Top Biotech Resolutions for 2017

By Todd Campbell and Kristine Harjes Markets Fool.com

Battered by bad news, beaten-up biopharma has some work to do to restore investor confidence in 2017.

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The industry remains under scrutiny because of pricing decisions, pipeline failures, and profit concerns. What can top stocks likeGilead Sciences(NASDAQ: GILD) andValeant Pharmaceuticals(NYSE: VRX) do to win back investors?

In this episode of The Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes is joined by Todd Campbell to offer up some resolutions they'd like biotech's C-suite to stick to in 2017. Could these ideas get the industry back on track? Listen in to find out.

A full transcript follows the video.

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*Stock Advisor returns as of January 4, 2017

This podcast was recorded on Jan. 4, 2017.

Kristine Harjes:Welcome toIndustry Focus, the podcast that dives into a different sector of the stock market every single day. I'm your host, Kristine Harjes, and it is January 4th, 2017, meaning it's our firstHealthcareepisode of the new year. Healthcare contributor Todd Campbell is joining me via Skype. How's it going, Todd?

Todd Campbell: Hi, Kristine! How are you?

Harjes: I'm great. Welcome to January!

Campbell: Yeah, Happy New Year!

Harjes: Thanks! It's my birthday month, I'm excited.

Campbell: Exciting!

Harjes: So, we are jumping the gun a little bit this week and talking resolutions. I say we're jumping the gun because next week we'll actually get to our individual financial resolutions across the entire Industry Focus team. But Todd and I thought it would be fun to do this first show on resolutions that we hope healthcare companies are making in 2017. 2016 was a pretty brutal year to be a shareholder in many healthcare companies. The biotech sector as measured by the IBB was down 18%. There were plenty of individual companies as well across the entire healthcare spectrum that bled even worse than that. So, it's a new year. Todd, do you think they're going to turn around?

Campbell: Listen,I'm an optimist at heart.

Harjes: Tough sector for that.

Campbell: Yeah. Let's hope that a lot of the damage had been done, and some of these biotech companies make some smart moves and get a little bit more successful. We saw a lot of surprising disappointments last year, and hopefully we won't get a repeat this year. I'm sure we're going to address some of those resolutions, but before we get into that,I'm going to put you on the spot.

Harjes: Oh, boy.

Campbell: Do you have any personal resolutions for this year?

Harjes: I have financial resolutions for sure. Those I'm going to save for the next show. I don't have any non-financial ones specifically. Do you?

Campbell: Well, my goal would be, like many Americans, once we get up into middle age -- God, I hate saying "middle age." But starting to put on a few pounds more than I'd like to have. So I'm going to try and drop a couple pounds.

Harjes: Yeah, that's the holidays. All right, good for you. Best of luck with it.

Campbell: Well, I figure it's healthcare-oriented.

Harjes: Yeah, that's pretty related, I would say. All right, great. Let's get to giving some of these companies some advice. Hopefully we have a coupleexecutives listening in,trying to see what Kristine Harjes and Todd Campbell wouldlike them to do in 2017.

Campbell: Hey,as we've seen in the past,that wouldn't shock me.

Harjes: (laughs) Younever know. The first company we want to talk about,and this one couldn't possibly be a surprise toany of our regular listeners,Gilead Sciences. What do youthink they need to resolve to do in 2017?

Campbell: Gilead Sciences needs to lose a little weight, too.

Harjes: (laughs) Yeah! That'sa good way of putting it. This is a pretty bloated company,if you're talking about cash. They have $32 billion just sitting there in cash andequivalents,and it's been weighing them down.

Campbell: Oh, boy. They haveso much money on the balance sheet, andit's almost like investors are, "Do youeven know what you want to do with it?" They've saidover and over, quarter after quarter, "We want to put it to work, we want to buy smart, we want to acquire companiesat the right price." But we've also, at the same time, seen a lot of high-profile deals get gone that could have reignited investor enthusiasm last year. Gilead Sciences has struggled a bitover the last 12 months -- declining sales because of lower unit volume growth forhepatitis C and some price competition. They could use some positive news here in 2017 that helps show investors, "This is our path forward to growth."

Harjes: Yeah. I give this company a lot of credit,and I do trust their management team a ton, but some time in 2017, they're going to have to pull the trigger.

Campbell: You would think so. They've been pretty smart about raising money and padding that balance sheet at cheap rates. They have the dividend that they're paying out to people, you could argue, wouldn't that money be better off used somewhere else? But right now, they're not using that money for anything, so, yeah, give it back in a dividend.

Harjes: Right, that or those share buybacks. They've been very generous about those.

Campbell: They did $10 billion worth of share buybacks in the first three quarters of the year, but that's slowed down dramatically. In Q3, they only bought back about $1 billion, and a lot of people thought it was maybe a sign that they were getting ready to make a push and do a deal. I don't know. There's no question that M&A valuation has gotten off the charts crazy.Medivation went for about 14 times sales. I've seen some studies that say we're now in the mid to high double digits. There's a deal out there right now that's being theoretically negotiated forActelionbetweenJohnson & Johnson, Actelion, andSanofi,and that could be at a multiple of 14-15 times sales. So, I understand that these deals are pricey now. But at the same time, you have a company likePfizer, who also has a ton of cash out there, and they gave investors a pathway toward their growth. They made a big splash with biosimilars, which could be a big market over the course of the next decade. We'll call it, for lack of a better term, generic drugs biologics. It's a new thing we've talked about in the past on the show. And then, of course, with buying the leading prostate cancer drug, they showed that they're committed to growing in cancer. So, I think Gilead needs to make some of those same kind of moves to show investors, "This is how we're going to grow over the course of the next five or ten years."

Harjes: Right. And speaking of cancer, they did give us a little bit of a clue recently. I forget if the news came out this morning or not, but it was within the last couple of days. They just hired a new senior vice president ofhematology and oncology. This is somebody namedAlessandro Riva, who comes fromNovartis, wherehe was the head of oncology. This suggests to methat that's what they're looking to do -- beef up their oncology unit. It'snot done well in the past,but I think they're going to be persistent about it. IfI had to guess, I would say that is the field in which we'll see theacquisition made when and if it comes.

Campbell: Right. I absolutely agree with you. They're obviously committing to it. Zydelig has not been a success for them since its launch. We'll see. Maybe we should startmaking a list of possible targets in cancer.

Harjes: That would be a fun show, who Gilead could buy.

Campbell: Absolutely.

Harjes: Let'smove on to another company.This is an even more troubled companyover the past year than Gilead Sciences --Valeant Pharmaceuticals, which is acompany that is down85%over the past year. What do they need to do?

Campbell: Something.

Harjes: (laughs) Anything?

Campbell: (laughs) Anything. Valeant is a struggling company. It had thiswonderful business model that everybody was walking to years ago, where you buy a drug or acquire a company, you reprice that drug higher, and then you relaunch it with a brand-new marketing campaign. They chose to go that route and forgo internal development of candidates. They're one of the drugmakers that invests very little historically, relative to peers, in their own internal R&D pipeline. So, now they've run into a situation where they're incredibly heavily indebted, they've run afoul of regulators on some of their past practices for sales and marketing, and that's cast a long shadow over them. How is this company going to go from all of the struggles it's been enduring and be able to show investors, "This is how we're going to succeed in the future?" They'redoing some things right, but there's still a lot of question marks out there that I think they need to resolve to put those question marks behind them, and show investors, "This is where we're going to be in the next three years, five years, 10 years."

Harjes: Right. They havea couple of different ways that they could go abouttrying to turn themselves around.I do think we need a little bit more guidance onwhat exactly that will be. One thing that many investors have speculated is that they could sell part of the company, in particular, one name that comes up, theBausch+Lomb subsidiary of Valeant, which makes up roughly half of their revenue. This is a company that they acquired back in 2013 for $8.7 billion. Back then, it was generating $3.3 billion in annual revenue. This unit is now generating $4.6 billion annualized, based on Q3 earnings. So, in theory, that could make it worth around $12 billion, although everybody knows that Valeant is under pricing pressure and under all sorts of scrutiny, so I'm not sure what they would even be able to get for this unit at this point. It's such an interesting contrast to theActelionbidding that you mentioned earlier with J&J, where the pricing is just going up and up and getting inflated. I think Valeant is the complete opposite right here.

Campbell: Right. They're just not in a power position. They don't have the bargaining power. Frankly, Bausch + Lomb is the crown jewel of their organization. It's the only one of their three segments that posted year-over-yeargrowth in the Q3. My fear would be,you get rid of that unit, and you're left with the other stuff,to be diplomatic. Theseother parts of the business that aren't nearly as attractive. So yeah, if they go out, and they might get $12 billion, you're still stuck with $20 billion of debton the balance sheet, and now you have two slow-growing or no-growingparts of the business that are left. It's almost like they need to rebrand themselves, get rid of the Valeant name, take the Bausch + Lomb name, and tossthe other parts of the business to whoever will take it, say, "Take itoff our hands and take some debt with you."

Harjes: Yeah,trim the fat. I could see that, too.

Campbell: It'sgoing to be a very interesting year for them. The other thing I'd like to see them do, Kristine, and I knowyou and I follow this stock, quarter after quarter after quarter, they'vecontinued to cut their estimates, where they think they're going to earn. You can'tcontinue to do that and restore confidence.

Harjes: Yeah, those arediametrically opposed.

Campbell: Right. You have to rip the band-aid off. We have newmanagement there, that should encourage some people. That's good news. But you have to rip the Band-Aid off,you have to lowball those estimates for 2017, and then overdeliver. If they can do that,I think you restore some confidence. People start to get a little bit moreenthusiastic. You cutsome of that SG&A expense. Their SG&A as a percentage of revenue is about 27%. To put that in perspective, that's like 5% higher than J&J. That's double what Gilead Sciences is. Theyhave to do a better job,if the sales are going to decline, of keeping up on cutting the SG&A.

Harjes: Thatactually sounds extremely New Year's resolution-y. Make a fairly small goal and knock that one out of the park,as opposed to saying, "I'm going to lose 20 pounds," and when you don't lose it, youimmediately give up.

Campbell: Right. If you'reworking in the right direction,show investors that you are indeedworking in thatright direction. You can't just say, "Well, sequentially, we're seeing some improvement," and then cut forward guidance. That's not going to do it. You have to say, "Sequentially, we're improving, and look, we're exceeding the guidance we gave you." If they can do that,they don't need to sell these other parts of the business, they have some time. Andeventually, the year-over-yearcomparisons will get easier. As long as creditors are willing to play ball with them,and I think at this point they are, then 2017 could,if they play this right, end up being a transition year.

Harjes: Andthat's how you build back up the confidence.OK, Todd,let's get rolling with another company that we think should have a pretty firm resolution.

Campbell: You know what?I'm going to throw the entire biotech industryinto this one. I think biotech needs to take a really hard look -- biopharma, we'll say -- at the way they're pricing their drugs. They need to focus on innovation, and stop focusing on growth through price increases. Setting arbitrary, "We're not going to increase our prices more than 10%," and going right up to 9.9% --

Harjes: You're calling out Brent Saunders, aren't you?

Campbell: A little bit.Allerganwas at the forefront of saying, "We need to self-regulate on pricing, and we're going to commit to our consumers that we're not going to raise our prices more than double-digit rates." Sure enough, the reports fromdifferent Wall Street analysts who tracked the pricingshow that he did, indeed, comeunderneath that double-digit rate, but 9.5%? Consider the optics here, people. If inflation is 3%, and you're going at about 9% to come underneath 10%, I feel like thatdoesn't do a whole heck of a lot to encourage the average person who's reading this news flow and saying, "Great, I guess it's less than 50%, and it's less than 20%, but come on."

Harjes: To be fair, if you look at the industry as a whole -- and I don't think this is an excuse for Allergan -- relative to the broader industry, a 9.5% increase is actually not that much. The average price of a brand-name drug increased 16.2% in 2015. Those are the latest numbers we have from theExpress Scripts Drug Trend Report. Theseprices have also increasedalmost 100% since 2011. One-third of branded drugs increased their price by more than 20% in 2015. Which is just crazy. And it's veryindicative of this industry, where prices are inelastic. Can youimagine the price of aChipotlebowlgoing up 10% every single year? It wouldn't happen.

Campbell: Yeah, it wouldn't. You make a fair point. It's the right direction, and it shows that there's asocial consciousness, a social contract out there, to try and contain these increases. I thinka lot of people are looking at it and saying, "Butwhat's behind those increases? Did the cost to produce these drugs really increase 10%, and you're passing that cost on? Or did the cost toproduce those drugs increase 4% and you're padding profit by an extra 5%?"I think it's a fair question to ask. I think we have to move beyond this. We have to focus on innovation. We have to focus on how these drug companies are improving the lives of consumers and patients. AndI don't know whether or not we're going to be able to do that in 2017.

Harjes: But at its heart, that is what this sector is about. That's why I love it.I'm sure you're the same way.

Campbell: Oh, absolutely. It's fascinating. We see thephenomenal work that's getting done by companies, which actually is a nice segueinto another one that I have. Let's resolve to stop hyping early stage phase 1 results.

Harjes: Ooh, this is a good one.

Campbell: Right? Let'sstop going out there and saying, "Hey, we have this great phase 1 success story!" In a bid to beingable to do an equity offering, getting peopleconvinced that this is going to be the next drug that'sgoing to revolutionize Alzheimer's or whatever. Let's focus more on phase 3 drug successes and growth for drugs that arealready on the market, tied to unit volume, not pricing.

Harjes: Yeah. Theresponsibility for this one has got to fall both on the companies themselves for producing the hype, but also on investors. You can't blame people for being excited about new,innovative drugs. But onceyou actually translate that into the financial markets, and you get these bloated valuations for very, very early stage companies, you get the volatility and the heartbreak that we've seen in a company like, say,Anavex. You mentionedAlzheimer's. This is a company that wastaking a completely different approach to Alzheimer's. They had great phase 1 data, and thenall of the sudden, phase 2A, nope, there was a slight deterioration, actually, in the patients' mental abilities, and the stock plunged 50%.

Campbell: Yeah. As investors,we need to hold these companies accountable by not buying shares based on phase 1 data. Kristine,you and I have talked about it before --90% of drugs fail in clinical trials. 90%! So,the likelihood of a phase 1 success translating into an FDA-approved drug that's going to be a billion-dollar blockbuster? Small. Very small.

Harjes: Yeah. And maybe,if there wasn't so much hype about early stage candidates, you would find thelarger companies like Gilead better-able to make early stageacquisitions, because the prices wouldn't be as bloated. It's all related.

Campbell: And,theoretically, they might havea greater level of experience that allows them to recognize failures earlier on. So, yeah. I think,we can hold them accountable,but they should also be holding themselves accountable, and they should resolve to do that this year.

Harjes: Right. Speaking ofexperience, I think we have time for one more resolution. This one I'm going to give to manufacturing issues. Across the entire industry, we need to stop having drugsrejected by the FDA because of manufacturing issues. If you have a drug that works and is safe,it needs to be able to get the patients without being blocked by your facility not being up to par.

Campbell: Yeah. There were a host of them last year, Kristine, that we talked about, where the FDA said, "No, we're going to push back on this because we have some questions about how these drugs are going to be manufactured." I don't want to say it's ridiculous, but come on. We've been making biologics for a long time. A lot of these monoclonal antibodies, etc., they've been produced for a long time. For me, I struggle to understand how it is that large companies -- I'm going to call out Sanofi andRegeneronon this one -- how they're having some problems with their manufacturing that's causing delays in approval.

Harjes: Right. The Sanofi-Regeneron story, that one was a heartbreaker. Back in October of 2016, theyreceived a complete response letter, a CRL,which is basically a thumbs down from the FDA, for arheumatoid arthritis drug,because of manufacturing issues in one of the Sanofifacilities in France. This was where the drug wasfilled and finished --the very last step of the process. Interestingly, the active ingredient isn't even made there. It'smanufactured by Regeneronall the way over in New York. But just because of this one last step in the process that the FDA had some sort of issues with the facility, all of the sudden, they need to refile and fix these problemsbefore it can actually get to patients.

Campbell: Right. This was a drug that could have gotten approval in lateSeptember or early October. It could potentially be a $1 billion drug forrheumatoid arthritis. It showed really goodresponses versus Humira. And now you're wondering, what happens in March? We haveanother drug coming upthat is also getting filled in, finished at that samefacility. Will that get approved, or will it get delayed?

Harjes: Yeah.I think this would be a really good resolution for not just Regeneron and Sanofi particularly, but across the board,because we have seen it happen too many times in the past year.

All right, well,I think we're about out of time. Todd, thank you so much for helping me come up with this list. Hopefully, some ears thatcan actually make these resolutions happen will be listening in on us. Folkslistening, if you have any questions for us or just want to say hello,maybe give us some ideas for resolutions of our own, email us. Our email address is industryfocus@fool.com. Wealso have aTwitteraccount, the handle is @MFIndustryFocus. Asalways, people on the program may have interests in the stocks that they talk about, andThe Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. For Todd Campbell, I'm Kristine Harjes, have a Happy New Year and Fool on!

Kristine Harjes owns shares of Chipotle Mexican Grill, Gilead Sciences, and Johnson and Johnson. Todd Campbell owns shares of Gilead Sciences and Pfizer. The Motley Fool owns shares of and recommends Chipotle Mexican Grill, Gilead Sciences, and Valeant Pharmaceuticals. The Motley Fool recommends Johnson and Johnson. The Motley Fool has a disclosure policy.