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Insurers Take Aim at Big Pharma. This Small-Cap Stock Stands to Win.

By James Brumley - Jan 30, 2020 at 8:30AM

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Drug manufacturer Catalent is ready to capitalize on the drug industry's shifting norms.

The premise of generic drugs was simple enough. Branded medicines protected by a patent tend to be overpriced, but the equivalent therapy made by other companies once a patent expires should lead to price-lowering competition. As it turns out, however, generic drugs have become overpriced as well.

That's the stance the state of California has taken, anyway, with Governor Gavin Newsom announcing early this month the state is planning to launch its own prescription drug label. The Blue Cross Blue Shield Association doubled down on the idea with a more eyebrow-raising announcement just a few days ago, investing $55 million in pharmaceutical company Civica Rx to help it create a new subsidiary that will offer the health insurer access to self-supplied, cheaper generics for the people it insures.

If this is the shape of things to come -- and it appears to be -- a small drugmaker called Catalent (CTLT 0.00%) is quietly positioned to benefit in a big way.

Pharma's dividing lines are becoming blurred

One doesn't have to look very hard to find examples of vertical integration within the healthcare arena intended to lower costs. CVS Health acquired insurer Aetna in late 2018., JPMorgan Chase, and Berkshire Hathaway are teaming up in an effort to decrease the costs of providing their employees lower-cost primary care. Several other lower-profile deals have also blurred lines.

Pharmaceutical lab technician working with a test tube.

Image source: Getty Images.

The challenge for any entity looking to enter the drug business is clear, however. That is, they have neither the experience nor the facilities to bring marketable drugs to store shelves, so they outsource the legwork to a contracted manufacturer.

That's historically been names like well-known generics outfits Teva Pharmaceutical (TEVA 0.91%) and Mylan (MYL). Both used to be focused on production of generic drugs, but they simultaneously manufactured drugs that larger pharma names didn't want to bother making themselves. Now that the pharmaceutical business has changed so much, however, both of these players and their peers have opted to hedge their bets by doing a little of everything. Indeed, there are relatively few dedicated contracted drug manufacturers anymore, just as there are few generic-drug "pure play" investments.

Catalent is no exception to that new norm, reflective of the pharma industry's blurred lines. Catalent, however, can offer what states, insurers, and other cost-conscious consortiums increasingly want: a way to lower their costs, including the cost of creating a lineup from scratch.

Catalent in focus

At first blush, Catalent looks more like a clinical trial manager than a mere drug manufacturer. And to be fair, helping other pharmaceutical names with their research and development is a huge part of its business. It's been involved in over 500 developmental programs of biologic drugs, and it helps launch an average of nearly 200 drugs every year.

Take a closer look, though, and you'll see this company solves problems newcomers don't even know they'll have while bringing a new drug -- even a previously proven therapy -- to the market. For example, Catalent's Fusion platform gives customers real-time, cloud-based looks at their supply chain and offers developers a chance to view and approve packaging labels. It can also package pills and vials in a manner that provides the so-called blinds necessary to make a small trial's results credible, and its biologics arm has enough capacity to fill 132 million vials with medicine every year. Catalent's softgel technology improves the bioavailability of compounds that aren't terribly water soluble.

To the layperson, this won't mean much. To insurers and other groups increasingly looking for ways to procure drugs outside of traditional channels, however, Catalent is perfectly positioned.

Analysts certainly think so, anyway. The professionals are modeling revenue growth is in excess of 13% for this year, which should drive a small increase in per-share profits. Next year's projected 7.5% top-line growth is expected to boost earnings from this year's anticipated $1.97 per share to $2.21, jibing with Mordor Intelligence's expectation for annualized growth of the business at a pace of 8% through 2025.

Catalent (CTLT) results, past and projected revenue and earnings per share.

Data source: Thomson Reuters. Chart by author.

In that biologics are rapidly emerging as the predominant type of drug approved by the Food and Drug Administration and other regulatory bodies, however (roughly 65% of current clinical trials are testing biologics), Catalent has an edge on its competition. To that end, things are expected to heat up for Catalent in 2021.

Looking ahead

The dots between California's (and now Blue Cross Blue Shield's) willingness to wade into the generic-drug business and Catalent's capabilities aren't entirely connected yet. But as Catalent widens its net, insurers and healthcare providers are opening their minds to new possibilities. A convergence appears to be imminent.

In the meantime, another tailwind is blowing. Though Catalent doesn't need a buyout to thrive, nor does it need to make an acquisition to survive, either could be on the horizon. Mark Quick, executive vice president of corporate development for contract drug manufacturer Recipharm, noted last year that the five biggest names in the business still account for less than 15% of the contracted manufacturing industry's revenue, yet big pharma names prefer working with larger and fewer contracted manufacturers. A rival or a major pharmaceutical name that got out of the manufacturing game just a few years back could set its sights on Catalent, and be the better for it.

It wouldn't be a shabby outcome for shareholders either.

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Stocks Mentioned

Catalent, Inc. Stock Quote
Catalent, Inc.
$109.61 (0.00%) $0.00, Inc. Stock Quote, Inc.
$116.46 (3.58%) $4.02
Teva Pharmaceutical Industries Limited Stock Quote
Teva Pharmaceutical Industries Limited
$7.74 (0.91%) $0.07
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$417,401.43 (3.75%) $15,101.43
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$278.28 (4.02%) $10.76
JPMorgan Chase & Co. Stock Quote
JPMorgan Chase & Co.
$117.32 (2.98%) $3.40
Viatris Inc. Stock Quote
Viatris Inc.
CVS Health Corporation Stock Quote
CVS Health Corporation
$94.52 (2.33%) $2.15

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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