![Sid Ruttala](https://www.tamim.com.au/uploads/6/6/0/7/66077715/published/sid-square.jpg?1637198032)
Author: Sid Ruttala
- Over the past few decades the industry has been characterised by exponential declines in overall IRRs for new products;
- The above scenario can be attributed mainly to increased regulatory and compliance requirements which have incentivised massive consolidation in the space along with greater focus on maximizing the potential monetisation of existing patents;
- This is despite the fact that in nominal terms global biopharmaceutical R&D expenditures continue to be an outlier in comparison to even the defence and software sectors. This can mainly be attributed to significant cost increases as opposed to real growth though.
- Finally, this has also created certain unique characteristics such as public, private and academia collaborations (most recently seen in the development of the Covid Vaccines) as well as success stories such as India which has become the powerhouse when it comes to manufacturing capacity and generics.
Think for a moment about a company that is undertaking R&D. Given what we just mentioned around associated costs, it is likely that a significant proportion of their financing comes via the issuance of debt (rarely is it the case that, outside of the majors, biotech companies in their infancy have positive cash flows). Similar to our thesis around listed property, issuing debt, especially longer duration and locking in rates, is effectively a transfer of wealth away from debt holders to equity holders. Moreover, once a firm passes from the R&D stage to actual commercialisation (assuming that it doesn’t make itself a takeover target, consolidation is a hallmark of modern pharma), this effectively creates a double tailwind for equities investors.
Let’s also consider the actual attributes of intellectual property in this particular instance. IP protections effectively ensure that no one else can compete against a particular product line for a given period. In real terms this means it is behaving the same way and has the same scarcity value attributes of precious metals. In effect, if inflation is rising then a seller (of IP) just adapts the asking price and valuation in a much more fluid manner than would otherwise be the case.
But what if we’re wrong about inflation? A rather valid and pertinent question to ask. Even here, we feel that recent events have presented a turning point for the industry overall. Covid has shone the limelight on just how global and interconnected supply chains have become. Take the policy response in India which, as previously alluded to, manufactures approximately 50% of the global vaccine supply. The bipolar response of the central government which, much like the Trump administration Stateside, continued to hold election campaigns and enabled religious festivals (after taking a stellar initial response). The flip side of this scenario was that the second wave of the virus effectively crippled that nation’s ability to export its vaccine supply (which many emerging markets were relying on). The point here? We will likely see increased government support to subsidise and reshore certain manufacturing capacity. A certain tailwind, especially for the consolidated top end (including Pfizer which we spoke of last week).
Sticking with the topic of viruses and vaccines, resistance to second and third-line antibiotics is expected to be around 70% higher in 2030 (compared to 2005 in OECD countries). This, combined with a lack of new drugs and patents, will create a catalyst for the sector going forward. In essence, Antimicrobial resistance (AMR) will, even on conservative modelling, result in the death of approximately 10m people p.a. globally if current approval trends and increases in resistance exceed approvals. This creates another tailwind, not only in increasing regulatory efficiency for, if Covid has proven anything, it can be rather more efficient and timely in the presence of emergencies. Using current trends, even with AMRs, we are headed towards one.
Moving away from vaccines, some interesting and lucrative trends that are likely to play an increasingly prominent role are diabetes, oncology (cancer) and cardiovascular/respiratory, all of which we feel will continue to grow at exponential rates globally. On the first front, the changing eating patterns in emerging markets, incorporating more processed food and foods higher in sugar and salt, ensure that we should see a double digit growth when it comes to the diabetes segment. India, for example, is expected to roughly double its diabetic population between 2017 and 2025, from approximately 72m cases to 134m. According to the International Diabetes Foundation in 2019, “approximately 463 million adults (20-79 years) were living with diabetes; by 2045 this will rise to 700 million.” In an amusing yet somewhat twisted example of capitalism, “Nestlé would sell a problem with one hand and a remedy with the other”. With, amongst other things, their Nestlé Institute of Health Sciences, they are both enabling and profiting from the problem but also looking to enter the market for the treatment.
- Look for companies with significant patent protections and ones that operate in markets that have less regulatory intervention when it comes to pricing. In markets such as Australia or the EU, an interesting angle may be to find companies with organ drug designations. These patents protect companies that go after rare diseases and give longer term protection. One company owned personally is Neuren Pharmaceuticals (NEU.ASX) which has an interesting pipeline targeting Rett Syndrome and Fragile X, both rare but significantly debilitating conditions for adolescents. If the company does succeed in trials, it will have 7 years of exclusivity in the US, for example, in the distribution and marketing of these drugs.
- Look at the duration and nature of the debt on the balance sheet in conjunction with the nature of the eventual revenues. Moderna (MRNA.NASDAQ, owned), for example, continues to hold US $603m, a figure substantially higher than its counterparts in biotech. But, assuming it continues to hold its revenue run rate, this should not be an issue. Though the same cannot be said for its valuation at US $93.4bn, which seemingly prices it for perfection. Despite this, I continue to hold personally given their exposure to MrNA therapeutics in the Oncology and Cardiovascular categories.
- Stick to the more lucrative categories of Oncology, Diabetes and Cardiovascular. These categories are not only relevant due to the number of people they impact but because of the nature of the markets they are prevalent in which remain lucrative. So, while viruses such as HIV may still have a massive impact on emerging economies and vast swathes of the global population, especially Africa, the ability to price is quite limited. Put another way, cancer’s continued prevalence in developed markets makes it a margins game whereas diabetes and cardiovascular is both margins and growth. That is, greater pricing power combined with volume growth in markets such as India and South East Asia. Some personal favourites: Fate Therapeutics (FATE.NASDAQ, owned) for oncology, DexCom (DXCM.NASDAQ, owned) for diabetes, Bristol-Myers Squibb (BMY.NYSE) for cardiovascular.
- Outside of the three aforementioned categories, there is also much to be said for generics manufacturers who are able to get licensing agreements and scale across emerging markets. Here we are looking at not particularly high margins but great growth potential. Some firms that remain interesting are Sun Pharma (SUNPHARMA.NSE, owned), Lupin Pharmaceuticals (LUPIN.NSE, owned), Biocon (BIOCON.NSE, owned) and Cipla (CIPLA.NSE, owned). All of these working across the lucrative categories but playing the lower cost and poorer markets.
Next week we take a more in-depth dive into a number of the aforementioned companies including Moderna, Fate Therapeutics, DexCom and Bristol-Myers Squibb. Following which we shall conclude with a few of the generics manufacturers.