multiple myeloma drug. That launched back in late 2015 for use in the fourth line setting. So, pretty far back in patient treatment. But, as we moved in toward the end of the year, that's won approval now for use alongside Revlimid in the second line setting. Revlimid, of course, is the granddaddy in multiple myeloma with $8 billion in projected sales this year. Darzalex sales in the fourth quarter were $200 million. That gives it an $800 million run rate. That's not bad for a drug that only launched a year and a couple months ago. It certainly could indicate that this is their next billion-dollar blockbuster drug.

Harjes: This drug definitely has some momentum. Overall, Johnson & Johnson did deliver right around expectations. The one area they fell a little bit short was in their 2017 guidance. Right now, we're looking at anticipated sales of $74.1-74.8 billion, which, I believe you mentioned a little bit earlier, is about 4-5% growth. They had been expecting $75.1 billion going into the report. But there's still a lot to shake out in 2017, and that's not a huge miss right there. Lots to keep your eye on still with Johnson & Johnson. 

Last story of the day was something that just came out earlier this week, which is that the Humana Aetna merger was blocked by a District Court. This was a $37 billion merger within the health insurance industry that a lot of people had their eye on.

Campbell: We talked earlier about how the Dow Jones was eclipsing 20,000 partly because of deregulation. Apparently, the Department of Justice, the district court judge didn't get that memo. The Department of Justice basically has cried foul on this deal, they cried foul a while back, saying that by combining these two very large players in Medicare Advantage, it would cause a big problem to pricing and access to health insurance within markets where they overlap. These two companies, Aetna and Humana, attempted to try and assuage the judge by agreeing to sell some assets to another company called Molina Health. However, when push came to shove and the judge looked at all the different puts and takes, he determined that the risk was just far too great in that Medicare Advantage segment to go ahead and approve the combination of these two big companies.

Harjes: Right. When you look at the Medicare Advantage market, these are two of the three largest players, with UnitedHealthcare being the other one. This is a huge market. 31% of people on Medicare are enrolled in Medicare Advantage. And it's growing, the number of people enrolled in these private plans has tripled between 2004 and 2016. So, the thinking is, with these companies combining, there's nothing that could happen, no new competitors, no divestitures, nothing that would avoid the competitive issues that would come up. Essentially, the verdict came down to, no matter what happens here, they should have just completed independently to win more customers rather than try to get together to have that bigger negotiating power and win that way.

Campbell: Right. Kristine, it's not like we're talking about a product that you can buy on Amazon, regardless of what county you live in or what state or what town or whatever. These insurance programs do not offer plans the same in every community. They can be very different, and different companies can participate in those different communities. So, you have very different competitive marketplaces within each specific county or town throughout the nation. And I think the big risk was, OK, you consolidate power, but these two very large players turning it into the biggest player in Medicare Advantage, what happens in those communities that, say, are under-served? Where, maybe, UnitedHealthcare isn't currently participating in, or there aren't any other options. If you have that kind of a situation and give that much pricing power over something as important as health insurance to these insurers, who's to say that they're going to act in the best interest of the patient, and compete and drive those prices down?

Harjes: Exactly. Moving forward with these companies, Aetna will owe Humana a $1 billion breakup fee. Interestingly, neither stock really moved a ton. What I think will be the key thing to watch here, after we've already seen this news report, is what happens with the merger between Cigna and Anthem? There will be a ruling on that one soon. These are another two health insurance companies. It's an even bigger deal, it's $48 billion. And they have even more national overlap. So, you definitely want to keep your eyes on that one.

Campbell: Yeah. I don't think there's a very good shot of that deal going through. I think Cigna and Anthem haven't even put forward as good a united front as Humana and Aetna did. I'll be surprised if they go ahead and approve this. Listen, the Medicare Advantage Market specifically is growing and it's big. It's growing by about a million new subscribers annually. So, this is a lucrative business that is still attractive for these companies independently. Obviously, Humana is the most pure play of all four of these insurers, they get the majority of their sales from their Medicare Advantage business. So, if you're interested in a stock idea that would allow you to benefit from the fact that you have aging Baby Boomers who are going to be increasingly going into the marketplace and looking at their different Medicare options, maybe Humana is a name that should be back on your radar.

Harjes: Looking more broadly at the healthcare insurance industry, do you think that Humana and the Medicare Advantage market would be the way to play this? If you could only buy one health insurer, is that what it would be?

Campbell: Well, the thing that's nice about that is you don't have the risk of what's going on with the ACA. Yes, Humana has some participation in the ACA programs. But it gets the bulk of its sales through Medicare Advantage. Medicare Advantage is not impacted by the reform that's the repeal and replace of Obamacare or the ACA. So, you could look at it and say, the demographics support it, it's not as exposed to the risk of what could come in the future of this industry. So, it's definitely one of the more intriguing plays now that it's going to be on its own.

Harjes: All right. Thanks so much, Todd! As always, people on the show may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against these stocks, so don't buy or sell based solely on what you hear. That's a wrap for today's show. Until next time, Fool on!