Inflation Reduction Act: A Bullish Catalyst For Viatris (VTRS)

The Inflation Reduction Act (‘IRA’), enacted in August 2022, focused on several key areas. The legislation is very extensive and complex. This article will focus specifically on healthcare and the ramifications for generic pharmaceutical companies in the healthcare sector:

To reduce prescription drug costs, there was a provision in the IRA enacted to reduce the cost of certain drugs. Specifically, the period of exclusivity on small-molecule drugs was reduced from 13 to 9 years, while the timeframe that biologics are exclusive was left unchanged. This period is very dependent on the specifics of the product. An excellent summary may be found at Akin. The article finds that:

• Reduction in Exclusivity Period for Small-Molecule Drugs: The IRA introduced charges to reduce the market exclusivity period for small molecule drugs, while leaving biologics relatively untouched.
• Impact on Patent Litigation: The reduction in patent life is highly dependent on litigation and difficult to predict a priori. However, small molecule drugs (SMDs) have been reduced in patent lifetime compared to biologics.
• Biologics: Biologics are large, complex molecules derived from living organisms, often proteins or antibodies.
• Small Molecule Drugs (SMDs): SMDs are chemically synthesized compounds of lower molecular weight, which are more often taken orally via pills.
• Market Entry for Generic Drugs: Overall, the IRA provisions are expected to facilitate earlier generic entry, particularly for SMDs.
• Generic Drugs: Generics are produced after the brand-name drug patent expires.
• Branded Drugs: Branded drugs are marketed by a specific company under a proprietary name.
• Branded Generic Drugs: On occasion, branded pharmaceuticals are licensed to generic pharmaceutical companies, leading to branded generics, which can sell before or after competition with generic drugs.

In healthcare, branded pharmaceutical companies spend money on research and development (R&D) for many years before discovering a drug, which becomes a branded drug. While doing so, branded pharmaceutical companies patent their still secret discovery, before disclosing the exact identity of the new drug’s structure. This disclosure, known as a patent, is a quid pro quo. Literally, the company gives something to get something: in this case they give the secret structure of their new active pharmaceutical ingredient (‘API’), to get a set time period during which they have the exclusive right to sell the API. In 2022, the IRA suddenly changed the rules, shortening the period of exclusivity from approximately 13 to 9 years for SMDs.

While some of these changes are priced into the market, there are others that are overlooked. I believe this will create a bullish catalyst for certain stocks in the generic pharmaceutical space (those that compete with branded pharmaceutical companies following the period of market exclusivity by selling generic drugs).

Logically, since the stock market looks one to two quarters into the future, patent expirations further out may remain underappreciated, providing a bullish catalyst. Better yet, a specific timeframe for this catalyst exists. Since the period of exclusivity has generally been shortened, we should look at the highest-selling branded pharmaceutical products that began selling from 2011 through 2015. In other words, a branded drug that began selling in 2015 (9 years ago), would suddenly have its period of patent exclusivity thrown into question. New generic drugs will compete with the prior branded drug and the companies that manufacture them will potentially have a boost in revenue.

To research this, the FDA’s website was consulted. After some digging a potential candidate was found. In September 2018, Gilead Sciences, Inc. (GILD) announced its intent to launch authorized generic version of its blockbuster hepatitis C drugs Harvoni (ledipasvir/sofosbuvir) and Epclusa (sofosbuvir/velpatasvir) a major surprise at the time since they remain fully owned by a subsidiary. Indeed, the prices of Harvoni and Epclusa are still high, reflecting that profit margins due to exclusivity are still in place. This is an example of a branded generic drug that is not yet facing full generic competition.

In the above example: Harvoni is the branded name and ledipasvir/sofosbuvir is the generic equivalent, it is important to remember that these are SMDs. As such, the IRA was an unexpected development that may shorten Gilead’s US patents on these APIs and was not expected until 2030 and 2032 respectively.

However, the expected expiration date of 2030/2032 in 2018 was before the IRA shortened the term of patent exclusivity for SMDs by five years. Thus, we should expect a shortened window of exclusivity ending in either 2025 or 2027. Since the market looks one or two quarters this window of time could be excellent timing to buy stock in a generic pharmaceutical company launching new product lines of either generic Harvoni or Epclusa.

As noted above: Harvoni and Epclusa are now sold as authorized generics through a wholly-owned subsidiary of Gilead, named: Asegua Therapeutics. While the price of these drugs has been reduced, it has not dropped nearly as much as a full generic equivalent will.

Because Gilead has moved sales of Harvoni and Epclusa into the subsidiary Asegua Therapeutics, it is difficult to find exact sales that should be attributed to these drugs. First, the market’s expectation of the patent expiry for Harvoni and Epclusa was confirmed. In its most recent 10-K filing, Gilead discloses expected patent expiries that support the investment thesis:

This 10-K filing confirms our hypothesis, with Harvoni expiring in 2030 and Epclusa expiring in 2032 (EU) or 2033 (US). It should be noted that a central risk to this strategy is the as yet unknown implementation of the IRA. This is likely why the 10-K has not amended the date as yet. Some further digging on Asegua’s website confirms that these are the only two products sold by the Foster City-based entity.

Therefore, I believe Gilead could suffer a patent ‘mini-cliff’ in the near future, which should not concern investors in the stock too much. However, there are quite a few ‘mini-cliffs’ out there and the combined effect will be pronounced for generic drug manufacturers.

The ‘mini-cliff’ term is a reference to the major ‘patent cliff’ in branded pharmaceuticals around 2010. Around that time, many branded pharmaceuticals lost patent exclusivity, including: Pfizer Inc.’s (PFE) Lipitor, Merck & Co., Inc.’s (MRK) Cozaar/Hyzaar, Flomax (BI – private), AstraZeneca PLC’s (AZN) Arimidex and others. The ‘patent cliff’ weighed on the business models of many branded pharmaceutical companies. While these companies ultimately pulled through what followed was a golden age of generic pharmaceutical companies, with Teva Pharmaceutical Industries Limited (TEVA), Mylan outperforming the market. The most interesting example was Valeant, which became quite a saga with Bill Ackmann taking a large stake in the company leading to major losses. It is important to note that some of the issues that Ackman acknowledges are risks to this strategy as well, including:

• Business model: The aggressive drug pricing strategy of Valeant was unsustainable when Pershing Square Capital Management made its investment. It is important to consider the sustainability of pricing for generic drug-makers, who are not shielded from competition by a patent.
• Litigation Risk: The profit margins of generic drug manufacturers are highly dependent on competition and litigation. Valeant raised prices so aggressively that it was ultimately unsustainable.
• Execution Risk: The generic drugmaker may fail to bring additional products to market.
• These are also risk factors to the investment thesis of this article.

These risks should be carefully considered. Returning to Gilead’s patent ‘mini-cliff:’

Should the IRA shorten the exclusivity on Gilead’s patent, it would also render Asegua subject to generic competition. It is important to note that the main ‘patent cliff’ has already past. This analysis should not be interpreted as a short thesis for GILD stock, since the revenues are ultimately no longer consequential.

In 2016 Harvoni sold $9.081B and Epclusa $1.752B, contributed 30.1% and 5.8% respectively to Gilead’s net sales of $29.953B. For Harvoni that was a major decrease in sales from the prior year (a 34% reduction in sales from $13.864B in 2015). At the time, this was very material to Gilead’s business model as I noted in 2015. This highlights what wonderful, beneficial and valuable medicines Harvoni or Epclusa are. It must be stressed that lower prices may lead to larger sales as developing markets (like India, see below) open for the treatment of Hepatitis C, potentially saving the lives of individuals living in poorer countries.

Investors should take note that risking their capital in the pursuit of manufacturing such products is a net social good of the highest order. As such, the investment thesis presented is not only a financially sound one, but also should lead to improved patient outcomes, particularly among the less economically privileged. Below are the sales from Gilead broken into product segments to highlight the lowering in price of Harvoni and Epclusa.

However, as of the 2023 reporting period, sales of Harvoni (ledipasvir/sofosbuvir) and Epclusa (sofosbuvir/velpatasvir) have declined substantially. Last year, sales were only $1.769B, perhaps a major boon for a small generic pharmaceutical company, but probably not a major impediment for a robust large-cap pharmaceutical company like Gilead (~6.5% of $27.1B in 2023 sales). This is one patent ‘mini-cliff’ and there are certainly others, cumulatively creating an opportunity in the generic pharmaceutical sector. This is great news for patients, as they gain access to these wonderful drugs at a lower cost:

The profit margins of generic pharmaceuticals are lower due to increased competition, but a number of these new products should help to drive the best-positioned companies in the sector. $1.769B in sales is not a considerable sum for the likes of Gilead, but added with other products across the industry there is a lot of revenue up for grabs. As mentioned above, new markets will enable the absolute quantity of pills sold for Harvoni to expand.

To wit, please note that a branded generic Harvoni was launched in India under the brand name MyHep by Mylan. While any company could manufacture and sell Harvoni once it is fully generic, the manufacturing process of a generic pharmaceutical is still a very challenging one. The price of these drugs has still not fully been reduced, particularly in the US and EU.

An important note for the paragraph above: Mylan is no longer under the same name. In 2020, Pfizer Inc. (PFE) completed a transaction to combine its Upjohn generic pharmaceutical business with Mylan. The spin-off was completed, yielding a company named Viatris Inc. (NASDAQ:VTRS).

In the trailing 12-month period, Viatris had sales of $15.39B. Thus, the early patent expirations discussed above should be material to the stock. The company trades at a forward PE ratio of 4.1, price/sales ratio of 0.88, price/book value of 0.65. These metrics are very cheap when compared to similar companies such as Dr. Reddy’s Laboratories Limited (RDY), Teva, Organon & Co. (OGN), and Prestige Consumer Healthcare Inc. (PBH). Viatris is very attractive in terms of PE, price/sales, price/book, and dividend yield. The debt/equity and debt/EBITDA are higher than I would like, so further research should focus on the company’s plans to reduce its debt load.

Viatris’ website confirms that Harvoni (ledipasvir/sofosbuvir) and Epclusa (sofosbuvir/velpatasvir) are not available in its product catalog as yet. The speculation that they will move into this space remains unconfirmed, a risk to the strategy, but also an opportunity that the market has not priced in. Viatris generated ~$2.3B in free cash flow according to its latest earnings report, half of which was returned to shareholders by way of dividends and share repurchases, while the remaining half was reinvested in the business. With a market capitalization of $13.36B this is a very attractive cash-flow yield of 17.2%. One major risk and concern is the debt position and potential investors should carefully consider this. Other articles on Seeking Alpha have covered the issue in greater depth. $17B in net debt could negatively impact the business.

However, Viatris took on this debt at an opportune time when interest rates were lower and maintains a BBB investment grade rating. This level of debt should give investors pause (~7 times last year’s free cash flow). Viatris could founder if the investment thesis does not play out. On the other hand, these liabilities are a principal reason why shares are so cheap.

To get a sense of the product distribution for Viatris, the following slide from the latest earnings report is shown below. As one might expect based on the merger with Upjohn, the major branded products are legacy Pfizer, with Lipitor being the most recognizable. This bodes well for the investment strategy, as the company has successfully navigated commercializing legacy Pfizer products in the past and should be able to successfully navigate legacy Gilead products (such as Harvoni) into its brands. The above discussion highlights how this transition may occur sooner than the market is expecting, although it is not discussed in the above-referenced earnings report.

In conclusion, I believe the Inflation Reduction Act has created a potential catalyst for the stock prices of generic pharmaceutical companies. Viatris may be uniquely situated given its history and the patent expiration dates discussed above. There are many risks, including litigation, execution, and interest on an above-average debt load. However, for an aggressive pick, Viatris appears quite intriguing. It was not too many years ago when the ‘patent cliff,’ an expiration of many branded products in the pharmaceutical industry around 2010 led to a surge of generic pharmaceutical companies. The most memorable of which was Valeant in which Bill Ackman rode the wave higher with Valeant until it eventually crashed in mid-2015.

Valuation and Technical Analysis:

In order to calculate a fair value for Viatris, the following assumptions were put into a discounted cash flow model:

• Revenues will stagnate and remain so in perpetuity (~$15.4B/year).
• Net Margin will remain constant (15% Free Cash Flow Yield).
• A discount rate of 10% is applied and a growth rate of 0% is expected.
• Net debt at 89% of equity is removed from the terminal valuation.

Plugging these seemingly conservative assumptions into a DCF model returns an equity value of $25.6B or $21.33/share, indicating that Viatris in a zero growth scenario is undervalued by almost 50%:

Given the number of new products on the horizon, such a low growth sce`nario seems very conservative. Should these ‘patent mini-cliffs’ foster growth one should expect excellent returns moving forward.

From a technical perspective, the chart of Viatris looks compelling, with a pullback of 15% off 52-week highs presenting a buyable dip. When new products materialize, the market should price growth back into the shares. A 2-year price target of $25/share seems very reasonable in this instance.

Furthermore, while Harvoni and Epclusa are two examples, many others remain. In the nearer term, the company expects that Selatogrel and Cenerimod both have blockbuster potential. Thus, much like in 2010 when a ‘patent cliff’ accelerated the prices of generic pharmaceutical stocks, the IRA may accelerate us into a new golden age of generic drugs, presenting an opportunity for astute investors to realize gains that have yet to be priced in.