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Four Possibilities for Pharma Firms' Fair Values

The pharma industry's proactive approach to cost-cutting may be its saving grace.

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With U.S. health-care reform likely on the way, prescription drugs could lose some pricing power in the Medicare market. While highly unlikely, a national plan with strong pricing power controlled by the government could have a significantly negative impact on the value of large pharmaceutical firms.

On the other hand, we also expect expanded insurance coverage for the 46 million uninsured U.S. citizens over the next couple of years. In addition, drug firms typically generate half of their sales from overseas, mitigating the impact of U.S. health-care reform.

With these factors in mind, we've analyzed the impact of several possible U.S. health-care plans on our universe of large pharmaceutical stocks. The scenarios we modeled impact each of the payer groups differently, so the weight of each group's contribution to drug spending is important (see the image below). We did not include scenario analysis on drug reimportation or comparative effectiveness programs. Congressional Budget Office reports state that both of these plans would reduce health-care costs by 1% or less, and we don't expect a major impact from these proposals.

Scenario 1: Medicare Negotiated Drug Prices
(Likely Near-Term Outcome: Slight Pricing Pressure)

We believe increased negotiation power for Medicare represents the most likely near-term health-care reform. Currently, Medicare Part D provides coverage for people over 65 years old and offers a range of private insurance plans. Because participants are offered choices through several plans, the government lacks the purchasing power to demand better prices. Conversely, Medicaid offers very little choice, but the purchases are controlled by the government, allowing significant price discounts. We expect the government to use its buying power in Medicare programs and demand lower drug prices. We believe this could lower Medicare drug prices by 15%. However, since Medicare spending represents only 21% of U.S. drug spending and approximately 10% of worldwide drug spending, we estimate the average drug price would fall by only 2%. Under this scenario, our fair values for pharmaceutical firms would fall approximately 5%.

 Negotiated Medicare Prices
                                                           % Change                                                  Basis Point Change
  Volume Price Sales     COGS SG&A R&D   FV Change
U.S. Impact 0% -3% -3%     +100 0 0    
Total Firm Impact 0% -2% -2%     +100 0 0   -5%

Scenario 2: Increased Insurance Coverage
(Most Likely Outcome: Volumes Offset Pricing Pressure)

We expect the government will eventually pass a health-care plan that will add coverage to the uninsured population. The higher coverage should increase U.S. prescription drug usage by 15%, but we would expect the government to demand Medicaid pricing for this group, reducing the average U.S. drug price by 7%. We also assume Medicare drug pricing falls to Medicaid levels in this scenario. Overall, we expect increased volumes to largely offset the lower prices in this likely scenario, resulting in no impact to our larger pharmaceutical companies' fair values. Also, we feel this scenario encompasses the $80 billion in pricing concessions over the next decade that pharmaceutical companies negotiated with the U.S. government earlier in the year. While $30 billion of those concessions go to helping seniors pay for drugs that fall into Medicare's doughnut hole, the remaining $50 billion helps reduce costs in other aspects of government-sponsored drug insurance plans.

 Increased Insurance and Negotiated Medicare Prices
                                                           % Change                                                  Basis Point Change
  Volume Price Sales     COGS SG&A R&D   FV Change
U.S. Impact +15% -7% +7%     +200 0 0    
Total Firm Impact +8% -4% +4%     +100 0 0   0%

Scenario 3: National Plan
(Unlikely Outcome: Pricing Pressure Decreases Sales)

While unlikely, the U.S. government could develop a national plan, similar to plans used in Europe and other overseas nations. A national plan would cover the uninsured patient population, increasing drug volumes by 15%. However, pricing power would likely increase significantly as well, cutting the average drug price by 15% in the U.S. Our drug price decline assumes Medicaid prices for the entire U.S. population. We don't believe a national plan is likely due to opposition from many strong groups including lobbyists, health-care companies, and Republicans. However, under this unlikely outcome, our fair values for large pharmaceutical firms would fall approximately 10%.

 National Plan (U.S. at Medicaid Prices)
                                                           % Change                                                  Basis Point Change
  Volume Price Sales     COGS SG&A R&D   FV Change
U.S. Impact +15% -15% -3%     +400 0 0    
Total Firm Impact +8% -8% -2%     +200 0 0   -10%

Scenario 4: National Plan with Little Drug Choice
(Very Unlikely Outcome: Significant Sales Decline)

Our last scenario runs a national plan with very little choice, reducing the U.S. average drug price by 30%. Under this drastic scenario, our Big Pharma fair values would fall by approximately 38%. However, we also projected flat selling expenses, which would likely be reduced as a U.S. marketing effort would be less important in a strict national plan. Therefore, our fair values may not drop as far if selling expenses are reined in. Also, another important caveat is how drug companies would view international markets if the U.S. market became very unfriendly. Historically, when one payer becomes very aggressive, drug firms tend to push for pricing concessions from other payers. Therefore, we would also expect drug firms to demand better pricing from international countries, which have been enjoying U.S. subsidies for decades. The international gains could also mitigate our projected fair value declines.

 National Plan (All U.S. Sectors Get 30% Discount)
                                                           % Change                                                  Basis Point Change
  Volume Price Sales     COGS SG&A R&D   FV Change
U.S. Impact 15% -30% -20%     +900 +600 +300    
Total Firm Impact 8% -15% -10%     +400 +300 +200   -38%

This article originally appeared in Morningstar Healthcare Observer.

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Damien Conover does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.