Morningstar Magazine - August/September 2017 - 66

Investors

Opportunities in Immuno-Oncology
New cancer treatments show promise
for patients and investors.

SECTOR RAP

Laura Lallos

Morningstar's equity analysts find the U.S.
market overall somewhat overvalued, but there are
pockets of opportunity for long-term investors.
Pharmaceuticals are one of those areas, and some
key players in the sector are fortifying their moats
with emerging immuno-oncology drugs, as
discussed in a recent white paper from Morningstar
Research Services.1
To explore these opportunities, I spoke with
co-author Damien Conover, director of pharmaceutical research. Our conversation took place
June 1 and has been edited for length and clarity.

The other piece is that a lot of data is coming out
rapidly in immuno-oncology, such as at the
American Society of Clinical Oncology meeting
in early June. We're trying to help set the
stage for investors to appreciate the potential
for these drugs to not only drive cash flows
but reaffirm our wide economic moat ratings for
a lot of the firms we cover.
Dr. Tanguy Seiwert from the University of Chicago
recently joined us on a call where he talked
about how he's using these immuno-oncology
drugs in practice. We came away feeling
that these drugs are going to be used very rapidly
and will prolong patients' lives. That will
encourage more prescribing of these drugs; they
are going to be very important to patients and from
the perspective of generating cash flows.

Laura Lallos: What prompted your recent report

on immuno-oncology drugs?

What advantages do these drugs have over oldergeneration chemotherapy treatments?

Damien Conover, CFA, is a director
with Morningstar Research
Services specializing in pharmaceutical stocks.

Conover: Chemotherapy is the core bedrock for
most cancers, but it is a blunt instrument. It
kills the cancer, but it kills a lot of other living parts
of the body around it, and it can have a lot
of side effects. And it typically doesn't have a very
good long-term survival rate.

Conover: There are two factors driving our research
on immuno-oncology. The ability to innovate
new drugs to offset products losing patent protection is really a core element to the wide
economic moats for large-cap pharmaceutical and
biotechnology firms. When we think about
the next generation of products, immuno-oncology
drugs are very transformative, with a lot of pricing
power, and will likely result in a lot of cash
flow for these pharmaceutical firms, helping them
to offset some of the patent losses.

The new oncology drugs try to be more precise
with the drug treatment, and they allow the body
to work like it's supposed to. Generally, when
people develop some sort of tumor, the body will
recognize it and T cells will knock it out. With
cancer, the tumor cell will start to evade the T cells.
These new oncology drugs make the tumor
more visible to the T cells, enabling the body to act
like it should. That should lead to much better

1 Conover, D., Andersen, K., and Fitzsimmons, W. 2017. "Mapping Out Moats in Immuno-Oncology by Firm and Indication." May 11.

Morningstar August/September 2017

long-term outcomes, and so far, it is, especially
for certain types of patients.
Pricing power is key to pharmaceutical moats, and the
possibility of legislative price limits poses a threat,
as do secular trends such as supply chain consolidation.
Are immuno-oncology drugs better able to withstand
such threats?

Conover: Because of the innovation that they offer
and the complexity of the treatment-meaning
it's hard to substitute some products based
on how these labels are being developed for each
drug individually-it's very unlikely you're
going to see a massive amount of pricing pressure
for immuno-oncology drugs.

There's more pricing pressure for drugs in areas
where there's less innovation. Any generic
drug that hasn't felt pricing pressure yet will likely
feel it. But in the innovative drug space,
where there is less interchangeability, that's where
pricing power is probably going to hold up.
In your recent report, you projected overall immunooncology drug sales of $28 billion by 2021, which
is significantly higher than the consensus. What are
other analysts missing?

Conover: The main reason why we're more
bullish is that we're more comfortable ascribing
higher penetration of these drugs into key
markets. Right now, we are making projections
based off limited amount of data, phase 1
and phase 2 data, some phase 3 data. Some folks
in the investment community would like to
see the totality of data before they go to a higher
number. But we think the survival benefit,
particularly in non-small cell lung cancer but also
in a lot of other indications, enables us to get
to that higher sales number.

There's been a lot of focus on non-small cell
lung cancer, which is the largest indication for
cancer. There are a lot of patients getting this
disease and not a lot of treatment options, and this
is a big piece of that overall $28 billion that
we're projecting by 2021. But the other piece here
is that the consensus is not as bullish on
other indications, whether it be renal cancer,

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