Biopharmaceuticals February 8, 2017 Health Care - Biotechnology Industry Rating Market Weight

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1 The Henry Fund Henry B. Tippie School of Management Aric Jensen Biopharmaceuticals February 8, 2017 Health Care - Biotechnology Industry Rating Market Weight Investment Thesis We feel that the Health Care Biotechnology Industry has one more heavy stock price growth stage before maturity, but recommend a rating of Market Weight through the uncertainty of possible regulatory changes regarding pricing. Drivers of Thesis As long as there are people, there will be illnesses and disease. We believe that biologics will continue to move to the forefront of, and propel, prescription sales. Population is expected to increase at greater than 1% through As well, an aging population increases the occurrence of chronic diseases. The rare or incurable nature of most of the biologic indications will continue to enable biotech companies to charge patent-protected premium pricing. This semi-captive market has allowed successful companies to achieve operating margins greater than 40%. Advances in diagnosis and presence in emerging markets will provide biotech with an increasing patient base. The number of cancer diagnoses, in the US only, is forecasted to rise from 1.7M in 2015 to 2.4M in Risks to Thesis Healthcare reform could cause increased drug rebates for Medicare patients. This could lead to reduced access to capital for smaller biotech companies. Biotechnology Industry Market Cap (in billions) Amgen AbbVie Gilead Sciences Celgene Biogen Regeneron Alexion P/E Alexion Regeneron Celgene Amgen AbbVie Biogen Gilead Sciences 6.69 Operating Margin Gilead Sciences 60.93% Biogen 49.83% Amgen AbbVie 42.36% 38.86% Celgene 30.30% Regeneron 25.67% Alexion 24.88% New pipeline drugs are not guaranteed blockbusters. Only a small percentage of identified compounds make it through FDA approval 0 P/E ROE EV/EBITDA and even fewer go on to make a profit. 12 Month Performance Industry Description Biotech Health Care S&P % 20% 10% 0% -10% S&P Biotech S&P Health Care S&P 500 F M A M J J A S O N D J Companies in the biotechnology industry develop and manufacture large molecule drugs produced by living organisms. These drugs are used to treat patients with rare or hard to treat diseases ranging from cancer to HIV and Hepatitis. In biotech, companies with blockbuster drugs dominate the landscape. The industry saw incredible gains in the years prior to 2016, but saw a decline throughout the Presidential election season due to political scrutiny of high drug prices. Important disclosures appear on the last page of this report.

2 EXECUTIVE SUMMARY The biotechnology industry, much like the rest of the Health Care Sector, is defensive in nature. This has to do with its customer base. The patients who are treated with biotech drugs do not have many other options. The Federal Drug Administration (FDA) approval process consumes a lot of resources and the potential patient population is generally limited. For these reasons, patentprotected premium pricing dominates the industry. The patent and approval process also makes some individual equity investments a coin toss. A company can put all of its resources into its pipeline and not survive due to lack of a blockbuster drug. Established companies in the industry are starting to look for new ways to replenish their pipelines with promising compounds. They are doing this through mergers & acquisitions (M&A) and getting existing drugs approved for additional indications. This industry will provide returns in a stable economy, but there are questions about the repeal of the 2010 Affordable Care Act (ACA). Banner years for drug approvals were seen in 2014 (41) and 2015 (45), with many expected top sellers. While there were not as many approvals in 2016, the pipelines are full of promising drugs. We feel that the biotech industry has one more heavy growth stage before maturity, but recommend a rating of Market Weight through the uncertainty of possible regulatory changes regarding pricing. INDUSTRY DESCRIPTION The biotechnology industry has seen monumental growth since humble beginnings. From 2011 through 2015, the S&P 1500 Biotechnology index outperformed all others, up 309.2% compared to S&P Composite 1500 at 61.9% and 130.8% for the S&P Health Care index % 350% 300% 250% 200% 150% 100% 50% 0% -50% Cumulative S&P Composite 1500 S&P 1500 Biotech S&P Health Care The industry found some rough times during the Presidential election due to the focus on what are considered outrageous drug prices by politicians. During 2016, the S&P 1500 Biotechnology index dropped 12.8%, but has increased 3.6% since the beginning of Today, the biotechnology sector consists of over 1,200 companies and a market cap over $200B in The United States is the dominant player with 2015 revenues over $60B, as well as a market value of $360B. 3 Company Market Cap (Billions) 2016 Sales (Millions) 2016 Sales JNJ 1 $333.9 $71, % PFE , % MRK , % AMGN , % ABBV , % BMY , % GILD , % CELG , % LLY , % BIIB , % REGN , % ALXN , % ATLN , % INCY , % ILMN , % 1 Pharmaceutical Industry 2 Biotechnology Industry Page 2

3 Biotechnology covers a lot of areas, from biofuel to livestock feed, and to the focus of this report, biological medication. Biotechnology companies within the Health Care Sector focus on developing large molecule drugs extracted from living organisms to treat human diseases. The rare and otherwise incurable diseases treated by biologics cover an array of indications. These include autoimmune, heart, bone, liver, kidney, and brain diseases, among others. As the bigger biotechnology companies have started to mature, the sector has begun to behave like a traditional pharmaceutical company. In 2016, there were 326 M&A deals in biotech totaling $91B. The uptick in M&A activity correlates with recent decreases in R&D productivity among the twelve biggest companies reaching a 7-year low, as companies have begun using M&A as a tool to restock their pipeline. This was further aided by currently low interest rates. 4 Notable Deals Announced or Closed Since January 2015 M&A Activity Value (M) Shire acquired Baxalta 31,517.6 AbbVie acquired StemCentrix 9,793.8 Biogen spunoff Bioverativ to shareholders 5,128.9 Takeda Pharmaceuticals acquired 4,908.2 ARIAD Pharmaceuticals Allergan acquired LifeCell from 2,900.0 Acelity Holdings As well, more direct competition can be seen between pharma and biotech. This can be seen with AbbVie competing with Gilead in both Hepatitis C Virus (HCV) and oncology treatment areas. For these reasons, some have begun to combine pharmaceuticals and biotechnology as biopharma. Patents & FDA Approval Aside from the drugs attaining blockbuster status, patents and achieving FDA Approval are the most important part of a biotech company s success. There are three main types of patents that protect companies from biosimilars and other substitutes. The most important patent is a composition patent, which protects the biological or chemical structure of the drug. The second patent protects the drug for the specific use that the company plans. Finally, the third type of patent protects the product s manufacturing process. Patents in both Europe and the U.S. have a life of 20 years. 5 To develop and successfully bring a drug to the market can be both costly and timely, with average estimates of $2.6B and 95 months. 6 These figures stress the importance of having the proper patents in place to protect the investment. Typical drugs have a minimal amount of patent protection once on the market to recover research and selling expenses and make a profit. Once a potential compound is identified, preclinical studies are conducted on animals. If the company feels the drug is safe, they must apply to the FDA for an investigational new drug application (INDA). If approved, there are three phases in the clinical testing before market application. Phase I is focused on the safety of the drug, whereby it is administered in small doses to a relatively small group of healthy humans. If small doses prove safe, higher doses are administered to further prove the safety of the drug. In Phase II, which has the highest failure rate at 68%, the drug is given to a larger sample of people suffering from the disease. If proven effective and safe, Phases III ensues. Phase III is the lengthiest and most consuming phase of clinical trials. Double-blind studies are performed with a larger sample of people with the illness. Either a placebo or a drug previously approved for the illness is used to determine the relative effectiveness or the drug. It is estimated that the number of discovered compounds that make it through FDA approval is 1 out of % 80% 60% 40% 20% 0% Failure Rates at Various Stages of Drug Approval 36% 68% 40% Failure Rate 17% 89% Phase I Phase II Phase III NDA Phase I to Approval Data Source: Ernst & Young Page 3

4 RECENT DEVELOPMENTS Potential Repeal of Affordable Care Act A lot of speculation and uncertainty surrounds the new President s desire to reform the Affordable Care Act (ACA) of While it is unlikely to be fully repealed, the exact changes could have enormous effects on biotech. It is being proposed that Medicaid be allowed to directly negotiate with drugs companies on prices. Prior to the 2010 ACA, Medicaid drug rebates were at 15.1%, but rose to 23.1% due to the reform. 9 While it will not happen overnight, if it does at all, any further increases in the rebate could lead to decreased investment into novel research. Number of Approved Drugs In 2016, the FDA only approved 22 new drugs. This comes after levels of approvals reaching a 19-year high in 2014 and This can be partially offset by six approvals that happened in late 2015 (45 total) that were originally scheduled for early FDA New Drug Approvals Data Source: U.S. Food and Drug Administration Priority Review Vouchers Started in 2007 by the FDA, the priority review voucher (PRV) can be awarded when a new drug or vaccine is developed for rare pediatric diseases or infectious diseases such as cholera, leprosy, malaria, tuberculosis, and Zika, to name a few. The owner of the voucher is entitled to an expedited decision on one-time basis (from ten months to six months). This has led to companies trying to get a drug to market only to obtain a golden ticket. It is not necessarily that the drug will be a blockbuster, it is because big biotech and pharma companies will pay top dollar to purchase the voucher for themselves a wild card of sorts. Timing is everything. In July 2015, while Amgen received approval for cholesterol drug Repatha in Europe before Sanofi/Regeneron s Praluent. The opposite occurred in the US, though, due to Sanofi/Regeneron using a PRV. That particular voucher was bought for $245M from Retrophin, who had obtained the voucher as part of an acquisition. The highest amount paid for a voucher was $350M by AbbVie to United Therapeutics in August While this is not a significant market indicator, it shows the importance of patents, the lengthy approval process, and the emphasis that is placed on infectious and rare diseases. Orphan Drugs INDUSTRY TRENDS A medicine can be designated as an orphan drug if is designed to treat an illness or disease that affect a small population of people; a maximum of 200,000, 250,000, and 50,000 patients in the US, Europe, and Japan, respectively. Sales of orphan drugs are forecasted to grow by 11% per year and approach $178B in sales and 19% of all prescriptions by Multiple factors have led to the rise in orphan drugs. Due to how rare and life-threatening the indications are, premium pricing is seen in orphan drugs, with 17 of the 20 highest priced drugs in 2014 being orphan drugs. In 2014, the average cost per patient for orphan drugs ($111,820) was nearly five times that of non-orphan drugs ($23,331). Aside from the lucrative pricing, companies enjoy sevenyear marketing protection after approval and R&D tax credit of 50%. 12 Top Selling Orphan Drugs in 2016 by Sales Drug Company 2016 Sales (Millions) Humira AbbVie $16,078 Enbrel Pfizer/Amgen 8,874 Rituxan Roche 7,300 Remicade Johnson & Johnson 6,966 Revlimid Celgene 6,774 Neulasta Amgen 4,648 Copaxone Teva 4,223 Page 4

5 Mergers & Acquisitions Among the 326 M&A deals related to biotech totaling $91B, the largest was Shire PLC acquiring Baxalta for $32B in June. 13 This further illustrates the blending of pharma and biotech. Gilead Sciences continued its string of recent M&A deals in 2015 by acquiring Nimbus Apollo. In January 2017, Celgene acquired Delinia, Inc., diversifying its inflammation and immunology pipeline. 14 Increased Development of Oncology Drugs Cancer is noted to be closing the gap on heart disease to become the leading cause of death worldwide. The number of cancer diagnoses in the US is forecasted to rise from 1.7M in 2015 to 2.4M in These forecasts combined with advanced technologies have put oncology drugs at the forefront of the biotech pipelines. Cancer treatment spending is expected to total $150B by 2020 after increasing from $84B in 2010 to $107B in Company MARKETS AND COMPETITION Market Cap (Billions) 2016 Sales (Millions) 2016 Sales 2016 Profit Margin JNJ 1 $333.9 $71, % 23.0% PFE , % 13.7% MRK , % 9.9% AMGN , % 33.6% ABBV , % 23.2% BMY , % 22.9% GILD , % 44.4% CELG , % 17.8% LLY , % 12.9% BIIB , % 32.3% REGN , % 18.4% ALXN , % 12.9% INCY , % 9.4% ILMN , % 19.3% 1 Pharmaceutical Industry 2 Biotechnology Industry Amgen Inc. Amgen claims to have the most diverse set of drugs, utilizing eleven different modalities combined in their current products, pipeline, and drug discovery. 16 Among the competitors in this report, Amgen also boasts the widest array of treatment types. As of the end of 2015, these included their top seller ENBREL, mainly used to treat rheumatoid athritis, Neulasta, used in hematology/oncology, and Aranesp and EPOGEN, used to treat anemia related to chronic kidney disease. Together, these drugs accounted for 66% of their 2015 product sales of $20.9B, with ENBREL contributing 26% and Neulasta 22%. 17 Amgen s current pipeline contains twelve drugs currently in Phase 3 of development for new or expanded use, with half in the hematology/oncology treatment area Revenue R&D/Rev SG&A/Rev AMGN 22, % 22.0% ABBV 25, % 22.8% GILD 30, % 11.2% BIIB 11, % 17.0% CELG 11, % 23.7% AbbVie Inc. (in millions) Spun off of Abbott Laboratories in the beginning of 2013, AbbVie is a major player in biopharma. This is largely due to the success of Humira, which is a competing drug to Amgen s ENBREL and used to treat a variety of autoimmune diseases. Humira totaled over $14B in revenue in 2015, an increase of 12% from However, this leaves AbbVie vulnerable to Humira biosimilars due to the US patent expiring in December AbbVie s 2015 purchase of Pharmacyclics aided in stocking their pipeline with oncology drugs, one of which is expected to be a star in cancer treatment. Revenue 2016 RORC R&D 2016 R&D 2015 AMGN 6.1% % -4.4% ABBV 12.2% % 30.0% GILD -6.9% % 5.6% BIIB 6.4% % 6.3% CELG 21.3% % 52.1% RORC=Return on Research Capital Page 5

6 Gilead Sciences Gilead Sciences, along with Amgen, is a biotech giant that has had multiple blockbusters for the treatment of Hepatitis and HIV. Of the 2015 product sales of $32.1B, Harvoni, for the treatment of Hepatitis C, accounted for $13.8B. Recently, Harvoni has encountered competition from drugs recently released by AbbVie and Merck. This, as well as other competition, has led to decreased revenues and a decrease in stock value. Gilead released Epclusa, designed to treat all genotypes of HCV, in January Epclusa was introduced at a lower price than Gilead s other HCV drugs, Harvoni and Sovaldi. This is thought to be in response to scrutiny over high drug prices. direction is their weak pipeline, with only two brain drugs and one cancer drug in Phase III. 22 ECONOMIC OUTLOOK Aging Population & Obesity As health care advances, so does the life expectancy of humans and the prevalence of chronic conditions. This is compounded by the fact that the population is aging as a whole. Not only do these factors increase health care spending, and in turn fuel biotechnology revenue, it potentially creates unmet needs with newly-found illnesses. Gilead has a decent pipeline. They currently have eight drugs in Phase III. Three of those are for hematology/oncology, as Gilead looks to diversify their portfolio. 20 Through their HIV and HCV franchises, Gilead achieved a profit margin of 44.4%, which is the best in the industry. However, this may change as HCV revenues fall and Gilead scrambles to find more sources of revenue. Celgene Corp. Oncology drug specialist Celgene possesses a very promising pipeline of oncology drugs with 10 ongoing Phase III trials. In 2015, they spent nearly 40% of their revenue on R&D. Celgene also posted a 20.7% increase in revenue in 2015, in large part due to continued sales growth of Revlimid. This drug is in competition with the AbbVie/Johnson&Johnson drug Imbruvica. Revlimid, which brought in $5.8B in 2015, is currently in Phase III trials for additional indications and shows potential for further future sales growth. 21 Data Source: CMS Chronic Conditions Among Medicare Beneficiaries Chartbook 2012 Edition Estimates for had obesity rates above 35%, up from 13% in Along with these rates, the cost of health care related to obesity has followed upwards, amounting to an estimated $3,500 in higher costs per obese person. 23 Biogen Biogen, which specializes in the treatment on multiple sclerosis, seems to be at a crossroads. They experienced below average revenue growth relative to these competitors and dramatically slowed down R&D growth. As well, earlier this month they spun off their global hemophilia business. The worst indication of their Page 6

7 CATALYSTS FOR GROWTH Population While the population is not expected to grow at historic rates, annual world population is expected to continue growing in excess of 1% every year through This increases the occurrence of rare genetic diseases and hosts for infectious diseases. INVESTMENT NEGATIVES Healthcare reform could cause increased drug rebates for Medicare patients. This could lead to reduced access to capital for smaller biotech companies. Potential for biosimilars to erode premium pricing and decrease revenues. New pipeline drugs are not guaranteed blockbusters. Only a small percentage of identified compounds make it through FDA approval and even fewer go on to make a profit. VALUATION Steady Revenue Increasing Wealth in Emerging Markets Recent developments in the standards of care in emerging markets opens up opportunities. In places like the United Arab Emirates, investments in infrastructure and health care are taking place to provide an environment of health care tourism. Emerging markets serve to widen the base of possible patients for biotech drug treatment. INVESTMENT POSITIVES As long as there are people, there will be illnesses and disease. We believe that biologics will continue to move to the forefront of prescription sales. The rare or incurable nature of most of the biologic indications will continue to largely enable biotech companies to charge premium pricing. Advances in diagnosis and presence in emerging markets will provide biotech with an increasing patient base. Among the five competitors researched, only Gilead Sciences experienced decreased revenue in The other four continued upward trajectories with revenue growth near or above that of With strong representation in Phase III of their pipelines and recent increases in R&D expenses, we expect Celgene and AbbVie to increase market share within their treatment areas Biologic Patents Revenue AMGN ABBV GILD BIIB CELG Data Source: CNN Money By nature, biologic drugs are large complex molecules. This has led to patent protection being more complex as well. Due to the manufacturing process, any intermediate molecule could potentially be patented, as well. The manufacturing is also costly. Of the few biosimilars that have made it to market, they are not selling at near the discount that traditional substitute pharmaceuticals do. A tactic that makers of the original drug are utilizing is to Page 7

8 manufacture the biosimilars of their own drug before others do. Through 2020, very few major biotech drugs are set to expire. When combined with multiple drugs approved in 2015 expected to be blockbusters, there appears to be decent short-term upside. KEYS TO MONITOR Further Health Care Reform If scrutiny of drug pricing turns into action and pricing restrictions, it could be detrimental to the startup biotech landscape. Every biotech starts with the dream of one blockbuster. If the reward is minimized by regulations on the back end, it will make capital harder to come by in an already boom or bust industry. Advances in Oncology Treatment For years, researchers have been waiting for the breakthrough cancer medication. Many believe it is on the doorstep. With increased emphasis and R&D expense going towards oncology pipelines, we hope they are right. Pipelines With some companies slowing down R&D expenses and/or engaging in M&A, they must be sure to keep their pipeline loaded and diverse. This will be especially important if biotech and pharma continue to integrate. Celgene WHO TO WATCH FOR Celgene has recently been a rumored takeover target for the biggest companies in the industry and for good reason. There is currently no company expanding oncology treatment like them. Sales of Revlimid helped them grow revenue over 21% in As well, they followed up 51% R&D spending growth in 2015 with growth of nearly 21% in They currently have 10 oncology drugs in Phase 3 trials and even if one becomes a blockbuster Celgene could be here to stay. REFERENCES 1. Loo, J. (2016, August) Industry Surveys: Biotechnology. database. p S&P 1500 Biotechnology (SI) chart, prices, and performance FT.com. indices/tearsheet/historical?s=sp :iom. 3. Mergent Industry Reports: Biotechnology Sector September 2016 p Mergers & Acquisitions Could be a Key Catalyst for Biotech Stocks in 2017: Today's Reports on Cellect Biotechnology and Celldex Therapeutics. acquisitions-could-be-a-key-catalyst-for-biotech- stocks-in-2017-todays-reports-on-cellect Loo, J. (2016, August) Industry Surveys: Biotechnology. database. p Loo, J. (2016, August) Industry Surveys: Biotechnology. database. p Loo, J. (2016, August) Industry Surveys: Biotechnology. database. p Loo, J. (2016, August) Industry Surveys: Biotechnology. database. p New drug approvals fall to 6-year low in 2016 Reuters Priorityreviewvoucher.org 11. Loo, J. (2016, August) Industry Surveys: Biotechnology. database. p s Biggest Mergers. news/2016s-biggest-mergers html. 13. Celgene splashes out $300M on Delinia autoimmune biotech buy FierceBiotech. fiercebiotech.com/biotech/celgene-splashes-out- 300m-delinia-autoimmune-biotech-buy. 14. Loo, J. (2016, August) Industry Surveys: Biotechnology. database. p The_Shape_of_Drugs_to_Come.pdf. ience/pdfs/the_shape_of_drugs_to_come.pdf. Page 8

9 16. Amgen.com Corporate Website. February AMGN K 18. ABBV K 19. GILD K 20. CELG K 21. BIIB K 22. Obesity is Hurting the U.S. Economy in Surprising Ways - Bloomberg. articles/ /american-economy-has-aweight-problem-as-costs-of-obesity-mount. IMPORTANT DISCLAIMER Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. Page 9