Morningstar - Q3 2022 - 66

Investors
Inoculated Against Uncertainty
Big Biopharma can stand up against stiff
macro headwinds.
SECTOR RAP
Laura Lallos
Inflation, the threat of recession, and the
ongoing war in Ukraine have created an extremely
uncertain environment for investors. In a
recent report, Morningstar Research Services'
director of healthcare research Damien Conover
and healthcare strategist Karen Andersen
explained how the stocks of the big
biopharmaceutical companies offer protection
against these mounting macro headwinds.1
I recently sat down with Andersen to discuss
opportunities and risks in the sector.
While these companies can price their drugs
to withstand inflation, they do face another price
risk-that their prices are unjustifiably high
and may not be sustainable. Morningstar and
Morningstar Sustainalytics have enhanced
their analysis of this key ESG risk by incorporating
cost-effectiveness analysis from the Institute
for Clinical and Economic Review. Andersen
explained how Morningstar's new capsule system
uses ICER's benchmark information to assess
U.S. drug pricing risk.2
I spoke with Andersen on June 14, and our
discussion reflects conditions and valuations as
of that date. It has been edited for length
and clarity.
Laura Lallos: What makes these biopharma companies
less sensitive to inflation?
Karen Andersen, CFA, is a
healthcare strategist at Morningstar
Research Services LLC.
pharma industry, which makes them a smaller
piece of the pie. The one impact some companies
have noted is on clinical trial enrollment.
There are a lot of clinical trials that enroll in these
countries, so drug firms are scrambling a
bit to boost enrollment at other trial sites so that
pipeline programs don't get too delayed.
Andersen: There are two sides to this, the
pricing side and the cost side. On pricing, the big
biopharmas see most of their revenue from
branded drugs. These are typically drugs that are
patent-protected and usually have some
differentiation and significant pricing power. So,
passing through inflated costs shouldn't be
a problem. One caveat to that is that drug pricing
is kind of a headline risk right now. Any
price increases that stand out as much higher than
inflation would probably raise eyebrows.
On the cost side, the actual cost of goods sold
of the actual pills or injectable medicines is a small
percentage of sales on average, somewhere
around 10% of sales. The industry can absorb any
increased cost for the raw materials. As for
costs that are tied to wages, anything that's
reflected more in R&D or operating costs,
the industry can run cost-saving programs or trim
salesforces where needed.
Lallos: It sounds like the war in Ukraine is not
a significant factor for these companies.
Andersen: I'd say that's true for most. Several
companies have commented on the percentage of
sales that they get from Ukraine and Russia,
and it's typically less than 1%. Most of these firms
are very global, and these countries tend to
have lower income per capita and a less developed
Lallos: How protected are these companies in the
event of a recession?
Andersen: We've found over the decades that
demand for prescription drugs is relatively inelastic,
so less sensitive to changes in the economy,
which makes Big Biopharma a pretty defensive
industry. For example, in 2009, these firms
posted steady growth that was in line with prior
years and the years that followed, despite
a recession and the 2% decline in GDP that year.
Lallos: So, COVID-19 was a rare event?
Andersen: COVID was a little special in that it
did have a significant impact on healthcare
utilization. It was down by roughly a third. The
hospital system was overwhelmed and
stretched, and individuals were a lot less likely to
seek care for anything that wasn't of utmost
urgency. Patients delayed elective procedures, and
we even saw a significant decline in diagnosis
for a lot of different diseases, from HIV to
multiple sclerosis to cancer. That spills over into
demand for prescription drugs.
But now we've got vaccines and treatments, and
a high percentage of the country has either
been vaccinated or infected. So, utilization rates
have already rebounded a lot. We estimate they're
probably about 10% below pre-COVID levels.
This is a potential growth tailwind for this industry
as we head into the second half of the year.
Lallos: You mentioned the headline risk of raising
prices too much. What is the policy risk?
Andersen: U.S. policy changes have been
a background risk and an overhang on industry
multiples since around 2015. That's when
the industry first started seeing headlines about
1 Conover, D. & Andersen, K. 2022. " Big Biopharma's Moats Protect Against Inflation, Recession, and War in Ukraine, While New U.S. Drug Policy Looks Unlikely, " Morningstar. May 24.
2 Andersen K. & Bonomi, A., et al. 2022 " Biopharma ESG Risk: Introducing Our Capsule System for Assessing U.S. Drug Pricing Risk With ICER Cost-Effectiveness Benchmark, " Morningstar
Healthcare Observer, Morningstar. June.
66
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