Drug pricing reforms in the US will likely constrain growth for biopharmaceutical manufacturers, placing even greater importance on a company’s ability to successfully replenish revenues through investment and mergers and acquisitions. Those allocating capital well should see rewards in the form of share price gains, argues Jon Stephenson, Senior Portfolio Manager.
With the Inflation Reduction Act, (IRA) signed into law in 2022, the Biden administration seeks to address drug affordability and access as well as the billions of dollars in spending by Medicare, the federal health insurer covering more than 65 million retirees, among other issues including climate change.
The US is the world’s largest pharmaceutical market, with USD 630 billion in sales in 2022, or 42% of the worldwide total. At 65%, its contribution to profits is greater still. That is little surprise given that prescription drugs cost two to three times more in the US than in many other developed markets.
Patients’ out-of-pocket expenses – those costs not covered by insurance – are among the world’s highest, leaving three in 10 Americans to struggle to afford medications because of cost, the US government says, noting that profits at ‘big pharma’ grew as they spent more on stock buybacks and dividends than they spent on research and development (R&D).
A key component of the IRA is to enable taxpayer-funded Medicare, which spends more than USD 200 billion a year on outpatient prescription medicines, to negotiate directly with manufacturers on lowering drug prices. This is a marked change from past practice in which drug makers could set prices themselves and it is estimated that it could cut costs for Medicare by billions of dollars.
The first batch of 10 drugs subject to price negotiation were named recently, starting off a process that is due to see new – and likely lower – prices go into effect in January 2026 (see Exhibit 1). More and more drug prices will be negotiated in subsequent years.
Near-term impact on pharma’s outlook
While we believe the impact of IRA’s drug price negotiation provisions, marking the biggest shake-up in drug pricing in more than two decades, is material to drug makers’ near-term earnings per share (EPS) projections, it should be less material in the long run. That is because the vast majority of the drugs now selected were nearing the end of their patent term and would have been subject to generic or biosimilar competition within one to two years.
The first tranche of selected drugs (see Exhibit 2 below) includes 10 of the most expensive – and widely used – ones. Of them, Eliquis, Jardiance, Xarelto, Januvia, Farxiga, Entresto, Enbrel, Stelara and Novolog are all nearing generic/biosimilar competition, while Imbruvica has been eroding due to branded competition.
Negative and mitigating factors
The long-term impact of this legislation at a high level is incrementally negative for the broad biopharma industry, but likely significantly less so than reported by the media.
Factors negatively impacting the industry:
- Shortened life span for Medicare-levered drugs
- There could be pressure for deeper discounts on drugs in the same class as those whose prices are being negotiated by Medicare
- Eventually most drugs with Medicare exposure will be subject to negotiation since the number of negotiated drugs will rise to 20 a year and half of all authorised drugs will likely have exposure.
Certain analysts estimate the value impact on some Medicare-levered brands could approach 15% based on these factors. While the negative factors arising from IRA are legitimate, we note that investors should not conclude that the long-term impact on industry projections is that severe.
There are several mitigating elements:
- Drugs that are relevant for Medicare are only a portion of pharmaceutical company portfolios
- Modestly higher initial list prices on new medicines could mitigate some of the headwinds
- Biopharma companies will likely shift capital investment to less impacted products and categories such as biologics and medicines for orphan diseases, and put an increased focus on cell and gene therapies which are not subject to the IRA considerations
- Analysts consistently underestimate the impact on 8-12 year projections from branded competitive threats
- Consumer-friendly provisions in the IRA should provide a small positive offset in the form of higher drug use.
Net on net, while the IRA provisions are incrementally negative for the biopharma industry, we do not see them as an existential threat.
Not set in stone
While the IRA has been signed into law, there is a chance that aspects of the legislation become less onerous for the industry.
First, several large drugmakers and the leading US industry organisation have filed suits. Complaints include that the policy fails to strike the right balance between incentivising investment and innovation and improving affordability and access. The IRA could shorten the window for companies to recoup investments – leading them to cut back on research itself as well as R&D jobs.
Some legal consultants believe there is at least a 50% chance that these cases will go to the Supreme Court in 2024 with a decision in 2025 that could be favourable to the industry.
Second, there is a chance that after the November 2024 election, certain provisions are altered such as the differential exclusivity periods for small molecules and biologics. We see the probability of this as not high.
Consequences for investors
In our view, increased pressure on drug pricing was a question of time given that secular factors such as demographics, lifestyle changes, technology innovation and wealth effects are causing healthcare demand to outpace GDP growth. These factors weigh on healthcare budgets, setting the scene for winners and losers.
Large-cap biopharma has historically sourced much of its innovation externally. With an increased urgency due to the IRA, depressed small and mid-cap biopharma valuations and strong large-cap biopharma balance sheets, we expect mergers and acquisitions to heat up in the coming quarters. Recent trends seem to confirm a gradual pickup in M&A activity is already underway this year.
The Inflation Reduction Act (and the related drug price negotiations) do not change our view on the attractiveness of healthcare or our investment strategy.
We have consistently been underweight larger-cap biopharma companies most exposed to pricing pressure on legacy brands, while being structurally overweight more innovative small and mid-cap manufacturers which we view as part of the solution to big pharma’s problems.
In our opinion, the IRA codifies the need for the biopharma industry to innovate. Those companies committed to a culture of research & development capable of consistently replacing legacy revenue will likely be rewarded with higher valuations and those that are not will likely continue to see their stock prices languish.
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