As investors, we always look for “cheap names” and a very common metric for cheapness or value is the multiple. Common metrics are price/earnings, enterprise value/EBITDA, enterprise value/sales, or enterprise value/ peak sales (this is more specific to biotechs – particularly in the early stage of launch or late stage development).
However, just like other things in life, many biotechs or pharmas trade at low multiple for one or many reasons – I discuss contributors to “value traps” in biotech below.
VICTIMS OF THEIR OWN SUCCESSES: BLOCKBUSTER IS FACING LOE (LOSS OF EXCLUSIVITY / PATENT EXPIRATION), BUT THERE IS REPLACEMENT FOR CASH FLOW
This one is probably the most obvious case. With LOE, the revenue declines significantly although the magnitude and speed will vary depending on therapeutic area, modality (small molecule/biologics/ADC/gene therapy) or regulatory environment.
With decline of revenue expected in near-future, growth expectations go down significantly – investors dump the stock (pharma investors are looking for growth by definition – otherwise, you can go to industrials or other sectors that have low growth expectations but have very stable cash flow through entrenched market positioning). Other pharmas often announce restructuring to cut costs to maintain costs for dividend, but this often leads to vicious cycle as they are limited on how much they can spend on R&D – the source of future cash flows.
To avoid this problem, larger caps are CONSTANTLY on the lookout for acquisitions or product license agreements to fill up the pipeline as much as possible. They often look for assets in their therapeutic areas of focus. For example, it could be breast cancer franchise or central nervous system franchise, or even rare disease franchise. This helps sustain their moat – which are essentially great working relationships with key stakeholders:
Providers/doctors: to sell the drugs / push drugs out into the channel
Principal investigators: to design and execute on clinical programs and public studies in prestigious journals to herald findings.
Regulators: to design the study that balances TAM and success of the trial based on feedback with regulators).
Potential partners: to position as the partner of choice to maximize economic value for a partnered program in license transactions
I will use Roche as an example of how large cap pharma went through multiple compression due to fear around tapering growth trajectory and executed on commercialization for multiple expansion.
Stage 1: Fear around biosimilar entries on core drugs pushed down the stock price
In 2017, Roche management and investors had many things to worry about. Developed out of Genentech, Herceptin (trastuzumab), Rituxan (rituximab), and Avastin (bevacizumab) had served as cornerstone of its multi-billion cancer franchise and as enormous cash cow, but were facing biosimilar entries in 2018/2019 timeframe due to LOEs. Just to give a sense of the revenue cliff that Roche was facing:
Herceptin: received approval in 1998 and had $6.9bn of revenue in 2016 (13% of total revenue)
Rituxan: received approval in 1997 and had $7.4bn of revenue in 2016 (14% of total revenue)
Avastin: received approval in 2004, and had $6.9bn of revenue in 2016 (13% of total revenue).
Three products were responsible for whopping 40% of total revenue and Roche could face significant headwind / revenue loss in a matter of 2-3 years. 40% of total revenue at risk in 2-3 years is a major problem.
Obviously, it was negative for stock price and stock price decline from Swiss Franc/Sfr 290 in 2014 to as low as Sfr 200 in 2018 – despite all the quantitative easing and bull market.
Large cap pharmas are generally expected to have fairly stable stock price (hence often recommended as good stable dividend stock – an enormous fallacy that many financial advisors push out to their clients) – so you can see how painful it must have been for many investors.
Stock price reflects exuberance and concerns around Herceptin, Avastin, and Rituxan cash flows from Roche’s own trials or other competitive programs.
THEN APHINITY TRIAL READS OUT IN JUNE 2017
APHINITY trial result was announced at ASCO 2017. ASCO stands for American Society of Clinical Oncology and the conference is a premier oncology conference – a great venue for a big clinical break-throughs.
APHINITY trial compared combination of Herceptin and Perjeta (pertuzumab) against Herceptin monotherapy – the standard of care at the time. This trial was important because 1) it would provide an improved standard of care for breast cancer patients, and 2) Perjeta was the next-gen product in Herceptin franchise and was expected to be the next growth driver after Herceptin loses its exclusivity – there was a lot at stake for Roche’s breast cancer franchise. The metric that investors focused on was the magnitude of benefit from adding Perjeta to Herceptin – and it needed to be significant enough to make the extra cost worth it.
When the data came out, investors were disappointment. Below is the APHINITY data – long story short is that Herceptin+Perjeta combination (in blue line) did not separate enough from Herceptin monotherapy (in orange line). Investors believed that the data is not good enough to convince doctors that they should add Perjeta – therefore, Perjeta would not be able to replenish lost Herceptin revenue.
As a result, Roche stock price declined on that day, and sellside analysts lowered target price as well – further pressuring the stock. Big dip below is the day of APHINITY read-out and stock price continued to decline on fear.
However, the data was positive and Roche gained approval for Perjeta+Herceptin combination, and Roche started throwing its heavy weight around to push the drug out to the channel and marketing the combination aggressively with data and journal article.
ROCHE’S COMMERCIAL EXECUTION ON PERJETA DESTROYS GROWTH CONCERNS
With its strong commercial infrastructure, Roche successfully executes on commercialization of Perjeta and crushes bear thesis around loss of Herceptin revenue and thus growth profile of Roche group overall. As shown below, Perject became one of the leading growth drivers for Roche and is now solidly positioned as the new standard of care for breast cancer patients.
Ocrevus is now replacing Rituxan’s revenue in multiple sclerosis (Rituxan was used off-label in multiple sclerosis because of efficacy, but Roche is said to have decided not to run Rituxan trial in multiple sclerosis to give way for Ocrevus – but they are both anti-CD20 agents). Perjeta was right behind Ocrevus.
With strong commercial execution, investors became more comfortable with growth profile going forward, and Roche stock price roars up back to pre-APHINITY trial level – as shown below:
Key benefit of investing in large cap pharma is its deep pipeline and optionality. Roche has launched over 12 drugs since 2012 – essentially more than one every year.
In sports, they say “form is temporary, but class is permanent” – you could also say that about large cap pharmas with solid track record of development AND commercial execution.
CONCLUSION
Studying Roche’s path has many key takeaways, which are as follows:
Improvement in survival that does not seem material to investors can be very significant for clinicians and patients and they will use the drug
You should never underestimate the commercial distribution power of large cap pharmas in their sweet spots.
There is a lot of innovation with smid biotechs, but large cap biotechs also have them buried in internal pipeline – we just don’t see them earlier.
Dividend stocks can go under significant distress, but if you identify the key driver of the weakness and have a different view, you can make both high dividend yield and capital gain at the same time in a relatively short amount of time.
It pays to have research done on large cap pharmas with strong franchises and leverage short-term weakness to invest and the return profile can be significant.
What do you look for when you are thinking about investing in large cap pharma? Please comment below!
*not investment advice
How do you assess whether a commercial team is strong? Is it just historical track record or are there predictive factors?
Generally precedent is the best for large cap pharma and i also look at how strong of franchise they hold in that specific area. For smid cap biotech, I look at products that the commercial lead has launched in prior roles.
Thanks for the response! Follow up: When you say strong franchise, do you mean potent product/rich pipeline or do you also evaluate commercial strategy/KOL influence/prescribing behavior? Say the product’s profile is sufficient but not best-in-class, how much could be overcome with a successful commercial strategy (i.e. contracting)?
In biotech, things are very conservative – so I would say the history of successful product roll-outs would represent strong franchise. if you have strong established presence, you get the best access to the most promising pipeline lines and renowned KOLs. If a product is not best in class in oncology, it is very hard as oncology is extremely data driven. However, in other indications (like immunology), contracting could be more important – look at what ABBV is doing!
What do you like to look at for clues of strong commercial team?
I’m very much a novice in terms of biotech investing, so don’t really have a good point of reference in commercial assessment. What I am wondering about is how indication-sensitive is a commercial team’s success. You alluded to seeing how well specific franchises perform, but my high-level perspective is that know-how is know-how. Especially at large cap pharma, I imagine strategies can get passed along from franchise to franchise. Only real counter-argument I can think of is direct salesforce-provider relationships, where establishing relationships with specialists in a new area takes time. Thoughts?
it is not just know-how – it is all about deeply entrenched relationships across all stakeholders within specific stakeholders – even patient support groups.