3 Healthcare Stocks for Your Radar

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The healthcare sector is one the most exciting and volatile industries out there, with clinical trial results and administrative changes having the potential to make or break so many companies. Still, there are players in the space that have some nice padding against too much of that risk, and investors might do well to get some exposure to them in their portfolios.

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In this week's episode of Industry Focus: Healthcare, three Motley Fool healthcare writers pitch some of their favorite healthcare stocks. Listen in to find out what's so exciting about Novocure (NASDAQ: NVCR), Foundation Medicine (NASDAQ: FMI), and Celgene (NASDAQ: CELG), and the most important risks investors need to know before buying into any of them.

A full transcript follows the video.

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This video was recorded on Oct. 18, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Kristine Harjes, and it's Oct. 18. I'm very excited to be able to do another completely in-studio episode today for the continuation of our Pitch Week. Joining me in studio to discuss stock pitches from three of fool.com's finest healthcare writers is Vince Shen. Vince, how's it going?

Vincent Shen: I'm doing very well. I'm very excited to be here to talk about these healthcare companies.

Harjes: Well, thanks for joining me. We're about to hear about Novocure, ticker NVCR; from Brian Feroldi, Foundation Medicine, ticker FMI, from Todd Campbell; and Celgene, ticker CELG, from Keith Speights. Austin, let's hear pitch one.

Brian Feroldi: My name is Brian Feroldi. I cover healthcare and technology for fool.com. The company I'm talking about today is called Novocure. The ticker is NVCR. They are a $1.6 billion company or so, and they are a medical-device maker that's focused on cancer. Historically speaking, healthcare providers have had three tools to fight cancer. There's surgery, radiation, and chemotherapy. More than a decade ago, Novocure's founder discovered a brand-new modality of treatment. They called this discovery tumor-treating fields, or TTFields for short. In essence, Novocure discovered that surrounding a cancerous tumor with electric fields that are tuned to a specific frequency inhibit cell division. As a result, a cancerous tumor that is surrounded by these TTFields has a much harder time growing and in some cases can even shrink.

Novocure's first target for this new therapy is a deadly type of brain cancer called glioblastoma multiforme, or GBM. Novocure took its knowledge of TTFields and won FDA approval for a product called Optune. Optune kind of looks like a winter beanie hat with a cord coming out at the back. Inside the hat that the patient wears on their head is transducer rays that emit the electric fields when the device is turned on. The patient puts the hat on, plugs the cords into a battery array, an electronics kit that is carried around is about the size of a lunch box, and when turned on, the device starts to emit these TTFields, and they go to work on the tumor inside their brain. 

This modality of treatment is highly attractive for a couple of reasons. First, using Optune is completely non-invasive and has no systemic toxicity issues. You cannot say the same things about surgery, radiation, or chemotherapy. Anybody who knows somebody that has gone through those treatments knows that they are highly invasive and can often have many side effects. Second, Optune can be used by the patient right in the comfort of their own home, so there's no extra trips to the doctor's office. Once they get started, they literally use the product at home and to live their life. Finally, Optune can be used by itself, or it can be used in combination with other therapies. That means it's not a threat in any way to the big pharma companies that focus on cancer treatments, so there's no company out there that's really trying to hold TTFields down.

When I first learned of this technology I was extremely skeptical, because it almost sounds like magic. You basically put the device on your head, and somehow it treats brain cancer. However, Novocure produced some really interesting data earlier this year from a five-year study that showed that adding Optune to standard-of-care chemotherapy more than doubled five-year survival rates in patients with GBM. So that was really exciting, and that study really helped to knock down some of the barriers to adoption. 

Fast-forward to today. Optune is on the market. It's now covered by more than 90% of healthcare plans. So the device is actively being paid for. As of June, Optune was available in the U.S., Switzerland, Germany, Israel, and it just recently launched in Japan. About 1,400 patients were using Optune, and that figure grew 64% year over year. Since Optune costs $17,000 per month to use, that translates into more than $38 million in revenue last quarter. So the opportunity in GBM is quite large. Optune has 1,400 patients. Management believes that in its current markets, that its addressable market opportunity is about 13,000 patients. So that's a 10x growth opportunity. 

However, the thing that's really exciting about Novocure is, they believe TTFields can be used in many different types of cancer. The company has several phase 2 or phase 3 studies going on right now using Optune in brain metastases, lung cancer, pancreatic cancer, ovarian cancer, and mesothelioma. To put those disease states in context, about 300,000 patients are diagnosed with those cancers in the U.S. alone each year. So if TTFields works in those indications as well as it does in brain cancer, the upside is massive. 

Now this is an unprofitable company at this point, which is the biggest risk. However, management believes that it can become profitable based on its GBM opportunity alone. Its cash burn is decreasing every year, and the company has $185 million in cash on its balance sheet. They believe that should be plenty to get them the profitability without having to raise any more cash. Again, the company is called Novocure, NVCR.

Shen: OK, Kristine. I'm coming from this as a complete beginner. Very little experience going into the healthcare sector. It was a bit of a trial by fire, reading about these companies, trying to get a grasp of what they do in the indications of their various treatments. But this was a really interesting one to me. I thought it was very impressive what they're trying to do with this TTFields technology, and going through the website and seeing how non-invasive it seems. The devices on the head, for example, it just looks like a swim cap.

I was curious, from what I was reading, it seems like, in the past, traditional treatment for cancers has been with either the surgery and then the chemotherapy or radiation. Do you feel like, with Novocure's Optune, that they have managed to clear a hurdle in terms of acceptance? Speaking to you previously before the show, you seemed to show a little bit of skepticism. I'm curious to hear your thoughts.

Harjes: I do have a bit of skepticism with this company, because it sounds absolutely insane. Put this skull cap on and it's going to get rid of your brain cancer. Of course, it's not quite that simple. Mostly, what this cap is doing is prohibiting the tumors from growing. Sometimes it does shrink them, but in general it's going to be used alongside other more traditional therapies.

When I think about it from a doctor's perspective, I can see them using it in addition to the more traditional things as long as they know about it. I don't have a perfect knowledge of how much the doctors that treat this very particular form of brain cancer do know that this exists. But I have to imagine that, because it's such a niche disease, there's a community of doctors that they do talk about this kind of thing. Hopefully, they can share their experiences with each other and have word of mouth really do the marketing for this product. That's something that's a struggle for a lot of early-stage healthcare companies. If you just have one product on the market, you might not have the gigantic marketing team. So using that doctor community and the patient community as well is extremely important.

Shen: You mentioned the marketing aspect of it. Since the technology is so new, and they've had some positive test results -- but again, not every medical professional might be aware of it and how effective it might be. Besides what I imagine to be significant research-and-development investments and the spending there, does marketing tend to be pretty big expense line item for companies that are at this stage, maybe $1 billion? It's kind of small, relatively.

Harjes: Yeah, absolutely. It's one more reason that you always want to be looking at the balance sheets of these companies, to say, how much cash do they have on hand, and at what point are they going to be profitable?

One thing that Brian mentioned that I think is a very strong selling point for this company is, management thinks it will be profitable just based on just this one indication alone. That's without building in the expectation that it will get the label expansions. Cash burn is decreasing, he says. They have $185 million in cash, and that should carry them all the way through to profitability. But that's not always the case in healthcare. Many times, you see companies needing to issue a bunch more shares to pay for their marketing expenses, or relying on a bigger partner to lay out an agreement where the partner will do the marketing for you, but they're going to take a cut of revenue. So Novocure being able to avoid that is actually a pretty strong selling point.

Shen: I saw that the company, with the help of patents, which is very common for these biotechs, the TT treatment field, they kind of have those technology with those patents set to expire between 2021 and 2031. I'm wondering, that seems like it offers investors a pretty long-term view in terms of how this company can essentially monetize this technology that they've created. Is that a pretty good timeline? If I'm trying to evaluate a company's drug pipeline and I see that their patents expire in the next two years or 10 years -- what do you see as something that's secure, or a stronger amount of time for these companies?

Harjes: The longer, the better, of course. This is a medical device more than it's a drug, so it works a little bit differently. I'm not a patent expert, so I'm not even going to begin to try to explain the differences, but something that I will point out is, the range of the time frame you just said, 2021 to 2031, that's a pretty huge range. If I was an investor, if I was to look further into this company, I would want to drill into that and see, what is it? Is it that the main patent expires in 2021? Or is the main patent the one that's 2031, and maybe it's some smaller ones that other companies can begin to chip away at? It seems like this TTFields technology is something that's completely novel and completely their own, and I'm not sure how close another company would be able to get to duplicating it without infringing on their patents. So it remains to be seen.

Shen: OK. My last question is, in terms of the risk factors, what do you think is the biggest risk factor that investors should potentially be cognizant of for Novocure?

Harjes: I would answer that question by saying reimbursement. If you can't get payers, insurers to cover your device or your drug, you're not going to make it. You might be able to find a small market of people who are willing to pay out of pocket. But this is not a cheap device, so they will absolutely need to continue to work with insurers and each and every new indication that they hopefully do get this approved with.

They do, I want to point out, have kind of an interesting monetization strategy with this. It's a flat rate, a monthly charge, and that gets you the device, the consumables that go with it, and also the customer service if something goes wrong. Which is, I don't know, I think it's an interesting strategy. It's very much not in line with something you see with the razor-and-blades model, where you have the device and then additionally, you have people paying for the consumables. I think that will be a strong selling point to insurers covering this, where you know exactly what you're going to pay. It's a flat rate. There's not going to be asterisks involved with it. So hopefully, that won't be a huge risk, but it's definitely something that could really make or break this company.

Shen: Awesome.

Harjes: Austin, let's hear our second pitch.

Todd Campbell: My name is Todd Campbell. I am a Fool covering healthcare. And today I want to talk to you about a company called Foundation Medicine. The symbol there is FMI. I think one of the most important things that's going on right now in biotechnology is a shift away from diagnosing and treating cancer based on the location of origin. I think, increasingly, over the course of the coming decade or so, we're going to be doing genetic screening that's going to inform doctors' decisions and help people get matched up with the appropriate treatment and the appropriate clinical trial. It's all going to be based on biomarkers, the genetic code, the things that are responsible for the cancer's growth. If I'm right, then Foundation Medicine stands to benefit tremendously. They're already the market leader in genetic screening of advanced cancer patients. They have 35% market share and about $120 million in revenue over the course of the last 12 months. 

What makes this company really interesting isn't already that it has 35% market share. It's the size of the market opportunity. There are 1.1 million advanced cancer patients in the United States, yet only 10%-15% of them are currently being genetically screened. I really think that's going to change. One of the things that will help the change is if they can win FDA approval for their platform this quarter, a decision that's supposed to be announced. And if that happens, then Medicare is going to give them a distinct reimbursement code. Historically, when that happens, private insurers follow suit, and theoretically the floodgates could open up for many more patients to get genetically screened. 

The thing that is also interesting about this company is it has a very big, deep-pocket partner. Roche already owns more than 50% of this company, and Roche is already selling Foundation's products outside of the U.S. I think this is a little bit of a risky stock, but I think it's a stock that long-term growth investors might want to put in their portfolios for a long time. Five or 10 years, possibly.

Harjes: This is another company that's on the smaller end of the market-cap spectrum. FMI, Foundation Medicine, has a market cap of only around $1.5 billion, but it's working in this enormous blossoming space of genetic testing, as Todd points out in his pitch. This is the trend of healthcare, to become more and more personalized. So it sounds like Foundation Medicine has a pretty big potential growth trajectory.

Shen: It was good to hear about this example, because I actually remember a presentation that you gave at a recent Fool Fest on the state of the healthcare industry, and some of the investment opportunities in that space. I remember specifically that one of the big things that you were watching out for was increased personalization. This was a particularly tough one for me to understand all the technical details, to go through the 10-K. There's a lot of very technical terms and things along those lines. Basically, my view of what they offer, and please correct me if I'm off base, is that they'll receive cancer cells or samples of one for a patient, and their labs will create their genomic profile based on that sample, and then they can share that profile, and then the treatments, that will fit that profile to the physician. Is that about right?

Harjes: Yeah, what they're trying to do here is, they are a next-generation gene-sequencing company, and they make this thing called the FoundationOne. That's the approval that Todd mentioned in his pitch. That uses a computational analysis to determine if a patient has a biomarker that would then make them eligible for a personalized cancer medicine.

Shen: OK. For me, this seems like a really interesting opportunity. Management states a few times in their filing that Foundation Medicine is the only widely available portfolio of genomic profiling testing for routine cancer treatment. They seem to have this first-mover advantage, and a big chunk of market share, as Todd said -- I think he said 35% in his pitch. He also mentioned, toward the end, he said something about it being a little bit of a risky stock. Again, I'm curious to hear, what do you think is some of the big risks for this company, whether it's on the financials side, whether they have sufficient cash reserves like you mentioned for some of these companies that they need to have in order to reach that state of profitability, because they're not there right now.

Harjes: Yeah. As Todd mentioned, reimbursement, again, is going to be my answer here. But that could also be a huge opportunity for them if they're able to secure that reimbursement. I believe I saw at one point, they had an agreement with UnitedHealthcare, which is one of the giant insurers in the U.S., to cover FoundationOne.

Another risk that I'll point out is competition. There are other companies in this space like Myriad Genetics and Illumina, and they all slide into the space in slightly different niches. But if you look at a company like Illumina, for example, their market cap is somewhere near $30 billion. Foundation, I'll remind you, is $1.5 billion. So you could look at that as either a threat, where Illumina could very easily try to do what Foundation is already doing and do it on their own and do it better and out-muscle Foundation. Or you could look at that as an opportunity, where Foundation Medicine is an entrant into the space that has the opportunity to get maybe as big as Illumina.

Shen: OK. The last thing I would like to get your perspective on is, they seem to have this relationship with Roche, huge healthcare company. When I looked, it was over a $200 billion market cap. Roche owns about 60% of Foundation Medicine, from what I could find. What kind of role do you think Roche is likely to play in Foundation's future? Is this common, in terms of these massive healthcare companies investing in smaller players, and trying to get a piece of this technology or maybe innovative service that they're offering?

Harjes: I'm so glad you brought this up. This was the most interesting part of researching this company to me, figuring out, what is Roche doing here, what's their strategy, is this a good thing for Foundation? Roche took a stake in 2015 that gave them about half of the company. Their strategy was to be fairly hands-off with it. They were going to help out with some marketing outside of the U.S.; they would give Foundation some money. But they mostly wanted them to be independent. They have only three out of the nine seats on the board, for example.

This is so reminiscent of their relationship with Genentech, which was a drugmaker that they previously had a 56% stake in and then bought. The stake that they have in Foundation -- 56%. So, very interesting to watch that develop.

In general, when I see a larger partner come in and guide a smaller player, that to me is a bullish sign that people who know what they're doing and know what they're talking about in this space want to help out one of the smaller players in developing their product and making sure that the company succeeds. Hopefully it's a win-win for both of these companies.

Roche is a huge player in oncology, and as we talked about, the way that oncology is trending is toward personalized medicine. There's a whole slate of personalized gene-specific therapies. So yeah, I will be interested to see what goes on here. Roche actually did try to buy out Illumina years and years ago. So I do think they have their eye on Foundation. I don't know what's keeping them from just buying the company outright, but I would not be surprised to see an acquisition.

Shen: Cool.

Harjes: All right, on to our third and final pitch of the day. 

Keith Speights: Hi, I'm Keith Speights, and I cover healthcare. There are three things that I look up when evaluating a commercial-stage biotech stock. One is the current product lineup. Second is the pipeline prospects for the biotech, and third is the ability of the company to bolster both of those, to be able to go externally and find candidates to add to its current product portfolio or to its pipeline.

One stock I think checks off all three of those boxes in a great way is Celgene. First of all, with its current products, we have to talk about Revlimid. Revlimid is a blockbuster blood cancer drug for Celgene. Sales continue to grow. In fact, projections are, over the next five years, Revlimid will become the top-selling cancer drug in the world. So that's a nice feather to have in your cap for Celgene.

It's not just Revlimid, though. Celgene has another blood cancer drug, Pomalyst. It's actually growing faster than Revlimid. Staying in the oncology area, the company has a solid-tumor drug, Abraxane, that's knocking on the door of being a blockbuster. So Celgene is really strong in the oncology space. But the company is also making waves in the inflammation and immunology area. It has Otezla, which is growing by leaps and bounds, becoming a great drug in the autoimmune-disease space. 

Celgene has quite a few solid blockbuster drugs in its lineup. On the pipeline, things look, in some ways, even better. The company has 10 candidates that are expected to be approved within the next five years, all of which have blockbuster potential. Four of those have megablockbuster potential. They could achieve sales of $2 billion -- in some cases, quite a bit more.

One of the top ones that I really like is Ozanimod. Ozanimod is in a couple of late-stage trials, one for multiple sclerosis, another for ulcerative colitis. Should be a crown jewel for Celgene in just a few years. Then, on the blood cancer side, they have Luspatercept, which rolls off the tongue, unlike some of the drugs out there. It could be another great blood cancer drug for Celgene. 

Thirdly, we look at, how can the company bolster its current products or pipeline? Celgene is in great shape on that one as well. At the end of the second quarter, Celgene had about $10 billion, a little over $10 billion in cash. That's going up. The company's cash flow is absolutely terrific. One thing I really like about Celgene -- they have 47 partnerships with other companies, both big and small. So they have this great ecosystem that can bring them new candidates into the fold.

Celgene is in great shape on three the main categories that I look at, and I highly recommend this biotech stock.

Harjes: We've covered two small-cap companies, and Keith pivoted us to one of the biggest drugmakers in the space, so this will be a very different conversation. What did you think?

Shen: I really appreciated that he laid out those three evaluation criteria that he looks at when he's evaluating these biotechs. As you said, this is obviously the most established and largest of the three pitches that we've heard so far. It's incredible how the company has multiple treatments at this point clearing $1 billion, if not far more than that, annually. I guess, in this case, when you have a company that has an established products lineup, and I think something like 10 really strong drug candidates, he said blockbuster candidates, in the pipeline, is the big risk factor then poor trial outcomes for those products in the pipeline? Or are there other things to consider here?

Harjes: Yeah, that's definitely a big risk. The expectations for these potential blockbusters might already be baked into the stock. So if something goes wrong, it'll drastically remove value prop for the company.

I'll also point out that patents are always going to be something to consider when you're looking at the drugs that have already been approved. There's plenty of talk about Revlimid's patent and how strong it is, how long that will hold up. These kinds of things are often played out in courts. When will generic competition actually be able to get on the market and start eating away at market share? At that point, will it then be able to steal away share? These are always considerations to have in mind and risk factors that are there.

But something I really like about Celgene is, by spreading out their bets across this huge portfolio of partnerships, they're actually minimizing their downside risk pretty considerably. They're offloading that risk onto the smaller companies by saying, yeah, we'll fund some of your development, we'll be there for you to market your drug if it gets approved, but if you completely flop, we're only add a couple of hundred million, or whatever the initial investment is. We talked earlier about that sort of partnership and how it's pretty prevalent in the healthcare world. Celgene is the master of this. That is their playbook, to make this smaller investment in very early-stage companies with huge upside, but limiting their downside.

Shen: Very cool. I was actually going to ask you about the development pipeline, how companies approach this, whether the drugs in their pipeline tend to be developed in-house, whether they tend to acquire them. But it sounds like it's some combination, in this case, Celgene is really skilled in terms of leveraging these early-stage partnerships. Beyond those three criteria that Keith mentioned for evaluating companies like this, I'm curious how much weight can you put on something like management quality or experience. I feel like, with the complexities of the drug trials, the huge resources that get put into things like resources and development, I'm wondering if you see good management as offering something in terms of an X-factor, versus the quality of the treatments they're offering.

Harjes: Todd and I have done twice now an episode about something about, lightning in a bottle -- can these CEOs catch lightning in a bottle again? Meaning the show, both times, profiled a handful of companies to ask whether or not they'll be able to be successful again, because their leaders were previously successful in the biotech world. It's definitely something that we watch out for.

With Celgene in particular, what I really like about their management is, they're very trustworthy. This is a management team that, several years ago, laid out their expectations all the way through 2020, which is not something that you generally see at all, much less in healthcare where there's so much that's dependent on pipeline blow-ups and patent litigation and all these other question marks. But Celgene has already said we have a goal of $13 billion in revenue for next year; we would like to make $21 billion in revenue in 2020. For context, they made $11 billion in 2016. And generally, they have hit the mark for years. This is not a company that overinflates their expectations to try to drive up investor sentiment. They're very trustworthy. If anything, they will keep their numbers a little bit depressed and then try to exceed them.

Shen: OK. This is my last question, then. It speaks more broadly to these three pitches, and other investment opportunities in the healthcare space. For other listeners similar to myself who might not be as familiar with the sector, but think the opportunities and the advances we've seen in medicine are a really good place to put your investment money, do you think a sector-focused fund can sometimes be a better choice, rather than trying to understand all the intricacies and complexities? These three companies are all very different in size and their different treatments. What do you think about that?

Harjes: I think that's tough. It depends how much work you want to put into it. The index that I followed to track biotech is called the IBB, it's the iShares Biotechnology Index. There are a lot of really junky companies in the IBB. So my theory is, if you can weed them out and only hold on to the best of the best, maybe the ones that have proven management or the ones that have partnerships from larger companies with a lot more money to help them out with their trials and their marketing, you should be able to outperform that index.

But again, it depends on how much you want to put into it, and also how much risk you want to take on, because this is somewhat of a gamble sometimes. Even if you've done all of your research and you're completely responsible in making these decisions, you can't predict every pipeline blowup. You're just going to get knocked down off your feet every once in a while in this industry. It's how it goes. If you can create a well-diversified portfolio of individual stocks, I think you'll do better than if you were to buy the index. But that does take a lot of work, so it's really up to you how much risk you want to take on in return for that potential larger upside, and how much homework you want to do.

Shen: Sure. Thank you so much, Kristine!

Harjes: Thank you so much for being here, Vince! This has been fun. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Vince Shen, I'm Kristine Harjes. Thanks for listening, and Fool on!

Brian Feroldi owns shares of Celgene and NovoCure. Keith Speights owns shares of Celgene. Kristine Harjes has no position in any of the stocks mentioned. Todd Campbell owns shares of Celgene. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Celgene and Illumina. The Motley Fool has a disclosure policy.