Biotech Values

[drbio45]

I can't post who wrote this but I thought it should be posted

We are pretty sure that by the end of this week, most analysts will get it that the increasing Medicaid rebate as a result of healthcare reform will have an effect on the current earnings of any company selling drugs in the US. If GILD's stock gets punished today, as it was in the after-hours trading, the moral is when there is an industry-wide issue, don't be the first company to report. Let somebody else be the bearer of bad news. Technically, Gilead isn't the first company to lower guidance. The issue has been discussed since last week: by Roche (ROG.VX), Cubist (CBST), Lilly (LLY), Biogen (BIIB) and others. But, the analysts covering large-cap biotech appear to have just realized the problem. BIIB reported yesterday morning, but BIIB had less exposure to Medicaid, because Avonex and Tysabri are (how should we put it?) expensive for Medicaid. The other moral of the story is to raise prices while you can. HMOs did it. Now they are beating their numbers, despite the fact that they are supposed to be victims of healthcare reform.

• All kidding aside, after all these years, for us to talk about the potential pricing pressure on drugs and biologicals finally is starting to be meaningful -- not only in the US, but from governments around the world. If one is still investing based on what was taught in MBA classes in 1985, it is time to rethink the allure of investing in cash cow companies -- and, most mature drug companies and biotech companies have become cash cows. Let's put it in the language of Graham and Dodd. In an environment of diminishing pricing power and unfavorable regulation, the cash flow goes down and risk premium goes up, which leads to higher discount rate. With generics and biosimilars, the terminal value goes down and duration of the cash flow gets smaller. The end result: NPV is lower. We can't stress enough that in a period when the business environment is less certain (we won't use the term "political instability" because that would make us sound too much like tea partiers), the uncertainty of the cash flow stream is much higher. Even a month ago, we would bet most drug and biotech companies did not realize how much they would have to revise their earnings and cash flow forecast in just a month's time. Combining all of the above, cash cows are much less attractive.

• Lastly, and here we are dead serious, the final moral of the day is that in the biotech and drug universe, the only way to create value is innovation.