Tuesday, February 15, 2011

The Optics of Health Care Reform

Going over a cliff is one thing. Seeing over it should be much easier.

But, at least for now, Wall Street isn’t ready to take in the view. How else to explain the drumbeat of headlines about the negative impact of health care reform on pharma during the 2011 year-end conference call season?

“No one is really looking beyond the cliff today,” Sanofi Aventis CEO Chris Viehbacher declared during his company’s year-end earnings call at the start of February. “I haven't sensed anybody in the investment community really trying to figure out who's going to win in 2014 and '15. That's just not there.”

Viehbacher made those comments in explaining why he intends to wait until mid-year to offer a longer term outlook, until the company is more completely over its own patent cliff. In Sanofi’s case, that means a full-year of Lovenox generics, resolution of the uncertain status of generic Taxotere, and the end of the line for Plavix. (For more on the company’s overall performance, read "The Pink Sheet" DAILY story, here.)

“I would suspect as we get through a bigger chunk of the patent cliff, and we get closer and closer to 2012 and 2013, I think we're going to have more of a receptive audience to that, and that's why I think we want to do it then. I just think we'd be shouting in the wind a little bit if we tried to do it today.”

It’s not that the patent cliff is unexpected or dramatically worse than predicted. “Two years ago I stood up in front of a lot of you and said 20%-25% of the sales of this company are going to disappear between now and 2013 because of generic competition,” Viehbacher noted.

Rather, there is an overall negative sentiment, he believes.

“This is an industry that tends to focus on the negative. People start worrying about patent expires the day after you launch a new product. If you're any good in R&D, they're not going to give you any value for it in your portfolio. And if you're not any good at it they're not going to like you either.”

That negativity may be overstated, but there is no denying that investors have taken a decidedly glass-half-empty approach when it comes to the impact of health care reform on biopharma companies.

To be fair, the up-front costs of the law are significant—and a real crimp on the profitability of an already challenged sector. (See “Taking Lumps From Health Care Reform,” The RPM Report, June 2010.)

The health care reform implementation also includes a number of elements that further accentuate the negative. It isn’t just the size of the impact from bigger rebates, the new “market share” fee and the Medicare Part D donut hole discount. It's what they do to the P&L statement.

The health care reform impact, essentially, hits the trifecta for what analysts don’t want to see in a quarterly report:

(1) Lower gross margins. The increased Medicaid rebate and the donut hole discount represent an off-the-top reduction in revenues, with no associated reduction in costs. The same number of units are sold, just at lower prices. That makes for reduced gross margins across the board.

(2) Higher SG&A expenses. The market share fee (which begins in 2011) is accounted for as a sales cost and recorded on the expense line. At a time when manufacturers across the board are trying to show their seriousness about cost-cutting, the fee offsets some of those savings. While that is no different in profit terms from an off-the-top-line revenue adjustment, it further clouds the picture for companies trying to show that they are delivering on past promises to downsize.

(3) Higher taxes. The market share fee is (by law) not tax deductible. That means most pharma companies will report an effective tax rate that is at least a percentage point higher than it was in 2010. Again, that doesn’t change the magnitude of the hit, but it makes yet another closely watched variable look worse instead of better. Viehbacher observed wryly that another industry headwind—European price cuts—at least include an associated reduction in tax liabilities. (On the other hand, with corporate tax reform on the table in Washington, this isn't such a bad time for companies to report higher effective tax rates.)

Lower gross margins. Higher expenses. A higher effective tax rate. You can see why Wall Street isn’t loving health care reform right now.

Still, the impact of reform pales in comparison to the impact of the patent cliff. And, unlike a cliff, there is an upside to reform. All those discounts, rebates and fees helped buy an innovator friendly intellectual property system for biologics and biosimilars, improvements in insurance coverage (especially for high drug cost seniors who fall into Medicare’s “donut hole”), and, eventually, a much larger insured population to buy pharmaceuticals.

It is just that that all that happens on the other side of the cliff.

When investors are ready to look that far forward they may be in for a surprise. At least for some companies, what looked like a cliff may turn out to be a valley, with real growth prospects on the other side of the patent expiry period.

image from flickr user andrea trassati used under a creative commons license

1 comment:

Clark said...

Interesting article, and the cliff analogy is perfect. We can't see where we are going and it is going to be a sticky situation in figuring out the right path to go down. I would like to recommend a book called Uproot U.S. Healthcare: To Reform Healthcare by Deane Waldman, MD MBA. It has taught me countless topics revolving around healthcare and empowers the readers to come up with their own solutions. Best book out there for this topic in my opinion.