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Where do healthcare dollars go now?


I don't suppose they'd close the funds and give the money back?

About a month ago I penned a piece making the Case for Biotech Investing. The subtitle of that story was "Unique opportunity, unique risks." I urge you to read that story (paying particular attention to the "risks" part) before integrating this piece into your thinking.

Big Pharma's crisis

At this point, it doesn't matter for big pharma who wins the Presidential election. The FDA is suitably motivated from a series of high-profile safety problems to make internal changes to the approval of follow-on drugs. The only impact the Presidential election will have is how far those regulations will go and whether the new head of the FDA will be friendly or less friendly to big pharma's concerns as the rules are being changed.

I believe the most likely outcome of the FDA's internal review is to dramatically toughen approval pathways for drugs that are beyond the second entry into a particular class of drugs (i.e. "follow-on" drugs).

In the best-case scenario, Congressional intervention and FDA inclinations combine to force follow-on drugs to meet some sort of pharmacoeconomic test. To be approved, a follow-on drug must not only prove safety and efficacy, it must also show it is more cost-effective than currently available treatments. This can be done via simple pricing decisions, so this is not a particularly onerous requirement. It will mean lower revenues for follow-on drugs, however.

In a middle-case scenario, the FDA will require much longer trials with higher patient enrollment to satisfy safety concerns. Traditionally, drugs that are second to market enjoy a swifter regulatory path because they can take advantage of surrogate endpoints validated by the first drug to market. In this middle-case scenario, the FDA will make follow-on drugs go through the same onerous path first-to-market drugs typically endure in the hopes of shaking out unexpected safety problems.

In the worst-case scenario, Congress and the FDA will get together and require follow-on drugs to run competitive trials before approval. In a competitive trial, you pit a new drug against the standard of care (the first-to-market drug) and see which wins. If the new drug does not prove superiority, then it does not get approved. The costs of running superiority trials are enormous because of the small differences in efficacy between drugs in the same class. The effect of this legislation is somewhat dependent on the character of the FDA leadership. Unfriendly FDA leadership will take a broad view of what is competitive, erring towards requiring more superiority trials. Friendly FDA leadership, like we have now, would take a narrow view of what's competitive. Whichever the view, broad or narrow, it means significantly higher costs and additional delays for the drugs that are most lucrative for big pharma.

These developments could not come at a worse time for big pharma. With a shocking number of the biggest sellers coming off patent, big pharma is increasingly relying on me-too drugs to extend patent life and fill potentially gaping holes in their revenue streams.

Each of the reforms I discussed above represent delays - some measured in years - before big pharma can get a drug to the market to replace one facing generic competition. There is the real chance that instead of being able to bring a replacement drug to market before a lucrative drug goes off patent, big pharma will miss their timelines and the drugs won't debut until after the hole appears in their revenue stream. In the worst-case scenario, these follow-on drugs may never make it to market making those holes permanent.

Healthcare providers

Your typical big healthcare fund has big pharma and healthcare providers (including insurers) as the bulk of their fund. They likely throw in the big biopharmaceuticals like Amgen (AMGN:NASD) and Genentech (DNA:NYSE) for a little spice. Few invest in the development-stage biotech companies my firm covers, and the positions are typically insignificant.

Wall Street has had their eyes opened to the risks of owning big pharma in this current environment. Big healthcare funds who are rethinking their exposure to those names may have been thinking of redirecting funds to providers and insurers. Until this week, that didn't seem to be too bad a trade to me. With the flu fiasco, visits to doctors are likely to be up, making for bigger revenues for healthcare providers. The demographic situation is clearly in their favor as aging baby boomers make visits to the doctor as big a part of their lives in this century as visits to the head shop were for them in the last century.

This week, however, brought the news that Eliot Spitzer is turning his sights on this market sector. The group is down significantly as I pen this article and I expect this is only the beginning.

Even if Mr. Spitzer's examination of this sector is fleeting, regulatory and public policy pressures are likely to weigh heavy here. Medicare/Medicaid reimbursements will squeeze margins even as they increase in size. Health care reforms at the state level are almost guaranteed, each with its own peculiar set of costs.

Where to look next?

If you are a healthcare fund manager and the place where 95% of your fund is invested has these kinds of real, predictable macro level risks, what are you to do?

The cynical manager will stay the course, knowing that if enough of his/her colleagues do the same then he/she has a shot at outperforming them. Of course, such outperformance would mean simply losing less money for investors - which is not exactly a long-term solution to the problem.

Others will jump sectors, either seeking new jobs or broadening their fund description to allow them to invest in other areas. I wish them luck as there are few (if any) areas in the market not facing some sort of wall of worry.

The smartest of the bunch will realize there is one sector of the healthcare market that is mostly immune to these developments - biotechnology. As I noted in the article I wrote a month ago, biotech has its own special issues that cannot be ignored, but the sector focuses on first-to-market drugs in areas less likely to see heavy governmental regulation.

Their problems, biotech's boon

Let's take Merck (MRK:NYSE) for an example. The company just got a few billion in revenue vaporized from its P&L. Boatloads of lawsuits are on their way, making it likely Merck will cancel or dramatically reduce its dividend. What's the company to do?

If they are smart, they insert themselves in every partnership negotiation with development-stage biotech firms and use their cash hoard to buy themselves a new, more stable pipeline of first-to-market drugs. Those will be tricky negotiations as their biotech counterparts will be worried Merck might be distracted by litigation or blackballed at the FDA, but big checks have a way of assuaging those kinds of worries.

Let's say you are Pfizer (PFE:NYSE), who has their own issues with patent expirations. You feel pretty good your internal pipeline can plug the largest holes, but you correctly forecasted the potential delays I spoke about above. You've been aggressively courting (and buying) smaller biotech companies, making yourself a reputation of never getting outbid for a company you wanted. A desperate Merck enters the picture, throwing very large checks around in relation to their desperate need to plug holes in their product stream. The only winner in that kind of a battle is the biotech company on the other side of the negotiating table.

Which precisely completes my point.

Even if Merck doesn't clue in and start beating the bushes for new deals, big pharma execs will see the writing on the wall at the FDA and re-assess their timelines. Companies with unpartnered late-stage products that will be first to market are a rare commodity, and prices for partnering or acquiring them will be bid up accordingly.

So, we have the makings of a perfect storm for biotech here. Declining fortunes for big pharma and Mr. Spitzer's foray into the healthcare sector will set smart healthcare fund managers looking for other places to put their cash. There is no reasonable alternative for them other than biotech. At the same time, big pharma has a serious need to plug pipeline holes. An increasingly competitive deal environment will cause big pharma to bid up for acquisitions and (more likely) product partnerships. All of the above bodes will for the biotech sector.

Again, I have to caution the reader to take a moment and realize the unique risks involved in investing in development-stage biotech companies. Overnight risk is substantial and it affects every single one of the companies in the space at some point. The waters are rocky, but I believe the payoffs are commensurate with the risk for smart investors with a track record of keeping their heads.

For those who follow the Buzz, I've mentioned a long biotech (NBI)/short pharma pairs trade. This article is the rationale behind that trade.
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