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Morningstar | The State of U.S. Healthcare Laws Has a Low Impact on Australian Healthcare Stock Valuations

Despite many Australian-listed healthcare stocks we cover having substantial revenue exposure to the U.S., the latest potential regulatory changes in that market pose a low risk to our fair value estimates. The cost of and access to healthcare is an emotive topic among U.S. voters and hence at the forefront of political agendas. Of relevance to the Australian companies that operate in the U.S. is the draft Lower Health Care Costs Act, or LHCCA, which aims to improve transparency in the healthcare sector and reduce prescription drug pricing, as well as President Donald Trump’s recent executive order on transparency and comments on capping drug prices to the lowest developed-country level.

The Australian-listed healthcare companies with U.S. revenue streams in decreasing order of contribution are (reported or estimated): Mayne Pharma 93%; ResMed 50%, Fisher & Paykel 47%; CSL 44%; Cochlear 36%; and Sonic Healthcare 27%. However not all this revenue is at risk as pricing for medical devices supplied to public health, for the likes of ResMed, Fisher & Paykel and Cochlear, and the pricing of diagnostic services, provided by Sonic Healthcare, has already been subject to regulatory price action over the past few years. As a result, the most significant price pressure for devices and diagnostics is likely behind us.

As a result, with the focus squarely on drug pricing, narrow-moat CSL and no-moat Mayne Pharma are exposed to new regulatory changes; however, we quantify the potential revenue losses at less than 2% for both companies. The limited revenue impacts result in low downside risk to our fair value estimates of AUD 195 for CSL and AUD 1.00 for Mayne Pharma, which we maintain for both companies. The U.S. is a key market for Mesoblast’s research and development pipeline, however, we perceive there to be low risk to our price assumptions for the closest to market products included in our fair value estimate of AUD 1.50 and we leave the valuation unchanged at this stage.

A change to the price of a drug does not necessarily feed back directly to the manufacturer. We know the list prices of branded drugs in the U.S is higher on average than the European and other developed countries that it benchmarks itself against, a conclusion reached in the "Comparison of U.S. and International Prices for Top Medicare Part B Drugs by Total Expenditures" published by the U.S. Department of Health and Human Services in October 2018. However, the market is extremely opaque and the links between the list price, the revenue the pharma company receives and the cost to the patient are not directly related because of the role played by Pharmacy Benefit Managers, or PBMs, who collect a rebate from the manufacturer but do not pass it all through to the patient. With the withdrawal of the proposed rebate rule, which would have required a full pass through of rebates, communicated on July 10, this leaves the international price index proposal, or IPI, as the next consideration for lowering the cost of drugs

We estimate a less than 2% loss of revenue for CSL should the international price index proposal be implemented. The proposal targets physician-administered, not pharmacy-dispensed or self-administered, drugs supplied to Medicare referred to as Part B drugs. Based on sales included in a study by the U.S. Department of Health and Human Services, we estimate this to be approximately 7% of CSL group revenue. The study included CSL’s Privigen, an intravenous immunoglobulin, or IVIG, product, in its comparison of U.S. and International Ex-Manufacturers Prices of the Part B Category of Drugs and concluded that the price was “similar,” which it defined as within 20% of the international price on a per gram basis. The same outcome was concluded for competitor Grifols’ IVIG product Gamunex-C, and Grifols’ Gammagard was rated as lower priced in the U.S. A 20% downward price adjustment of CSL’s Part B products would result in a loss of revenue of 1.4% of group total.

Biosimilars, also referred to in the LHCCA, are not a threat to CSL’s plasma products as it is the high barriers to entry of the industry rather than patents that limit competition.

Despite earning over 90% of revenue in the U.S., we estimate a less than 2% possible loss of revenue for Mayne Pharma should IPI be implemented. The company earns the vast majority of revenue from generic products, a market where prices are already down more than 50% over recent years, and only 10% of revenue from branded products, a portion of which may be in the Part B basket. But the branded drugs distributed by Mayne Pharma are out of the exclusivity period and therefore unlikely to be commanding major price premiums. A 30% downward price revision on half of the branded basket, being 5% of group sales, would result in a revenue loss of 1.5%. As a result, implementation of the IPI proposal would not have a significant impact on our AUD 1.00 fair value estimate for the company.

Mesoblast doesn’t currently earn revenue in the U.S., however, its closest to market pipeline product is currently in the FDA’s biologics licensing approval process. Our price estimates for this potential therapy is based a competitor product in the U.S. market and is 20% lower than the equivalent product in Japan, the only country where it is registered. Nonetheless, with the U.S. a major focus for the company, drug pricing reform could pose a risk to the valuation of Mesoblast’s pipeline. We do not adjust our fair value estimate at this stage.

With over 700 healthcare-related bills currently in U.S. Congress, there is uncertainty over what laws will ultimately be passed. It is the view of Morningstar U.S. healthcare strategist Karen Andersen and equity analyst Jake Strole that IPI is unlikely to be implemented as detailed in their report of July 12, 2019, "Rebate Rule is Dead: Supply Chain Benefits, Drug Firms Pressured." Instead they expect drug price reform for Part B Medicare products could take a different form and with possible caps on out-of-pocket payments for self-administered prescription drugs. The nature of the revenue earned by CSL and Mayne Pharma in the U.S. results in low exposure to these types of drug price reform, limiting the impact to our fair value estimates.