Boy, Were We Wrong About Rite Aid and Opko Health

Everyone makes mistakes, and this week's Industry Focus theme week is all about celebrating (and cringing) at some of the biggest mistakes we've made on the show.

In today's Healthcare episode, hosts Kristine Harjes and Todd Campbell look at some of their biggest on-air mistakes in the past few years: predicting that the merger between Walgreens Boots Alliance (WBA 0.09%) and Rite Aid (RAD -15.79%) would go off without much trouble, and recommending what would turn out to be the worst stock out of a group of four up-and-coming biotechs. Find out what they have to say about why they made these mistakes, a few key lessons investors can glean from this, why an investing journal can be so useful, and more.

A full transcript follows the video.

This video was recorded on Aug. 23, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Aug. 23, and I'm your Healthcare show host, Kristine Harjes. I have healthcare contributor Todd Campbell on the line. Todd, what's on your mind today?

Todd Campbell: My fingers are tired from writing "I'm sorry, mea culpa!" in preparation for today's episode. [laughs] 

Harjes: As part of your notes, yeah, that'll be just about every line. Listeners, if you're just tuning in for the first time this week, Todd is joining me for the continuation of a theme week that we're doing on Industry Focus called "We Said What?" where we reflect on some times in which we were just plain wrong on the show. Hopefully, we can all learn from our mistakes, because let's admit it, we're not perfect.

Campbell: No. I think any investor that's been investing for a while recognizes that mistakes are common, and they can be wonderful teaching moments, so let's keep that in mind as we go through.

Harjes: Exactly. So, we'll have a clip where I said something that was wrong, and then for the second half of the show, we'll go over to one that Todd picked out for a prediction of his that was not quite on the target. To kick things off, here's a clip from our Oct. 28, 2015, show. This show was called "Walgreens Shows Its Hand, Scoops Up Rite Aid."

As you mentioned, one of the big questions that's still left here is, will this deal be allowed to go through by the FTC, which of course wants to prevent this kind of monopolization, or, in this case, it would be a duopoly, of the retail pharmacy business? Now, traditionally, the FTC doesn't like duopolies, and they will shut that kind of thing down. However, it's my suspicion that, given this push toward lower drug prices, I bet the FTC would let it go because of that particular point. If they can say, "This is bringing down this exorbitant cost that drugs are taking on Americans," then maybe it could be a good thing, and they would rather have that than shut down a duopoly.

So that was my speculation. For some context, the original deal that we were talking about was for $9.7 billion. It was announced in October of 2015 that Walgreens would acquire Rite Aid for $9 a share. That was later revised down to about $6.50-$7. It all depended on how many stores were divested. For some additional context here, these are the two major retail pharmacy players in the United States, and therefore the FTC did not want the type of power consolidation that could be involved with this deal. That's why there was the first revision of the plan. And eventually, we found out in June 29 of this year that the entire deal had fallen through, and the original FTC decision had been scheduled for July 7, but Walgreens ended up saying, "You know, they're just not going to approve this, so we're going to offer up a new deal to acquire just about half of Rite Aid's stores," which is a heck of a lot smaller than the original deal. And that's where we stand now. We had more details about this new version of the deal on the episode that we did on July 5, but there's no getting around the fact that back in October of 2015, I was just totally off the mark saying the FTC would let this deal go through.

Campbell: You were just hopeful! You were hopeful! There's nothing wrong with hopeful. Yes, you were optimistic. As investors, we sometimes get optimistic, and we connected some dots, and the dots were, with the push to try and drive down prices, maybe they would let this go through. The reality is, however, there's no denying that the pharmacy marketplace has gotten very consolidated since 2000. You've got a handful of players who dominate that market. You have Walgreens, you've got CVS, and you've got Rite Aid. So, combining Walgreens and Rite Aid together, OK, yeah, that would have created a behemoth in the space, and theoretically, that could have eliminated competition in certain local markets to the point where they weren't going to get this deal approved. Shares of Rite Aid, Kristine, have been absolutely pummeled on the news of the new revised deal.

Harjes: Yeah, they fell 26%.

Campbell: I'm curious to put you on the spot again for next year's episode --

Harjes: Oh, great! [laughs] 

Campbell: -- and see if you have any thoughts for Rite Aid from here. Will this deal get through?

Harjes: Yeah, I'm really hesitant to speculate again on it. But it's really hard not to do, because watching what has happened to Rite Aid's shares over the past 22 months -- I think that's the right number -- since Walgreens started talking to the FTC about potentially scooping up some or all of Rite Aid, it is fascinating. Rite Aid's shares are down to about one-third of the level they were before this deal was ever announced. They're down 73% just since the beginning of this year. Right now, they're hovering around $2.25 a share. If you recall, the original deal was for $9 per Rite Aid share, so the market has just completely crippled Rite Aid.

Campbell: Kristine, just to jump in for one quick second because I don't want to forget this point, what's interesting to think about, in that original deal, if you include debt, that deal was worth over $17 billion. So Walgreens was willing to pay, including debts, $17 billion to get its hands on Rite Aid. Now, what's Rite Aid's market cap today?

Harjes: $2.34 billion.

Campbell: $2.34 billion, and they still have half their stores, and they still have their pharmacy benefit manager. So I wonder if there's a little bit of a disconnect. Maybe that's the uncertainty. The uncertainty is, we don't know whether or not the deal will close, and if it doesn't close, you still have Rite Aid as a relatively troubled and highly indebted company.

Harjes: Yeah, they have $7.2 billion in debt. I think, actually, I have learned from being wrong the first time about this, because I'm so intrigued by Rite Aid as a value play right now, but I haven't bought any shares, and I think that actually is the hesitation of, I was wrong about whether or not the FTC would let this go through once. I could be wrong again, even though right now, sitting here looking at it, I'm going to say, I do think this will go through. And even if not, I think Rite Aid is grossly undervalued. But that being said, I still haven't put my money behind it, because I'm looking at this like, well, I understood the situation incorrectly the first time around, so I'm going to try to learn from that and say deals are not done deals until they go through. It's dangerous to try to grab an arbitrage opportunity, especially because if you look at what happens when these deals fall through, the stocks are absolutely crushed. And while it doesn't look like to me that Rite Aid has farther that it could really fall based on the value of the business alone, it could. And who am I to say that won't?

Campbell: Right. Is this a falling knife or a value trap? Or is this truly a bargain-bin buy? That's the big question. I had a mentor back in the '90s, Kristine, and one of the things that I learned from that mentor was, don't worry too much about the bottom 10% of a move or the top 10% of a move. Focus your attention on that 80% in the middle. So I think investors should basically take a step back and say, "I don't need to be perfect in timing my entry and trying to get to the bottom. Why don't I let this play out a little bit, because it's likely that if it does close, there will be opportunities for me to benefit and make that 80% of the move after, rather than trying to be a hero and stepping up into the uncertainty?"

Harjes: Yeah, I think that's great advice. For investors looking to do that here, take a look at the value of the stores. Consider that Walgreens will be able to cherry-pick the ones that it wants. Also consider that the way in which it will cherry-pick them will have a lot to do with what the FTC says it's allowed to choose as far as the geographical footprint goes. Also, look at its PBM. Rite Aid has EnvisionRx, its pharmacy benefits manager. That's a whole other part of this business that doesn't really get talked about a lot, and I suspect the value of that isn't really being considered in the full market cap of this company.

Campbell: Yeah, Kristine, just to jump in again on that point, because it's a good one, I crunched some numbers on that not that long ago in an article I posted on The Motley Fool, and one of the conclusions I came to is, as a standalone company, that EnvisionRx could be worth anywhere between $2.4 and $4 billion on its own, which is intriguing.

Harjes: Interesting. Yeah, I don't think I read that one yet, so I will definitely go ahead to the site and look for it. If anyone listening wants to read it, shoot us an email at [email protected], and I will dig it up and send it along for you. 

Todd, I'm going to take myself out of the mistakes spotlight and pivot over to you. In our July 27, 2016, show, we talked about CEOs that were enormously successful in one business venture who were back at it trying to catch lightning in a bottle again. We featured Tesaro, NantKwest, Puma Biotech, and OPKO Health (OPK -1.20%). And in an effort to put you on the spot, or give our readers a tidy conclusion, I asked you to pick your favorite. Here's a refresher of what you said:

We've talked about four different companies today -- Tesaro, NantKwest, OPKO, and Puma. If you could only buy one of them, which would it be?

Campbell: That's a great question. I'm going to have to go with Phillip Frost and OPKO Health, mainly because we have a pathway to profitability on that one. We know that they've got drugs that are already approved, we know that they're doing a lot of business in their lab business right now, and we have a pretty good idea that they're going to be able to translate that into shareholder profit in a relatively short period of time. So that would be the one that I would focus on if I were an investor today.

Harjes: Any thoughts on that?

Campbell: I could have picked Tesaro's Lonnie Moulder. Tesaro got an approval for their PARP inhibitor, and sure enough, its shares have gone from $95 to a high of $180 and still trading around $120. That would have worked. I could have picked Puma. It got its approval of Nerlynx recently, and its shares have gone from $49 to $80. But no, [laughs] I settled with the safe play, going with Phillip Frost, OPKO Health. And sure enough, its shares have been flushed down the toilet bowl, falling from $10 to about $6, which is even more painful when you think about the fact that this has been one of the strongest periods for market returns in recent memory.

Harjes: So. [laughs] What did you learn from this?

Campbell: There were reasons that I sided with and picked Phillip Frost. Phillip Frost is a proven leader. And I love investing in companies with proven leaders. Rome wasn't built in a day. Phillip Frost has been starting, successfully, running companies, and then selling them since the 1970s, and he's one of the wealthiest healthcare entrepreneurs in America. So I think sidling up next to him was not necessarily a mistake long-term, but certainly a mistake short-term. And I think the short-term mistake I made was to fail to understand how much shares could fall if a couple of key catalysts were either slow to develop or outright disappointed. Do you me want to walk through those catalysts, Kristine?

Harjes: Yeah, there's been a handful of them over the last year or so since we talked about this. Do you want to start with maybe the slow launch of Rayaldee?

Campbell: Yeah. Rayaldee is a very intriguing drug, because it's a prohormone for vitamin D that works better than existing vitamin D supplements that are given to patients with chronic kidney disease, that suffer from vitamin D insufficiency. Vitamin D insufficiency can cause calcium loss in bones, bone weakness, and all sorts of other problems. So it's an important indication; it's important to have treatment options available for it. The problem is, after Rayaldee launched, it did not have widespread early-on inclusion in drug formularies at insurers. So the patient population that was covered by insurers that would pay for these drugs was pretty small, and sales, frankly, have been a rounding error and aren't even broken out in OPKO Health's quarterly results yet. Perhaps, according to Phillip Frost in the second-quarter conference call, they'll start to break those numbers out for us in the fourth quarter of this year. And there's opportunities there theoretically for Rayaldee to finally deliver on its promise. 

But Rayaldee wasn't the only disappointment. You also had Varubi, which is a drug that's approved for use in patients who are suffering from vomiting and nausea after receiving chemotherapy. That's a very important market. It's worth hundreds of millions of dollars a year, and Varubi is licensed by Tesaro, which is Lonnie Moulder's company. So far, sales have been slow to grow. Sales in the second quarter were only about $2.9 million, and with OPKO collecting double-digit royalties, again, a rounding error considering that the company is doing $300 million roughly in quarterly revenue because of its diagnostics business.

Harjes: And that wasn't even the only disappointment.

Campbell: Yeah. They also came up shy in a very important trial that was evaluating the long-lasting human growth hormone treatment in adults. They have a drug that's partnered up with Pfizer. A lot of people thought that if this drug reached the market and eventually got approved for use in kids, pediatric use, then this could be a big moneymaker for OPKO Health. Unfortunately, in December, they announced that the trial missed its mark. They haven't given up on the drug, but that trial was a failure. So overall, you have this confluence of disappointments over the course of the last 12 months that has really taken a toll on the company's stock price. You add that together with the fact that sales in the diagnostic business, which is basically the specialty lab that they run, have pretty much flatlined at around $300 million, a little over $300 million, there hasn't been a lot of excitement or enthusiasm to drive up the market cap of this company.

Harjes: So, clearly, it's been a disappointing year for OPKO shareholders. Where do you stand now going forward on it, Todd? Do you think it's, "Looking back on it, I was wrong, this is a terrible company, investors should stay far away from it," or do you think that now, at the lower share price, there might be an even better opportunity for investors to scoop up some shares at a discounted price, because now, going forward, is where the real promise is? Or something in between the two?

Campbell: There's a couple different takeaways I guess I have on this whole thing. I think, yes, you stick with proven leaders, and yes, there's a lot of opportunity still ahead for OPKO. I don't like buying drug-development stocks on sale as using the value argument only because, as we saw last year, a lot can happen with clinical trials. You can say, "There's all sorts of opportunities still in the pipeline," which there is, drugs that could rack up lots of sales for this company over time. But those trials could fail. You have to take a look at it and say, "I'm not going to buy it solely because it's cheap relative to where it was last year. Things happened that the outlook now has changed." 

But I think you can look at it and say, Rayaldee could still deliver on the goods. We'll know better early next year what the sales trend, the prescription trend is for that. Varubi, which again is marketed by Tesaro, there's a PDUFA date at the FDA that could approve an IV formulation. If that formulation gets approved, that opens up the vast majority of the marketplace for this type or this class of drugs. That, theoretically, could start meaningfully generating revenue in 2018. And there's a pediatric study ongoing in human growth hormone still that reads out in 2019. If that trial is good, then Pfizer and OPKO will split the profits on both OPKO's drug and Pfizer's existing drug in that indication, Genotropin, which is selling at a clip of over $100 million per quarter. So there's still reasons besides value that you'd want to own OPKO Health. And certainly, Phillip Frost remains incredibly committed as a shareholder in this company. He continues and has continued to increase the number of shares he owns over the past year, even in the face of all these disappointments.

Harjes: Some of the dates that you mentioned when you were running down your list of catalysts going forward are pretty far in the future. That speaks to me about a bigger problem with investing in biotech, which is opportunity cost. Many of the stocks that look interesting today are likely to take a long time before they prove out. Something that regular listeners of the show have heard us talk about before is keeping an investing journal. That's so important, so I'm going to say it again -- keep an investing journal, specifically to combat this type of mistake, or looking at the mistake incorrectly when maybe it wasn't quite a mistake yet, is to write down exactly the dates that you're looking for. So the PDUFA dates, when the FDA might approve a drug, or a forecast for when you think a company is finally going to turn profitable, things like that where, if it's a date that's relevant to your investment thesis, you want to have it written down in front of you, so that when that date comes and goes you can reevaluate your thinking and figure out if, indeed, you were right. 

If, for example, your investing thesis for OPKO had something to do with a PDUFA date that's years and years out, you want to know that and you want to be very aware of it for several reasons, one of which is that, maybe it's not really the time to invest just yet. Maybe there are better places for your money now where you can get more validation sooner that you actually are placing your money in the proper place. Of course, we are long-term investors here at The Fool, but in the short term, if you're going to look at a company that is declining over the course of one year and think, "Oh my gosh, I was wrong, I need to exit," but you're still waiting for a catalyst that's years in the future, then you're going to end up cutting yourself short, and you'll never even see the potential gains that you were hoping to get in the very beginning.

Campbell: That's a great point, Kristine. I'm going to throw another point out there, too. We've talked about on the show previously, especially in biotech, diversify, diversify, diversify. I selected one stock out of these four --

Harjes: To be fair, I made you do that.

Campbell: Yeah. Well, that exposed us to a lot more risk. If we had just invested across all four of them, you would have done very well, because of the success that we saw with Puma and Tesaro. So, I think diversification is always something that's very important across this space. Never put all your eggs in one basket hoping that you're going to hit a home run.

Harjes: Yeah. And it's important not to beat yourself up too much about single mistakes, because overall, if you're right 50% of the time, you're a really, really good stock picker.

Campbell: Very good stock picker, and you'd be a great baseball player.

Harjes: Yeah, exactly! So, Todd, I'm not going to beat you up too much about the OPKO mistake, and I'll try not to beat myself up too much about getting the Rite Aid-Walgreens merger information predicted incorrectly. And that'll do it. Hopefully we can learn from these mistakes and move forward and be right at least 50% of the time, hopefully more!

That's all for today's episode of Industry Focus and the Healthcare edition of the "We Said What?" theme week. Thanks so much for tuning in. If anyone has an investing lesson that they want to share with the team, feel free to reach out to us in The Motley Fool Podcast group on Facebook, or by email at [email protected]. 

As always, people on the program may have interests in the stocks 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. This show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!