A Missive on the HCV Market Saga, Drug Pricing, & Biotech Sector Implications

February 05, 2015

Given debate on drug pricing that was re-ignited on the Gilead (GILD) 4Q14 earnings call last night, I thought it was appropriate to add my own irrelevant voice to the thousands of existing voices weighing in on the issue. This is a particularly important topic to the industry right now especially with the politicians throwing their “high conviction” views around whilst not being quite sure of the difference between MCOs, HMOs, and PBMs. 

The Hepatitis-C Virus (HCV) market is at the epicenter of this debate mostly because >4M patients are infected with HCV in the U.S. and GILD’s Solvaldi reached a >$12B run-rate within 9 months of launch (making it about 5x more meaningful to the economy than the iPhone). Even before Solvadi reached it's astonishing run-rate as the best drug launch of all time, the House Committee on Energy & Commerce drafted a 03/21/2014 letter to GILD requesting information supporting Sovaldi pricing. This scrutiny in HCV has created a broader pharma/biotech sector concern about the sustainability of pricing in other large specialty indications such as Cardiovascular (CV), Diabetes (T2DM), Multiple Sclerosis (MS), Rheumatoid Arthritis (RA), and Oncology.

Image Source: Evercore ISI

Source: Evercore ISIImage Source: Evercore ISI

Addressing the HCV specific side of the debate, I’ll side with the 32 sell-side analysts covering the stock that say these pricing concerns are overblown (except for 1) who published >100 pieces of research, hammering home this point. This view is not at all novel or differentiated. So why would I bother publishing a blog post on a fully consensus view? Because the rationale is variant from most investment cases that I have read.

Since being right is not important but making money is paramount, it is far more important to know the rationale and the pathway to the answer than the answer itself. Too often, the right answer and making money are mutually exclusive. When you castigated your high school math teacher for giving you a C+ for getting all the right answers but not showing your work—now you know that maybe there was some real world education in there after all.

Onto the rationale, GILD therapeutic regimens will dominate the HCV landscape at whatever market price that the oligopoly structure dictates (the same industry structure that exists in every high value IP protected pharmaceutical market). This means over time the player who controls volume will expand Wholesale Acquisition Cost (WAC) pricing and by association net pricing will follow in lockstep assuming the 46% gross-to-net discount is maintained. GILD will control volume and the other oligopoly players (ABBV & MRK) will fall into line as is the case across indications & pharmaceutical history. ABBV in particular must fall into line as the same PBMs that they just assisted in targeting HCV pricing are now talking about targeting Humira in RA, which accounts for 63% of ABBV revenue (25% RA indication)—leaving ABBV wondering why they started all this in the first place and definitely more sensitive than GILD to further escalation. There are several issues at play here: 1) Therapeutic Outcomes; 2) WAC vs. Gross-to-Net Pricing Discounts; 3) Patient Volumes; 4) Pharmacy Benefit Manager (PBM) industry structure; 5) Translation to other drug markets.

Therapeutic Outcomes

Summarizing therapeutic outcomes simply, GILD has the killer app. Sovaldi/Harvoni based regimens will provide >90% cures with minimal treatment failures in 1 pill without Ribavirin in 8-12 weeks. On the other hand, the ABBV regimen will produce at least 10% less cures, take 2x as long, produce 10% treatment failures that will need re-treatment with GILD regimens, and be contraindicated in HIV co-infected patients which will have to be treated from the start with GILD regimens. This is four very important variables to potentially whiff in estimating. One would hope Express Scripts (ESRX) and others who went exclusive ABBV performed an intensive modeling exercise in negotiations to make sure the discounts were apples-to-apples but somehow I doubt that it was so rigorous (people who can do that kind of work with any accuracy don’t work for ESRX). As a result, GILD’s regimen is worth a substantial premium and within 35% variance of any other player on pricing it is going to be used. Where GILD based regimens are not available due to exclusive agreements, it will be demanded by doctors/patients/employers (and eventually PBMs in exclusive arrangements with competitors), especially as real-world experience is garnered with competitive regimens and they are found to lack relative efficacy/convenience as well as produce a substantial full price GILD regimen retreatment cost. It will probably take 12-18 months for this to be realized.

WAC vs. Gross-to-Net Pricing Discounts

Second, WAC vs. Gross-to-Net Pricing Discounts has been the biggest bait-and-switch going in the pharmaceutical industry for years. Every therapeutics expert has become accustomed to dramatic gross-to-net adjustments across many indications driven by a WAC that is intentionally stratospheric offset by a discount that is intentionally dramatic to make governments and payers feel like they are getting a great deal. Evercore ISI published a terrific note covering this concept with regard to Diabetes on 02/03/15. Still, the 46% gross-to-net discount guidance given by GILD on the conference call ruffled the feathers of investors because it is double the 22% realized in 2014. However, GILD manages a business and not a portfolio so what they have done is very shrewd. They have accepted optically large gross-to-net discounts off of the WAC that was initially inflated from the get-go (by design knowing they would have to offer 50% discounts to the government) in order to ensure that they capture >60% market share. Once they have the share, they control the market and are the undisputed oligopoly pricing leader. This position will be solidified by the therapeutic outcomes tailwind that will develop over the next 2 years. Once entrenched, GILD will start raising the WAC price and the minority share players with follow. Government & payers will feel good because they are getting 40-50% off the WAC. However, it won’t take many years of 5-10% WAC price increases for 50% off the WAC to equal the originally inflated pie-in-the-sky launch WAC. This is historical trend that we have seen play out with drug prices in general as well as in diverse indications with many players of varying shares, especially T2DM, RA, MS, and Oncology. This will play out over years.

Patient Volumes

Third, GILD’s shrewd bait-and-switch doesn’t end with pricing but also encompasses volume. Despite its extreme success in 2014 with $15B in worldwide sales, GILD faced significant barriers to patient access that all drugs face in their first few years of launch. At 46% gross-to-net discount with formal arrangements with 7 Payers/PBMs (5 are exclusive) representing >60% covered lives, all of these barriers will now be removed. No doubt, this will result in significantly more volume in 2015-16 than otherwise might have been possible and will offset the majority if not more than all of the short-term price discounts. Even better, it will solidify GILD’s oligopoly leadership status and allow a more favorable pricing model long-term. The chief reason payers are concerned is not that new age HCV drugs aren’t a great value (vs the long-term cost of treating chronic HCV and ultimately liver cancer) but that this is a cure market so they are worried about huge boluses of patients seeking treatment all at once at high prices. As more patients are treated, the market gets smaller so these concerns wane. As payers move on to something else, price will skyrocket as HCV volume and notoriety declines relative to other indications. This will happen over the next 12 months.

Pharmacy Benefit Manager (PBM) Industry Structure

Fourth, PBM structure favors GILD as well as much higher WAC pricing long-term. PBMs get a small cut of what they save the pool of employers that they represent on pharmacy products so there is good reason to target HCV near-term. However, as PBM customers and their doctors actually use competitive regimens, they will obtain inferior outcomes versus GILD regimens and doctors/patients/employers will complain. Popular media will switch from “PBM takes on drug goliath on pricing” to “PBM denies grandma best-in-class drug.” Furthermore, the inferior outcomes will cost the PBMs margin, and they may find out that the pricing concessions demanded from ABBV were not near enough once they assess real world SVR inferiority, treatment failures, contraindicated patients, and full price GILD regimen retreatment cost. Every patient that fails an ABBV regimen or is HIV co-infected is going to go on the GILD regimen at the full WAC price— it won’t take many of these to destroy any price/margin advantage of an ABBV regimen to the PBM. Evercore ISI published a great note on this subject on 01/16/15. As a result, you could easily see PBMs with exclusive deals with ABBV breaking them as fast as they made them— further solidifying the position of GILD as lead oligopolist. This will occur in the next 2 years.

Translation to Other Drug Markets

Lastly, the Street is now in heated debate as to whether the HCV experience will translate to other large specialty indications. This is a mostly misguided debate as it is HCV that is following the exact lifecycle of all the large specialty indications: drugs are approved, oligopolists vie for share by offering large gross-to-net discounts, the market develops as it may, and then everyone starts raising the WAC. What the debate should be focused on is if there are characteristics of HCV that will prevent it from evolving as attractively as MS did for example. The answer is yes--there are critical differences chiefly that HCV therapies are cures and immediate treatment is not necessary given slow progression of disease. In addition, HCV patient advocacy groups aren’t nearly as well developed or organized as the other specialty indications. Good luck to payers and PBMs trying to control pricing and cutting exclusive discount deals in chronic indications with rapid disease progression and well entrenched patient advocacy groups. They’ll get dragged in front of Congress faster than Dick Fuld in 2008. Therefore, HCV pricing is likely to go parabolic as the market develops but not until the requisite volume step downs are seen with curing the market. Once the volume goes away, the public eye goes with it and pricing will go nuts. This makes HCV quite a bit less attractive than a market like MS long-term; however, GILD already trades at 10x vs BIIB at 20x so I would say that is likely overly reflected at this point.

It’s about making money not being right, and the two are often mutually exclusive.

Net-net, does this mean you need to rush out and double down on GILD, biotech generally, or that sexy gene therapy name that has nothing to do with GILD/HCV and has been unduly punished? Absolutely not as the drug pricing thesis outlined above isn’t immediately monetizable. To adapt a famous Denzel Washington line from Training Day, “It’s not what you know it’s what you can get others to believe.” At this time, it’s going to be difficult to get anyone to believe and impossible to get them to invest. Let’s wait for the initial rounds of doctor/patient complaints and the first evidence that a PBM is going to break an exclusive with ABBV. For now, the lever on the trap door has already been pulled and now there is only one way that can be undone.

As of 2/05/2015, GILD closed $99.90 under its 50/150dma at ~$101 (5x average volume on 02/04 weakness). Regardless of its specific relevance to other names, GILD is the sector bellwether. It’s even hard for Real Madrid to win when Cristiano Ronaldo isn’t playing. Biotech generally has underperformed the SPY over the last week by 4% but has outperformed over the previous year by 12%. Such significant near-term underperformance is usually the start of something not the end. The SPY has been shaky at best at +28bps on the year and is underperforming every major market as volatility breaks out to multi-year highs. 22 of 24 trading days this year have featured volatility of >1%. Volatility is the enemy of leverage and by corollary the enemy of returns. 

There are at least 30 portfolios at Millennium/Citadel alone that are position crowded into all the same biotech names— mostly the midcap sexy stuff like gene therapy, CAR-T, and oncology stocks. It won’t matter that HCV has nothing to do with those areas— just that it was the initial trap door. Israel Englander’s SkyNet (risk management algorithm) was already flashing enough red lights due to the volatility in the general market alone and now the bellwether name in the bellwether sector has caught a cold. Now SkyNet is going to DEFCON 5. The portfolio managers of these books are chickens in the coup with their necks extended too far and SkyNet is the razor wire that’s about to fly across the coup. It will take control of their books and unwind them to the tune of 25-50% just like what occurred last spring when biotech corrected 25% (02/25/14 to 04/15/14). This correction occured within the context of a general market that was down 35bps over the same timeframe and much friendlier especially in terms of volatility than what we have today. This process of creative destruction may have already started as we have seen several biotech stocks in key areas trade abnormally weak absent fundamental developments and without associated weakness in the indices.

This is not negative— it’s positive. The behavior of these risk models, global macro hedge funds, and black boxes last spring (and repetitively 2-4x per year since the outset of QE) were the fire from which once in a lifetime alpha generation opportunities have been cast.

It’s about making money not being right, and the two are often mutually exclusive. Furthermore, the right evolutionary pathway is usually more important than the right answer. Analysts have been proven dead right time and again especially in the long-term— the problem is they are too often right from the wrong prices. This tendency is especially severe in the biotech sector where valuations are abnormally sensitive to changes in investor discount rates, which have been rising in January and so far looks like they will continue to do so in the immediate future.

-Branden Muhl


The views and opinions expressed herein are those of the author and do not necessarily reflect the views of any of the companies mentioned in this article.  Further, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the writing serve as the basis of any investment decision and it has been provided to you solely for informational purposes only and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such.