Buy it or build it

Read this article to understand:

• The key investment risks and opportunities for the sector
• What impact Inflation Reduction Act reforms could have on US healthcare companies
• The main ESG considerations

During COVID-19, the prospects for healthcare looked promising (see “The future of pharma” ).¹ The pace of regulatory approvals for new treatments had been trending up gradually for two decades and the pandemic saw a spike in innovative drugs like mRNA vaccines and accelerated approvals to combat the health crisis.²

With COVID fears subsiding, 2022 saw what Nature called a “COVID hangover”, with fewer approvals. The question many investors are asking is whether it is a temporary hangover or start of a longer-term downward trend. That is crucial as, with many patents due to expire by the mid-2020s, companies need innovation to ensure their future growth.³

Current evidence suggests the former; out of 37 approvals by the US Food and Drug Administration (FDA) last year, 15 were for biologics (which relate to complex biological products), the second-highest number in 20 years and double the number in 2017 (seven). Biologics being more complex drugs, this tends to show approvals maintain a high rate, especially since the main decrease in approvals was in treatments for infectious diseases, which supports the hangover thesis.

There are fewer accelerated approvals, which some see as a sign of tightening from the FDA, but it could equally be a pause after the breakneck speed of approvals during the pandemic. Controversy around the accelerated approval in June 2021 of Biogen’s Aduhelm drug, designed to treat Alzheimer’s disease, also seems to have driven some of the pushback, as many doctors believed the clinical data was not robust enough to prove the drug’s ability to slow cognitive decline.⁴

More broadly, clinical trials continue to see good success rates: 71 per cent globally in 2022, against a previous five-year average of 62 per cent, while companies like Pfizer and Abbott generated large cash surpluses from vaccines, therapeutics and tests during the pandemic, which they have since used for acquisitions, fuelling innovation inorganically.

These trends are supportive for investors, albeit not without risks. The AIQ editorial team brought together Brian Bunker (BB), senior credit research analyst, Matt Kirby (MK), fund manager, global equities, and Sora Utzinger (SU), head of ESG corporate research, to explore opportunities and challenges.

Where do you see the main investment opportunities in healthcare?

BB: Healthcare is close to 20 per cent of US GDP, yet Americans experience worse health outcomes than peer countries. The US healthcare companies most likely to be successful are those that help lower costs or bring innovative solutions to care.

Areas helping to lower healthcare costs include ambulatory surgery centres, generic drug manufacturers, contract research organisations and home healthcare providers. Areas of innovation include med-tech and biotech pharma.

One area we have been avoiding on the credit side is large pharma companies. In the second half of the decade, many will see patents expire, so they must refill their drug pipelines to continue growing beyond 2025. Large pharma is likely to be active in M&A given strong balance sheets, low biotech valuations and slower growth prospects. We prefer firms with strong internal R&D engines, as it would be credit-negative for us if a company levered its balance sheet to buy innovation through a large M&A deal.

MK: On the equity side, it depends which part of healthcare we're looking at, as there is a lot to go through, from pharma to biotech, life sciences, healthcare providers and med-tech.

In pharma, European firms have more catalysts for growth, especially over the next 12 months. Quite a few are related to line extensions, where drugs have already been approved in a different setting, making them safer innovations. Success rates are generally closer to 70-80 per cent than 50-60 per cent, so they have less impact on investor sentiment but are helpful from an equity standpoint.

In the US, pharma is currently more focused on commercial execution. Some companies have enormous drug franchises driving a lot of their net present value – Merck with KEYTRUDA, which is the standard of care for lung cancer and other areas; Humira and SKYRIZI for AbbVie; Mounjaro, which is the key story for Eli Lilly; and Pfizer's COVID franchise, although that continues to be guided down.

Another area we look at is R&D. The market has been ascribing increasing value to pharma companies with what is perceived to be a proven R&D engine that can generate good returns. There are many different factors, but key elements are cost, speed of development and decision making. Some companies have made good progress improving their R&D engines over recent years, yet the market is unwilling to give them the benefit of the doubt until it is backed up with positive late-stage trial data. We find these the most interesting investment opportunities.

On innovation beyond pharma, in areas like biotech and life-science tools, the US is far ahead of Europe. It is an interesting area right now because biotech is high risk, markets have been volatile and funding has been softer because of interest-rate pressures. At the same time, M&A has begun to pick up as larger players look through near-term pressures to acquire highly innovative companies at more attractive prices.

The US Inflation Reduction Act (IRA) provisions to lower healthcare costs might help accelerate deals, so if interest rates started to come down, it could be an interesting area.⁵ We are looking at a few pockets, including cardiovascular disease and obesity.

Another area of interest is therapeutic delivery. We try to find companies whose product or service benefits more than just the patient. For example, Halozyme, which we hold in our Social Transition Global Equity strategy, has developed an innovative drug delivery technology to convert intravenous medicines into subcutaneous form, cutting administration times from hours to minutes.⁶ That does not just benefit patients, but also payers and doctors, and pharma companies want to work with them as well.

SU: One area we find interesting from a solutions standpoint in equities is diagnostics. When looking at it through an antimicrobial resistance (AMR) lens, the potential is significant and underappreciated; for an antibiotic to work, it must be precisely targeted to the pathogen to have an effect and minimise resistance down the line. But the World Health Organization (WHO) highlighted more than 50 per cent of antibiotic treatments globally are initiated with the wrong drug in the first instance and without proper diagnosis.⁷ That demonstrates the need for upstream diagnostic capabilities to initiate robust treatments for pathogens.

More broadly, we are looking at a huge global health problem because nearly half of the world's population has no or very little access to appropriate diagnostic services. That is a result of a combination of factors, including resource constraints and funding, but also infrastructure investments that haven't occurred. You need places for diagnostic equipment to be installed and work properly.

We see opportunities in diagnostics companies offering targeted solutions that respond to pathogen recognition, allowing the pairing of a correct antibiotic to a disease. We also like companies with the capability to expand into environmental monitoring, quality assurance and reporting services – monitoring soil health, groundwater contamination and so on. This also benefits human health and is responding to a huge pocket of underserved needs in low- and middle-income countries.

MK: From an access to health and financial standpoint, diagnostic companies have a lot of the characteristics we are looking for. In-vitro diagnostics account for roughly two per cent of health spending but are involved in about 60 per cent of medical decisions, making them a low-cost and critical enabler of the healthcare system. They also generate high gross margins and a large proportion of their revenues is recurring. They are typically growing in the mid-single-digits with the opportunity to leverage an installed base that increased significantly during COVID. Finally, they benefit from structural growth tailwinds like the shift to more decentralised and automated diagnostics tools. In many cases, we don’t believe valuations reflect these strengths.

What does the large drop in biotech valuations last year mean for M&A?

BB: Biotech companies are long-duration names, meaning they don't have a lot of upfront cashflows. When interest rates went up, that hurt biotech firms because their long-dated cashflows were discounted by a higher number. Meanwhile, pharma companies are flush with cash and looking at upcoming patent expiries, so M&A is likely to pick up. It has already been strong this year, with Pfizer's $43 billion acquisition of Seagen and Amgen’s acquisition of Horizon. Those most likely to do further M&A would be names like Pfizer, Bristol-Myers and Merck. Those are the top three in the US.^8,9

MK: In Europe, Novartis is often linked to larger biotech companies. Its main acquisitions have been focused on trying to bring in technology platforms in gene, cell and radioligand therapy and it has bought insiRNA capabilities as well.¹⁰ Seagen, which Pfizer acquired, is a specialist in antibody drug conjugates (ADCs) viewed as a new approach to replace many areas of chemo over time. Generally, companies with novel platform technologies can be acquired at significant premiums.

Another approach we are seeing is pharma companies looking to buy firms earlier than in the past, taking on some of the clinical risks but at a lower price. Merck bought Acceleron before its phase-three data.¹¹ When that data came out positive, it meant Merck had been able to buy a good asset at a lower price, although with a bit more risk at the time. It did the same again a few weeks ago with Prometheus in a $10.8 billion deal.¹² Prometheus also has an interesting asset, but this is still in clinical trials. 

Is M&A impacting the way we invest?

BB: It is impacting the credit side because we care much more about downside risk, so we don't like it when a company significantly increases its debt to buy assets. We look for companies that can grow organically or via smart tuck-in deals [acquisitions of smaller companies that are fully absorbed into the larger acquirer]. On the opposite side, we look for companies that could be potential acquisition targets, which could lead to a tightening of their credit spreads.

MK: In equities, markets are generally cautious when it comes to M&A, in pharma particularly compared to areas like managed care or life sciences, where large players like Thermo Fisher, Danaher and United Health are viewed as good capital allocators. There are all sorts of challenges integrating acquisitions into large pharma organisations. Pharma management continues to suggest it wants to focus more on bolt-on, smaller acquisitions.

What are the other main risks?

BB: Recent noise around the US debt ceiling has raised concerns we might see lower government funding with cuts to Medicaid, although Medicare cuts are unlikely at this point.

In terms of other risks, labour has been a persistent issue since the beginning of COVID for providers, especially hospital names. During COVID, hospitals had to hire contract labour, because of employees calling in sick or being travel nurses, for three to four times what they were paying employees. That is starting to improve slowly but will remain an overhang. Government reimbursement will eventually catch up and improve some of that margin dilution, but it will take a couple of years to recoup the margin loss.

MK: As Brian said, the big thing we are starting to see this results season is a rotation out of some healthcare providers or at least the insurers (the managed care organisations, or MCOs) into medical devices or med-tech.

Now that COVID and staff shortages are less of an issue, we have started to see procedure volumes pick up. That is supportive for med-tech. There has also been less pressure on raw materials, so the outlook there is better than it has been for years. On the flipside, MCOs benefited from the underutilisation of their assets for several years and are now facing the impacts of that reversing, which is why they look less attractive.

On the ESG side, MCOs are a key solution for the US in tackling its soaring healthcare costs, but they are also partly to blame for how we got here. It is encouraging from both a social and financial standpoint that we are seeing MCOs accelerate the shift to outpatient setting, where treatments are administered without an overnight stay in a medical facility, which makes costs significantly lower. On the med-tech side, while the outlook is more attractive now, there are certain reasons why we continue to see issues around product quality and few signs this will ever change.

BB: MCOs have less of a tailwind from lower utilisation, but the key question is whether companies have priced for it. They have hit their medical-cost guidance for the first quarter so, despite concerns they may have been under-reserving, they seem to have priced adequately for expected utilisation.

On the med-tech side, utilisation is a positive. The thing that hurt last year was inflation. For the most part, these businesses don't have pricing power, which is a problem when inflation is high. But inflation is starting to stabilise, so it is becoming less of an issue while med-tech companies are now getting the benefit of higher utilisation. That's a positive environment for med-tech and there is a lot of innovation in that area as well.

What could be the impact of the Medicare reforms announced as part of the IRA?

SU: The IRA marks a huge milestone in terms of drug-pricing reform. Initially, prices will be negotiated for ten of the highest-spend prescription drugs dispensed by pharmacies. That will then increase to 20 of the highest-spend drugs by 2029. In terms of market share and the proportion of spending that will be covered, that's not inconsequential given this increase will also include intravenous drugs and other treatments you can't get over the counter but need clinicians to administer.¹³

Another interesting element is the cap on out-of-pocket spending insurers can require. The cap is $35 a month for insulin, for instance. For lower-income households and those eligible for subsidies covering some of these drugs, this will have huge ramifications.

The access to health debate has expanded considerably since the pandemic. A few years ago, it focused on what companies were doing in low- and middle-income countries, where they were trying to build up an operational footprint and create markets from the bottom-up. The debate has expanded towards what this access looks like in a developed-market context, where there is huge inequality in the social determinants of health and access provisions. This is also happening upstream where we talk about how to make clinical trials more inclusive and diverse.

This policy reform on US drug pricing responds to a huge element of the access equation in developed markets. Out-of-pocket costs for insulin products, for instance, increased by almost 40 per cent between 2007 and 2020 among Medicare beneficiaries who aren't necessarily classified as low income. That is alarming.

A huge number of beneficiaries also fail to collect prescriptions because of the cost.¹⁴ Better adherence to prescribed drug treatments could therefore be an unintended benefit of price reform. Capping prices for expensive treatments, as for cancer or hepatitis C, can ensure better compliance with treatments, leading to lower mortality and costs over time.

BB: That is the reason a lot of insurance companies are willing to have zero co-pay for some of these drugs. United Healthcare announced zero co-pay for several drugs, including insulin. It is a way of incentivising people to take their medicine and keep them from ending up costing more to the healthcare system.¹⁵

But an argument from pharma companies is lower prices will give them less money or incentive to innovate. They say if a potential drug’s price must be low, a company may decide it is not worth proceeding with costly clinical trials.

MK: The other argument pharma companies have been making is, when you shorten the exclusivity period for these small molecules and biologics drugs, it won’t give the company enough time to reach a large cohort of patients before the economics become less attractive. This is especially the case in oncology; companies often first release drugs in undertreated areas where the patient is most at risk and has the highest unmet need, then work their way through to a larger cohort of patients with earlier-stage cancer. A shorter exclusivity period creates less of an incentive to innovate and reach more difficult-to-treat patients.

BB: But pharma companies are starting to react in other ways. A good example would be Amgen. It bought a company called Horizon that specialises in medicines for rare diseases, which tend to be more isolated from some of these reforms.

Pharma companies are smart and capitalistic. They will optimise their business for whatever legislation is in place. If they see push-back on high-margin drugs, they will go to areas that promise the highest profits.

The drive towards personalised medicine continues. What are the implications?

SU: From an ESG standpoint, investors need to understand the extent to which companies can convince stakeholders all data will be anonymised, propose a viable research process and convince regulators what they do is within ethical boundaries.

The onus for companies will be to evidence how they are beefing up their ethics capabilities, not just at the board level, but across the organisation. That could mean upskilling board members and bringing in complementary skillsets to be able to grapple with these questions, but it's too early to tell where companies are moving. However, I expect more pharmaceutical companies trying to build out internal artificial intelligence (AI) capabilities; GSK has now brought in a non-executive director with expertise in AI and machine learning who works across the organisation and is attached to different teams.¹⁶

AMR has become a major issue. Are firms making progress?

SU: It’s always a few steps forward and several steps back. The AMR benchmark analysis over the years shows dozens of promising antimicrobial projects have exited the pipeline for various reasons. But there has been a steady trickle of new additions, which balances out those exits.¹⁷

We are now seeing more progress on specific antibacterial, anti-TB and antifungal medicines that hopefully also meet the innovativeness criteria of the WHO; those criteria identify candidates showing a high level of promise and value to combat antimicrobial resistance, for instance because they have a new built-in mechanism of action against target pathogens.

On the policy side, there hasn’t been enough progress on pull mechanisms. Historically, we've seen focus and effort on push mechanisms, such as specific AMR funds putting capital behind the research process, but not enough on mechanisms like guaranteed revenue schemes to pull these drugs into the market. Both are needed. Many studies have been written about what pull mechanisms could work, such as subscription models with fixed annual payments, a minimum revenue portion running through a set period and one-off milestones like market-entry rewards or one-off prices.¹⁸

In short, progress is piecemeal and slow, and we need more clarity around policy schemes to encourage investments, but we are looking at a huge set of solutions. There are promising candidates in the pipeline, and diagnostics have been underappreciated as a potential piece of the puzzle.