Small Drug Firms Get Boon From D.C. --- Large pharma companies need innovation to deal with drug-price law, and that will help smaller biotechs.

"Engaging in a legal brawl with the U.S. government isn't necessarily the wrong move when your back is against the wall, but it does signal desperation.

Pharmaceutical companies and insurance giants are generally known for having it their way more quietly, deploying armies of lobbyists to shape lawmaking in the capital. That approach failed last summer, when the government empowered Medicare to negotiate some drug prices.

Merck's lawsuit against the U.S. government is probably just the beginning of a wider industry effort to fight the law all the way to the Supreme Court. So far, though, Wall Street isn't particularly enthused. By the end of Tuesday, when Merck announced the legal complaint, its stock was among the worst laggards in the S&P 500, dropping 2.7%. It fell another 1.4% on Wednesday.

Barring any surprises, in less than three months Medicare will publish a list of top-selling drugs set to face negotiation. Merck, in its lawsuit, said it expects its diabetes drug Januvia, which had global sales of $4.5 billion last year, to be among the initial batch. It accuses the government of extortion and of violating the Fifth Amendment's clause against taking private property for public use.

Legal experts said Merck will face an uphill battle. "Merck doesn't have a constitutional right to sell its drugs to the government at the price that it sets," wrote University of Michigan Law professor Nicholas Bagley. "That'd be nuts."

More broadly, the industry's main argument is that the law will harm innovation. While the precise impact to innovation is debatable, what is clear is that it will hurt pharma's earnings: A recent Wells Fargo analysis estimated a hit of up to 5% to some companies' revenue in the first three years of the law. An additional consequence is more deal making, benefiting many biotech players.

Even before the law, known as the Inflation Reduction Act, passed, pharma companies had been under pressure to boost business development to offset nearly $200 billion of blockbuster-drug annual sales going off patent by the end of the decade. Since the law effectively speeds up the clock on that revenue cliff, the industry's need for new drugs has only grown.

For an illustration of that, take Merck: Its biggest drug is cancer immunotherapy Keytruda, which had sales of $21 billion last year. Whereas Keytruda would likely face a biosimilar in 2029, the IRA means its price could be negotiated down earlier, in 2028, writes Wells Fargo's Mohit Bansal. While a one-year difference isn't a huge earnings hit, it adds more urgency to build out the pipeline, he says. That helps explain why Merck was willing to pay an eye-popping $10.8 billion for Prometheus, a company with a promising experimental drug but no approved products. More such deals are likely to come across the pharma space.

For investors, that means that betting on nimble innovators, rather than the acquirers, should continue to pay off. So far this year, the SPDR S&P Biotech ETF is up 6.5% while the NYSE Arca Pharmaceutical Index is down 1.7%. The gap is even starker when isolating for biotech's likely targets. That is a reversal from last year, when the pharma index returned 4.9% versus a 26% decline for the biotech fund.

Broader market shifts also are at play. Last year, investors poured money into healthcare, which is seen as defensive during a market downturn. This year, money is flowing back into riskier industries like tech and anything with "artificial intelligence" in the company description.

It also doesn't help that we are about to enter an election year, when healthcare companies tend to underperform as political rhetoric escalates, says Goldman Sachs senior healthcare strategist Asad Haider. Rather than rolling back the IRA, the talk among Democrats is about expanding the law, he notes.

Anna Kaltenboeck, who helped write the IRA and now oversees the drug-pricing practice at ATI Advisory, a consulting firm, notes that healthcare isn't likely to go away as a hot-button issue because it is at the top of the list of complaints that members of Congress field from constituents.

Trading at 15 times forward earnings versus 19 for the S&P 500, pharma will eventually be too cheap for Wall Street to ignore. But until the political dust has settled and the tech rotation has played out, investors in smaller drug developers can reap the gains from pharma's headaches." [1]

1. Small Drug Firms Get Boon From D.C. --- Large pharma companies need innovation to deal with drug-price law, and that will help smaller biotechs. Wainer, David. 
Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 09 June 2023: B.10.