(11/24/15) Best Ideas in Biotech

The most important source of competitive advantage for biotech firms is intangible assets. To further characterize the long-term prospects of the biotechs in our coverage universe, we have isolated six factors that contribute to the establishment of strong intangible assets, explains Karen Andersen in Morningstar StockInvestor.

Generic Barriers to Entry

Patent protection and orphan-drug exclusivity are key barriers to entry for generic drugs. Barriers to entry are especially high for complex biologic molecules.

The introduction of biosimilars is increasing competition for most established biotechs, but we think Amgen (AMGN) and Roche (RHHBY) can sustain their wide moats thanks to strong new product launches and innovative pipelines.

Major improvements to formulation—like Roche’s subcutaneous versions of Rituxan and Herceptin and Amgen’s on-body delivery of Neulasta—can further protect branded biologics from biosimilar competition.

Rare-disease products are often eligible for orphan-drug exclusivity, which provides seven years of market exclusivity in the US and ten years in Europe, regardless of patent life.

Therapeutic Focus

Biotech moats are influenced by therapeutic areas of focus. For example, orphan-disease niches benefit from efficient scale: It can be cost-prohibitive for multiple firms to invest in manufacturing capacity and clinical trials to serve a very small patient population.

This results in monopoly-like market share and strong pricing power for firms that specialize in very rare diseases, such as Alexion (ALXN) and Biomarin (BMRN).

Diversification

The breadth of a firm’s portfolio can be an indicator of its R&D productivity or business development success and provides a buffer against increased competitive threats to any single product.

Diversification gives investors greater confidence in a biotech’s ability to sustain attractive returns on invested capital. Amgen, Roche, Shire (SHPG), and Novo-Nordisk (NVO) are among the more diversified biotechs we cover.

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Research and Development Strategy

We prefer firms that have a proprietary drug-development platform or have demonstrated expertise with in-licensing and acquisitions in a specific market niche.

For example, Roche has used its diagnostics expertise to personalize much of its pharmaceutical pipeline, and Biomarin continues to demonstrate its ability to develop effective enzyme-replacement therapies.

We think firms like Lexicon (LXRX), Exelixis (EXEL), Isis (ISIS), and Alnylam (ALNY)—while all early-stage, no-moat companies—could begin to establish moats if their research platforms show signs of success.

A strong research and development strategy can also take the form of well executed acquisitions, such as the purchase of Pharmasset by Gilead (GILD).

Gilead’s product lineup reflects a growing record of identifying opportunities in infectious-disease treatments.

Pricing Power

At a basic level, we think firms that have more exposure to the US private-payer market have more pricing power than firms exposed to government payers and international markets.

Government payers account for a growing share of drug spending in the US due the aging of the baby boomers and expansions to Medicaid eligibility. This could eventually lead to legislative changes that give the government greater power to regulate prices.

Cash Generation

Lastly, firms with access to more cash flow are able to fund internal investment and pursue in-licensing or acquisition opportunities. This advantage naturally follows from the other intangible asset factors.

Our Best Ideas in Biotech

On balance, we see biotech moats getting stronger as a result of improving intangible assets.

Patent expirations and biosimilar competition are countered by expanding product portfolios, improved R&D productivity, and management focus on therapeutic areas with the best pricing power and room for differentiation.

Below are our current best ideas in biotech:

Amgen: Facing biosimilar competition in the US, but Amgen’s branded and biosimilar pipelines have stabilized its moat trend.

Biogen: Despite competitive threats in multiple sclerosis, we’re bullish on Biogen’s unique focus on neurology and its novel pipeline.

Gilead: Improving diversification, an unparalleled track record with acquisitions, and dominance in HIV and hepatitis C give Gilead a stable wide moat.