Biotechs are still treading water and have not participated in the year-end rally yet. I hardly ever comment on the larger political events since for the most part they impact pharma more than the small cap biotechs. However the current medicare changes will have some major impacts. One group of doctors impacted the most is oncologists. Oncology practices depend on outpatient infusion centers as the major income source and it is the reimbursement for IV oncology drugs that drives the bottom line of these centers. IV drugs have been traditionally reimbursed at 95% AWP (average wholesale price) by medicare but the clinics pay much less to vendors. The more drugs a clinic uses the bigger the discounts. Oncology practices make the difference between the 95% AWP that the government reimburses vs the steeply discounted prices they are actually paying. This income is the margin that makes outpatient oncology viable as a business. All oncologists realize that this is a very distorted pricing system however the reimbursements for nursing time, office care, family consultations and all the work it takes to deal with very sick and dying patients is so minimal that practices have become dependent on this “drug money”. All this will now change as of Jan. 1st ’04. Drugs that already have codes (which are most drugs) will now be reimbursed at 83 to 85% AWP. The slight bump in reimbursement for services will not offset these big loses. What will happen-smaller oncology offices may close, the larger ones will cut back services and send patients getting the most poorly reimbursed drugs to the hospital outpatient department. The whole system will become much more cumbersome, patients will complain and eventually the law will be changed. The bigger problem is that the law is scheduled to change again in ’05 and nobody can figure out what the new formula will be but the sense is it only gets worse. Given all these changes are there any investment decisions that make sense? In this note I will detail a few opportunities.
The opportunity arises for new drugs that are coming onto the market and don’t have a current billing code. These drugs will still be reimbursed at 95% of the AWP. Given that they are as good as or better than older competitors oncologist will switch very quickly to the new drug because of the enormous reimbursement differential. One such new drug opportunity is Aloxi (palonosetron), a 5-HT3 receptor antagonist from MGI Pharma (MOGN). Please see archives fro notes on MOGN. This drug was recently approved to treat chemotherapy induced nausea and vomiting. In a nut shell it lasts much longer than competing products, which makes it a better drug. In a normal environment I would expect a slow to moderate uptake by oncology practices perhaps driven by oncology nurses who are always very sensitive to patient discomfort. However this is the “perfect storm” for MOGN. Two currently used drugs in this class, Anzemet and Kytril, are scheduled to be reimbursed at 80% AWP while Zofran is scheduled at 85% of AWP starting Jan. 1. The new medicare pricing will drive oncology practices to Aloxi overnight. They are already signing contracts to convert on Jan 1. The market for this class of drugs in North America is about $850 million/year, which includes the use of both the IV and the oral versions of 5-HT3 inhibitors. Oncologists will usually give the drugs IV in the office at the time of chemotherapy infusions followed by pills to be taken when the patient goes home. Aloxi will be given IV and lasts long enough to eliminate the use of pills. MOGN intends to price Aloxi at about 3 times that of other agents in its class-this premium takes into account the fact that patients will no longer have to pay for pills. The company pays about a 33% royalty to Helsinn (a Swiss company) but this includes cost of goods-MOGN’s major cost will be marketing. I got out of most of my MGI Pharma just before the FDA PDUFA date on the fear that some untoward event might delay the drug and crash the price. I wish I had stayed in. MOGN now trades at $40.50 with a market cap of about $1.27 billion (the company has about $100 million in cash). So the question is how much more could the company be worth considering its already lofty market cap. I think the medicare change reflects a change in this company’s fortunes. In my estimation it is likely that MGON could get half the market in the first year and maybe even more-considering that most private practices will convert. Hospital use, which makes up about 35%, may be a little slower to follow. Hospital formularies usually take a number of months to make changes but again reimbursement should drive that market as well. MOGN has also recently licensed Aloxi for post-operative nausea and vomiting in NA. Using a conservative metric of 5X sales and estimating an aggressive ’04 sales of $400 million you arrive at a valuation of $2 billion which is almost twice where it is now (deducting cash gives a current valuation of about $1.15 billion). I think the trajectory will become apparent after release of 1st quarter ’04 sales data. I bought MGI Pharma in my personal account last week at approximately $39/share.
Another company that may benefit from the same type of scenario is Praecis (PRCS). Their drug Plenaxis for prostate cancer was just approved and the new medicare rules will drive sales away from Lupron and other similarly acting agents. However there are some use issues and restrictions that will continue to limit the market in the US. On the other hand I believe the company is underpriced and may get a broader approval in Europe which will impact the valuation story. I have Praecis in my private account and the Model Portfolio (see archives for further details).
As a matter of disclosure I want all readers to know that I own many of the stocks I write about in my personal account and always maintain a long position. I am not a stock broker or a registered investment adviser. I also write about many of these stocks in alerts for BioSpace, which can be found at www.biospace.com. . Biotech Insight is a web-based newsletter published and archived at www.biotechinsight.com. Alerts and newsletters are sent electronically to subscribers. The following is further disclosure: Dr. Garren is a member of Biotech Insight Management, LLC, a California registered investment adviser and the general partner of a hedge fund that invests in biotechnology companies, including many of the companies discussed in this newsletter (www.biotechmgt.com). Garren is a member of the advisory board of New York based InvestBio and their chief biotechnology strategist. I recommend many of these same stocks to the investment funds mentioned above. It should be noted that hedge funds could go both long and short on any particular stock. The information in this column under no circumstances serves as a recommendation to buy or sell stocks. Please also see the disclosure about Biotech Insight archived on BioSpace.
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Ronald Garren, the editor of InvestBio is also a technical consultant to the Biotech Select Focus Portfolio domiciled at Schwab and managed Capital Management, Joel Smolen RIA.