Tax Reform Takes a Bite Out of Biotech Stocks

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Healthcare companies will largely benefit from tax reform that lowers the statutory business tax rate to 20% from 35%, but those in research-intensive sectors such as biotechnology could end up with an unpleasant surprise at tax time. That's because Congress is considering eliminating the orphan drug tax credit and neutering the research tax credit. Could these changes slam the brakes on new drug discovery?

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In this episode of The Motley Fool's Industry Focus: Healthcare, analyst Michael Douglass and contributor Todd Campbell explain how changes to tax credits may make the GOP tax bill a bitter pill for the biotechnology industry to swallow. They also update investors on CVS Health's (NYSE: CVS) planned acquisition of Aetna (NYSE: AET), and discuss how Apple (NASDAQ: AAPL) wants to use its Apple Watch to spot heart attacks and strokes before they happen.

A full transcript follows the video.

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This video was recorded on Dec. 6, 2017.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Wednesday, Dec. 6, and we're talking about three big news items in healthcare: Aetna-CVS, tax reform, and an Apple heart study. I'm your guest host, Michael Douglas. Kristine is sick today, so I'm filling in for her. Sorry, everybody! I'm joined by Todd Campbell. Todd, good to have you!

Todd Campbell: Michael, it's great to be here, and great to be able to chat with you today! For a second there, I thought maybe you lost your way on your way to film the Financials show.

Douglass: [laughs] Yes, as probably many listeners were questioning that at the beginning, like, wait a minute, I've heard this guy recently. Let's start off with the big news item that really, for Industry Focus listeners, isn't necessarily a big news item. Aetna and CVS are officially planning to merge. We'll talk about this very quickly, because you and Kristine obviously covered this heavily recently, and Kristine was actually on the Market Foolery show yesterday to talk about it. So, listeners, if you're looking for more details, check out those shows. But, it looks like things are officially planned, at least. CVS is offering $145 in cash per share plus 0.8378 CVS shares. That's roughly $207 per share of Aetna.

Campbell: Yeah. Tiny deal, right? [laughs] A $69 billion deal, Michael. Kristine did a great job covering it earlier this week on one of the other podcasts. I urge everybody to listen in, but just to give you the highlight reel, like Michael said: $145 in cash plus CVS shares. Based on CVS's trading price at the time that it was announced, it's about $207 per share in Aetna.

You'll notice that Aetna isn't trading at that level yet. That's because, Michael, there are some questions as to whether or not regulators will OK it. We've seen some pushback on insurer M&A in the past year. So, there's no guarantee that this deal goes through. But, it's certainly intriguing, because it continues in the vein of, how will insurers survive and thrive in the future with rising costs of care and less ability to continuously raise premiums? The idea of being able to create a vertically integrated company that not only insures patients but is able to provide them with drugs and give them care through CVS's Minute Clinics is certainly intriguing. So, it's something we're going to want to watch.

Douglass: And one of the things you highlighted there was, you said, past insurer deals have certainly run into some regulatory scrutiny. What's interesting about this is, as you noted, it's a vertical integration play. CVS and Aetna are in different parts of the healthcare value chain. What's really interesting about this to me is, the Department of Justice just stepped in and has begun fighting the AT&T-Time Warner merger, which is another vertical integration play. So, it'll be interesting to see what the parallels are between that and this. I suspect that is one of the reasons why Aetna isn't trading near at its potential buyout price, because there's a lot of concern that even vertical integration could have a lot of regulatory scrutiny.

Campbell: Right, there's not a whole heck of a lot of overlap between these two companies; CVS does have some Medicare insurance clients through its SilverScript business. That theoretically could overlap somewhat with what Aetna is doing in the Medicare side of the world. Like you said, it's more a question of, will they be OK with consolidating so much might within the industry overall? These are two Goliath companies merging to create an even bigger Goliath. So, I think that's something that investors will want to watch.

Probably also important, Michael, just to let people know that the trend isn't limited to Aetna and CVS: UnitedHealthcare, came out earlier today and announced that they're spending $5 billion to acquire the healthcare provider business from DaVita. This is something that's widespread across the industry. People are looking at and saying, how can we survive and thrive in the future. Maybe one of those ways is to get rid of all of the profit margins from all of these different parts of the business and just consolidate it all in one company. We'll see if it pans out.

Douglass: And specifically speaking about you UNH and their Optum group, UNH's Optum has been planning to expand its primary care and ambulatory service footprint to something like 70 or 75 markets across the United States. So, there's a lot of interest in continuing that expansion. And this is just part of that broader strategy.

With that all of out of the way, let's get onto the main news and the big story we're talking about, which is tax reform. Folks who have been listening to all five shows know that a couple of weeks ago, on the Financials show, Matt Frankel and I talked through tax reform. We were talking about it more from the personal finance side. Today, we're really going to be talking about it from a business side. It's interesting, the headline that you see is, big tax breaks for businesses across the United States. But the fact of the matter is, the devil is in the details, which is why instead of rallying on Monday, biotech stocks sold off in response to the Senate's passage of the Republican tax plan. Now, like I said, that's a surprising outcome if you're looking at the headlines, because frankly, the headlines indicated that these are big tax breaks.

Campbell: Right, but it's all about the fine print. Right, Michael? It's all about, like you said, the devil in the details, and what's tucked inside of the bill. Without a doubt, let's lay this out, we know this is a boon to profitability for most companies, because you're going from a standard scheduled rate that's in the mid-30s down to, you go with what the Senate is proposing, a corporate tax rate of 20%. So, wow, that's a big drop, and that's obviously going to flow through down to the bottom line. If you look up, if you look at effective tax rates over the last 12 months, you have companies like Gilead, they're at 24%, UnitedHealthcare is at 34%, CVS, which we just talked about, 38%. There are a lot of companies in healthcare that will benefit from the reduction down to 20%. However, in research-intensive industries, companies with a big chunk of their operating costs tied into research and development --  so, technology, biotechnology, life sciences, to some extent, medical devices and expensive equipment -- those companies could end up getting a little unfortunate tax surprise.

Douglass: Yes. The House and Senate bills are different. We're going to be talking a little bit about both of them. Listeners, expect a little bit of switching as we're saying, the House bill does this, the Senate bill does this. We're going to do our best to make it as clear as possible and signpost for you. But, just be warned. The House bill does away with the orphan drug tax credit, and the Senate bill actually cuts it from 50% to 27.5%. So, let's step back a little bit and talk through what that means. Orphan drugs are drugs for incredibly rare diseases, the sorts of diseases that are so rare that it's not necessarily worth a healthcare company's enormous R&D investment to find a drug that can treat or, even better, cure that disease. So, one of the things the orphan drug tax credit did -- and it was passed in 1983 -- was entice drug makers to study and develop drugs to treat rare diseases.

Campbell: Yeah. Things like muscular dystrophy and those types of things, where a significant amount of work needed to be done. But like you said, there wasn't a tremendous financial incentive for drug makers to go out and take on the risk of trial failure, which we've talked about on the show over and over again. 90% of drugs that go into clinical trials end up in the waste bin of the laboratory rather than on pharmacy shelves. So, there's a significant risk to these companies to take on. And if you're only developing a drug that's going to be used in a couple of thousand patients, it's hard to make a lot of money on that. Now, there are other dynamics -- pricing, etc. -- that can go in and still make these drugs pretty lucrative.

But, back in 1983, and over the course of the last 30 years or whatever, this has been a credit that many companies have relied on to help them come up with these breakthroughs in a lot of these rare disease indications, including muscular dystrophy. And the disappearance of discredit in the House bill and the roughly halving of it in the Senate bill does raise some questions of, how much will that crimp profitability -- because again, you're going to end up having to pay more in taxes, because a credit comes off dollar for dollar on your tax liability. It's not a deduction.

Tax deductions lower your income that gets taxed, while tax credits reduce dollar-for-dollar what you owe in taxes. That's how a lot of these biotechnology companies end up with effective tax rates that are lower than 20%. So you have your statutory scheduled rate and you knock off all your deductions and then you get a rate, and then you take your credits against that, and that lowers your tax bill even further. So there is the concern among some that by eliminating this credit or reducing this credit, you will have less investment into the development of orphan drugs, and less profitability for those companies that continue to invest in the development of orphan drugs.

Douglass: Right. The National Organization for Rare Disorders actually said that this, and I quote, "Would directly result in 33% fewer orphan drugs coming to market." Now, of course, predicting the future is notoriously difficult, and predicting the future with any precision is even tougher. Ask anyone who's a meteorologist. But, it's definitely distinctly possible that this could, at the very least, crimp profitability for a lot of these orphan drug makers. Now, some accounting firms have been talking about, yes, the reduction in the orphan drug tax credit would make a difference. But, potentially, some of this could be worked over to the R&D credit.

Campbell: But Michael, wait! [laughs]

Douglass: But wait, there's more! First, before that, let's talk through the R&D credit, what it is and what it does a little bit. Then, we'll get to the other nuances that are coming through in these tax bills.

Campbell: OK, great! As you can imagine, biopharma companies spend a tremendous amount on research and development. Just think how expensive it must be to run a clinical trial involving thousands of patients. Right? So, there are some advantages that the government gives to encourage companies to continue to invest in R&D, those R&D credits. What those R&D credits can do is, it can provide you with up to $0.135 for every qualified dollar that you spend on R&D. It's a dollar-for-dollar reduction to your tax liability, because it's a credit, not a deduction. That obviously can increase your earnings per share, it can reduce your effective tax rate and improve your cash flow. Another nice thing about these research and development credits is that you can carry them forward for up to 20 years. So, imagine that you are a young, early-stage biotechnology company working on a big indication like Alzheimer's or something. You're going to incur a tremendous amount of development costs. But, you don't have any profit to offset it. Well, you can carry these credits forward. And once you launch your drug, you're able to use these credits to reduce your tax liability. So, it's a very valuable tool to drive research and development, not only in biotech and biopharma, but across life sciences and of course in other sectors like technology. But, again, we have some fine print in the Senate bill, not in the House bill, but in the Senate bill, that theoretically jeopardizes these credits and make them useless.

Douglass: Right. This is what's called the Alternative Minimum Tax. You've probably heard of the Alternative Minimum Tax before described for personal taxes. The idea of the AMT, as it's called, is that the wealthy often have a lot of deductions and credits they can take: itemize their taxes, give a lot to charity, mortgage deduction, etc. What the AMT basically says is, if you make a certain amount of money, you have to pay at least a certain minimum percentage of your income in taxes. So, no matter how many deductions you have, you can't get below a certain effective tax rate. And the corporate AMT works essentially the same way. What's interesting for the Senate bill is, they essentially slashed the corporate tax rate to 20%, and they left the corporate AMT at 20% as well.

Campbell: Effectively everybody will be an AMT payer under the Senate bill, is essentially what it breaks down as. If you take any deductions off of your 20% business tax rate, you're going to end up triggering AMT. And the beauty about AMT is, it significantly limits your ability to use those credits. So, by tucking the corporate AMT back in at the last minute -- it was actually out of it, and this corporate AMT issue is not even in the House bill, it wasn't in the Senate bill until the night preceding the vote, and they did it for some funky reasons to make the deficit look lower, so they could get it passed using a simple majority, etc. They stuck it in there. I don't think it's going to stand. But, the way it sits right now, the Senate bill would effectively make everybody an AMT payer, and make these research and development credits useless.

Of course, as everybody was digesting the Senate vote on Saturday and Sunday, and Monday opens up, they're looking at some of these companies and saying, some of these companies have hundreds of millions of dollars in deferred tax credit carry forwards that they've been planning to use that may end up worthless, and all of these companies are spending money in biotech on R&D and they may not be able to get the benefits of using these credits later on.

Douglass: Right. Ionis Pharmaceuticals, for example, fell 8% on Monday. They have almost $200 million in deferred R&D credits on their books. And you saw a number of these sort of rare-disease-focused companies that are finally going to be able to, theoretically, to start benefiting from some of these credits that they've been carrying forward for years, are now suddenly faced with this moment where they're like, what's going to happen? Of course, as you noted earlier, Todd, the likelihood that this particular AMT scheme will remain in whatever final bill ultimately gets passed, if a final bill gets passed, is very unlikely, because a lot of people are pretty up in arms about this.

Campbell: Yeah. If you to put your policy hat on, right Michael, and start looking and saying, there's no way that we can go forward by including corporate AMT dropping the rate to 20%. We're either going to have proportionally lower AMT to something very low, like 10% or less, to avoid screwing up the other parts of tax reform, or we're going to have to get rid of it entirely. But then again, you're trying to reconcile the House bill with the Senate bill. The Senate bill is already pushing up against that $1.5 trillion deficit level that allows them to pass with a simple majority. So, you're going to have to make up for any savings, any -- if you get rid of the AMT, you're going to have to find that money somewhere else to keep the deficit below $1.5 trillion. So, we're going to have to watch and see how this all shakes out, because it could create another unintended consequence in fixing AMT. We don't even understand what it could be yet.

Douglass: Right. And at the end of the day, one of the key things we have to keep in mind with tax policy is, tax credits and deductions are usually there to incentivize certain things. The mortgage deduction is there to incentivize you buying a house. The 401(k) deduction is there to incentivize you saving money for retirement. The R&D credit is there for very good reasons.

Campbell: Right. You want research and development in your country. You don't want it somewhere else. And what we're seeing globally now is more and more countries are providing and increasing their research and development credits, so they can win away that development activity to their countries, away from the U.S. So, the last thing that we would want to do is reduce the ability to allow those credits. It just doesn't make sense to me. It would be a bad move.

Douglass: Exactly, particularly in a country like the United States, which is such a leader on drug development.

Campbell: Yeah. I think the orphan drug tax credit, that's either gone or getting cut in half, so we're going to just have to live with that. And I'm sure, from an investment standpoint, because we're an investing show, people are wondering, where do we go from here? I think it was probably an overreaction, what we've seen since the Senate bill passed. It depends, obviously, on how they reconcile the two bills. It could very well be that the weakness we've seen in biotech and technology has been a little bit of an overreaction that provides a buying opportunity for some of the leading names. These are still good markets. These companies are still going to be able to make some money.

Douglass: Yeah, just something to keep in mind, that it may end up being more of a reversion to the mean as opposed to just destroying companies left, right, and center.

Let's turn to our third story of the day, the Apple health study. This is something, Todd, that you and Kristine actually, you hadn't talked about this precise study, of course, but you had talked about the opportunity with wearables, what they can do to help make us healthier, and this idea of big data and predictive analytics and all this, on the May 16 Healthcare IF episode.

Campbell: Yes. "Will Wearable Tech Make Us Healthier?", if anybody wants to google it and listen in. It was a great, fun show where we dove into the different companies that are developing wearables, and how they could significantly change or improve upon treatment and evaluation and disease management for things like diabetes. We focused a lot of attention on diabetes. What's really intriguing to me about the Apple heart study that just got announced on Nov. 30 is, it's kind of a game changer. It's kind of exciting, because we're talking about moving from wearables providing you, I can look down and see what my heart rate is right now, to the next step, of taking that information and actually interpreting it and coming to some conclusions that maybe can help save lives.

Douglass: And this is one of the interesting things about wearables. I think, when people are thinking about wearables today, what they're often saying is, sure, I can get my steps tracked, I can get my heart rate, I can answer a text message, whatever the case may be. But what's really interesting in the future for wearables is, their opportunity to essentially serve as another data point for healthcare providers. This specific study, which is being conducted by Stanford Medicine, is essentially looking at whether the Apple Watch can spot atrial fibrillation, or AFib, which is a life-threatening heart condition, it's the leading cause of stroke. Just to be clear, AFib causes 130,000 deaths and 750,000 hospitalizations in the U.S. annually. So they're not looking at something small here. This is a big condition. And frankly, it's a condition that they should be able to gather a lot of data on through Apple Watches.

Campbell: This is important, too, because think about it, you're not diagnosed with AFib until you have a problem, typically. You suffered a cardiac event, and then they're able to determine, "Oh my God, that's caused by AFib." The goal here is to turn that on its head, and say, if we provide patients with -- to back up for a second, what we're talking about here is using the regular Apple Watch, and then patients can download an app from the iTunes store, and that app is going to be able to, by using software algorithms and sensors, determine what your heart rhythm is and then look for anomalies in your heart rhythm. So, it's fascinating, because it's an opt-in study, and it's available to everybody who owns the Apple Watch Series 1 or higher, and you have to be 22 or older to enroll. That's just fascinating, because theoretically, you have this huge population of people who already own these watches, who may be interested in making sure that they're healthy, that could enroll in this study and, like you said, collect all of this data. Maybe that prevents some of those 750,000 hospitalizations every year. Because, the way it'll work is if the Apple Watch spots an abnormal rhythm, it's going to alert you, and it's going to allow you -- you'll have the opportunity -- to have a phone call or a video conference with a physician. And based on how that conversation goes, you're either going to end up getting in the car and going to the ER, or calling an ambulance and going to the ER for testing, or you're going to get sent in the mail a patch that will conduct an electrocardiogram, which can be used to determine whether or not you absolutely do have AFib or not. By diagnosing it earlier on, obviously, you can take preventative measures in your life and hopefully avoid that surprising cardiac event later on that is so life threatening.

Douglass: Right. One of the cautionary components that we should talk about is, we just talked about how AFib doesn't usually get diagnosed until after an event. It's possible that, it turns out AFib is a little bit more common than we thought, because again, we tend to only see it when something really bad happens and someone has already been hospitalized. So, it could be that there are higher diagnoses of AFib for folks who it wouldn't have ended up affecting as much as to a hospitalization level.

Campbell: Yeah. They feel like they've put enough controls into the study design to be able to eliminate false positives. But we won't know. We won't know for a while whether or not that's the case. And the last thing you want to do is be unnecessarily scaring people and sending them to the ER for something that really might not have caused any kind of real problem for them for 30 years or 40 years or whatever. So, that would be, I guess, you would say, the other side of this story. We don't know exactly what this will determine. If this actually does help matters and save lives, which, I expect you will be able to save some lives using this, and whether or not that offsets that risk of the false positives and the costs to the system, etc., that are created because of those. But, nevertheless, I think this is a fascinating study. I think it's pointing us toward the way that technology is going to continue to merge with healthcare over time. And I think it's one of those things that, you look at what are the defining moments, the tipping points in the developments of new technology, I think we're at one right now when it comes to wearable technology and healthcare.

Douglass: I would absolutely agree. One thing I will add is, in healthcare, the name of the game is early detection. So, whether it's cancer, whether it's a stroke, whether it's heart disease or diabetes, the earlier that the healthcare system can get involved, the better patient outcomes are going to be overall. And if this helps with that, then that's going to be a tremendous boon, not just Apple's bottom line, not just to wearable watch sales, but to the overall health of the American population. And that in and of itself is a huge win.

Alright, folks, that's it for this week's Healthcare show. Questions, comments, you can always reach us at industryfocus@fool.com. 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 Todd Campbell, I'm Michael Douglass. Thanks for listening and Fool on!

Michael Douglass owns shares of Apple, Gilead Sciences, and Ionis Pharmaceuticals. Todd Campbell owns shares of Apple and Gilead Sciences. The Motley Fool owns shares of and recommends Apple, Gilead Sciences, and Ionis Pharmaceuticals. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends CVS Health, Time Warner, and UnitedHealth Group. The Motley Fool has a disclosure policy.