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Obama's Healthcare Plan Is Big Bark, Small Bite
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by Jason Napodano, CFA
When President Obama's administration released the proposed budget for the upcoming fiscal year, drug stocks quickly dropped. Fears of socialized medicine, or "Hillary-Care 2.0" turned investors away from the sector.
Was the drop warranted?
There are 6 key components to healthcare reform that could have a meaningful impact on pharmaceutical and biotechnology companies in the near future.Four of these are potentially negative, whereas the other 2 are potentially positive.
First Potential Negative: Increasing Pricing Rebates
The new proposal calls for an increase in Medicaid rebates from the current level of 15% to 21%. This equates to a 6% decrease in pricing power by all the companies in our universe into the Medicaid market. If we delve deeper into the ramification of this action, we see that the potential earnings impact for most large pharmaceutical companies is in the area of 1%, at most.
Most pharmaceutical companies average roughly 5% to 20% of their U.S.business to Medicare / Medicaid. Some companies, including Wyeth (WYE), Pfizer (PFE - Analyst Report), and Abbott Labs (ABT - Analyst Report) are on the low-end, whereas others, such as Bristol-Myers Squibb (BMY - Analyst Report), Eli Lilly (LLY - Analyst Report), Merck (MRK - Analyst Report), and Gilead (GILD - Analyst Report) are on the high-end.
The overall impact to the top-line is muted significantly for companies with greater sales outside the U.S., including PFE, ABT and Johnson & Johnson (JNJ - Analyst Report).
Notice Abbott and Pfizer are on the right side of that list twice, low exposure to Medicaid, high percent of sales outside the U.S. But nevertheless, we would classify the 1% EPS risk associated with increased pricing rebates as mostly bark, only a tiny bite.
| Company | % U.S. Revenues* |
Est. % Govt. Biz |
% At Risk Exposure |
| Abbott Labs | 48% | ~8% | ~4% |
| Bristol-Myers | 59% | ~14% | ~9% |
| Johnson & Johnson | 51% | ~9% | ~5% |
| Merck & Co. | 56% | ~10% | ~6% |
| Schering-Plough | 30% | ~8% | ~3% |
| Eli Lilly & Co. | 54% | ~18% | ~10% |
| Pfizer, Inc. | 42% | ~6% | ~3% |
| Wyeth, Inc. | 47% | ~5% | ~2% |
| *Revenues include all operations, not just Pharmaceuticals | |||
Second Potential Negative: Biologic Generics
It is clear that we will have some sort of path to approval for generic biologic drugs, or "biosimilars," in the near-future. New draft legislation is expected to call for 10 years of market data exclusivity for new biologic drugs - a victory for the biotech industry as Representative Henry Waxman (D-CA), Chairman of the House Energy and Commerce Committee, recently introduced a bill calling for only 5 years of data exclusivity.
But biosimilars will not be as devastating to biotech products as generics were to small molecules. Manufacturing biologic drugs is significantly more cost prohibitive and knowledge intensive than small molecules.
Biotechnology companies themselves often struggle with manufacturing scale-up and meeting demand. Manufacturing Eli Lilly's Erbitux or Amgen's (AMGN - Analyst Report) Enbrel is no easy task. There are few generic manufacturers with the necessary expertise, or capital required, to manufacture large batches of biosimilars.
And, there are significant additional hurdles. If the FDA will require proof of bioequivalency, then generic manufacturers will need to start doing costly large-scale clinical trials - something most will shy away from doing. Conversely, if the FDA does not require a bioequivalency study, we believe most doctors will shy away from using the "biosimilar" products because they know the complexity of the manufacturing process and have no proof that the generic Aranesp really is identical to the branded Aranesp.
It's a catch-22 that generic companies looking to break into the biologic market will have to deal with.
That being said, firms with potentially the biggest risk exposure to generic biologic legislation include Amgen and Biogen Idec (BIIB - Analyst Report). Teva Pharmaceuticals (TEVA - Analyst Report) is most likely the biggest winner.
| Neupogen (Amgen) | 2013 | Neulasta (Amgen) | 2015 |
| Aranesp (Amgen) | 2014 | Enbrel (Amgen) | 2012 |
| Myozyme (Genzyme) | 2016 | Fabrazyme (Genzyme) | 2015 |
| Herceptin (Roche) | 2019 | Avastin (Roche) | 2018 |
| Rituxan (Roche) | 2018 | Lucentis (Roche) | 2018 |
| Erbitux (Eli Lilly) | 2017 | Remicade (J&J) | 2014 |
| Humira (Abbott) | 2016 | Synagis (AstraZeneca) | 2018 |
Third Potential Negative: Drug Reimportation
A consortium of 4 Senators (Dorgan D-ND, Stabenow D-MI, McCain R-AZ, and Snowe R-ME) introduced in early March 2009 the, "Pharmaceutical Market Access and Drug Safety Act." The bill would allow U.S.-licensed pharmacies and drug wholesalers to import FDA-approved medications from Canada, Europe, Australia, New Zealand and Japan - areas where drug prices are on average 35% to 55% lower than in the U.S. The legislation would also allow individual consumers to purchase prescription drugs for personal use from safe, reliable, FDA-inspected Canadian pharmacies.
The Congressional Budget Office (CBO) estimates the bill would save American consumers $50 billion over the next decade, including more than $10 billion in federal government savings. If we assume the savings are linear, or average roughly $5 billion per year, that represents approximately 2% of the total U.S. $250 billion pharmaceutical market. The EPS impact from a 2% haircut to the top-line of each pharmaceutical company, assuming drug reimportation hits everyone equally, is extremely manageable, and will most like average no more than 1% to 2% per company if enacted.
Fourth Potential Negative: Tax Reform
(This also the one with the most teeth.) .
Tax reform has little to do with fixing the healthcare system and more to do with closing loopholes and going after drug company's profits directly. It is also by far the most socialistic approach to the problem, as we would classify drug reimportation and biosimilars as more capitalistic approaches.
Over the past several years large-pharmaceutical companies have gotten quite good at lowering their effective tax rates thanks to foreign subsidiaries and R&D credits. In fact, the average tax rate using the 14 largest U.S-based pharmaceutical and biotech companies in 2008 was 23%.
It is possible that the President's proposal could raise the effective rate for each firm to 30% by closing these loopholes and cutting R&D tax credits.
That equates to a 7% increase in effective tax rate for the average company, or as much as a 20% to 30% decrease in net income. The details on the tax reform aspect to President Obama's proposal have yet to be divulged, but this does have the potential to be a significant negative for our coverage universe.
| Abbott Labs | 22% | Amgen | 22% |
| Bristol-Myers | 22% | Alcon, Inc. | 15% |
| Genentech | 36% | Biogen Idec | 29% |
| Genzyme | 34% | Gilead Sciences | 27% |
| Johnson & Johnson | 23% | Eli Lilly & Co. | 21% |
| Merck & Co. | 17% | Pfizer, Inc. | 22% |
| Schering-Plough | 15% | Wyeth, Inc. | 30% |
It's not all potentially bad news though with respect to healthcare reform.We see two potentially very positive changes that could emerge as a result of new legislation.
First Potential Positive: New Research Funding
In early March 2009, President Obama reversed a standing executive order from the previous administration by lifting the federal ban on human clinical testing of embryonic stem cells. This opens the door to potentially billions of dollars in government funding for this new, and potentially breakthrough, platform.
Stem cell companies, although mostly small and unprofitable, are the biggest direct beneficiary of the news. However, big pharmaceutical companies are clearly interested in stem cell research, and with a significantly more friendly administration in control, we may see a big push in this area in the coming years.
Besides opening up funding for stem cell research, the Obama administration has made it clear it wants to see additional increases in funding for infectious diseases such as HIV/AIDS and Hepatitis-C, as well as for cancer and obesity-driven diseases such as diabetes and cardiovascular disease. At this point, similar to the proposed tax reform, the details are thin. How much money the government will spend and who will get the money remains to be seen, but Genzyme (GENZ) and Gilead would seem to be the two biggest beneficiaries of increased funding in their core areas.
Second Potential Positive: Increase Coverage
This is the "no-brainer" when it comes to how universal healthcare would benefit big drug companies. There are an estimated 40 million people living in the U.S. without health insurance. Opening up some sort of government sponsored program that would insure even half of these people would be a significant revenue driver. We would view this as a systemic benefit across the entire universe of healthcare companies.
Potentially another 20 million Americans looking to use prescription drugs could mean as much as another $25 billion in drug sales per year. That would equate to an increase of over 10% in 2010. Therefore, even if pricing drops by 6% and reimportation takes down sales by another 2-3%, the net top-line impact of Obama's healthcare reform may be negligible if the size of the target market increases.
Healthcare Reform Is Necessary
Fixing healthcare, or at least starting on a long-term solution, is at the center of President Obama's plans for the next 4 years, and for good reason.
According to the National Center for Policy Analysis, the unfunded liability associated with Medicare / Medicaid is roughly 7x that of the current unfunded liability for Social Security. By 2030, it grows to 15x the size.
Social Security may be the "third rail" in American politics, but Medicare / Medicaid is the train bearing down on the tracks.
Still Waiting on the Details
It is also critical to realize that many of the details to President Obama's proposal have yet to be ironed out. That debate will take place on the floor of the House and Senate over the next few months.
What was released last month was more a broad stroke, sweeping legislation, plan of action. The President called for a $634 billion healthcare reform reserve fund over 10 years aimed at fixing many of the problems that exist with the current system. This $634 billion is paid for through $318 billion in tax increases on Americans earning over $250,000 and $316 billion in savings to be squeezed from drug makers, hospitals and managed-care companies.
The net result of healthcare reform is likely to be limited on big pharmaceutical earnings.
As noted above, the effective tax rate change has the potential to take the biggest bite out of profits. What we may end up seeing is a small reduction in revenue growth rates for the largest firms by 2% to 4%, with almost this entire drop hitting the gross margin line. Operating margins are likely to remain stable as most of the company look to cut costs and synergize through mega-mergers (Pfizer-Wyeth, Merck-Schering, Roche-Genentech). The mega-merger trend should continue, with names like Bristol-Myers, Eli Lilly, Sanofi-Aventis (SNY - Analyst Report), and AstraZeneca (AZN - Analyst Report) most likely the next to jump into the fray. Net margins could take a hit if tax rates increase, which would certainly have a negative impact on earnings, but we expect that this type of broad-based impact to the entire sector will have only limited impact on applied valuation multiples.
When the President's budget is finalized we should get a better sense on how the above 6 forces will impact each name individually. At this point, the fear of healthcare reform seems entirely more bark than bite. Although there is bite, the Amex Pharmaceutical Index is now down 13% YTD, and our calculations show that the expected earnings hit, excluding the tax rate issue, is significantly less.
Wishing you luck,
Jason Napodano, CFA
Senior Analyst, Zacks Equity Research
Jason covers the pharmaceutical industry for Zacks Equity Research. His article on how health care reform may impact the drug sector helps us view certain stocks in a new light.For example, Teva Pharmaceuticals is identified as a potential big winner with new generic biologic legislation. If you'd like to see Jason's in-depth research report on TEVA issued April 1, you may download now by starting a free trial to our Zacks Premium service.
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