Drug Innovation Can Surmount New US Law’s Price Caps

Investing Perspectives on Healthcare Stocks

01 November 2022

5 min read

The cost of prescription medicine is a constant strain for many Americans. While new federal legislation may soon lend relief, some investors worry that profitability will pay the price.

Attached to the new US Inflation Reduction Act is a multipronged mandate on pharmaceutical companies to limit or lower drug prices—particularly for insulin and blood thinners, among the country’s most-prescribed drugs. As expected, price controls raise investor concerns that companies will have less incentive to develop new life-saving treatments—a costly, time-consuming process.

Based on our assessment, however, prescription drug development could accelerate, not decline, driven by new technologies and better cost efficiencies within drugmaker pipelines.

Lower Drug Prices Can Be a Game Changer

Improving the affordability of essential medicines, which can be cost-prohibitive for many Americans, offers real financial relief. About two-thirds of personal bankruptcies in the US are linked to soaring medical expenses. And millions who can’t afford their prescribed medication endanger themselves by self-rationing or forgoing it.

On the other hand, drugs remain more cost-efficient than physician or hospital services, based on their prices as a percentage of all US healthcare spending. The pharmaceutical industry still delivers relative value, but it can always do better, and we think the new law will help.

For instance, the act’s key beneficiary will be Medicare, the largest single purchaser of prescription drugs. The law gives Medicare the authority to negotiate prices and secure rebates for high-cost treatments, which could save billions. About $111 billion is spent annually on prescriptions in the Medicare Part D drug benefit alone, according to the Congressional Budget Office (CBO).

Beyond its negotiating powers, the new law eventually will cap out-of-pocket Medicare patients’ prescription costs to $2,000 annually and limit insulin costs to $35 per month (Display). It will also extend drug-related subsidies for Affordable Care Act insureds, whose numbers have spiked since the COVID-19 economic crisis.

Key Prescription Drug Provisions of the Inflation Reduction Act

From price caps and rebates to Medicare subsidies, mandates under the new law will roll out over the next seven years.

As of August 18, 2022
Source: Kaiser Family Foundation and AllianceBernstein (AB)

Drag on Profits, R&D May Be Minimal

While regulators finalize details, there’s concern that price controls could crimp new research and development (R&D), considered the industry’s lifeblood, ultimately reducing the incentive to innovate which could shrink the availability of new cures and treatments.

It’s worth noting, though, that negotiated price reductions apply only to the top-tier priced treatments that have been on the market for some time: at least nine years for pills or 13 years for injectables. This means the negotiation mandate will initially target only 10 drugs (out of 20,000 currently FDA approved) when this mandate takes effect in 2026. The law’s influence on the number of novel drugs coming to market will likely be modest as well. Of the 50 new drugs introduced annually, the CBO estimates that just one will be directly disrupted.

At the same time, the pharma industry will continue to transform, especially across in the tools, timelines and technology that serve it—all to the benefit of the companies that ride the wave. What won’t change is R&D momentum, in our view. Innovation is burgeoning across the healthcare sector in areas like DNA sequencing, artificial intelligence and machine learning, with strong applications to drug discovery and development.

DNA sequencing has especially turbocharged pharmaceutical research, and the cost to use it has steadily fallen; the price to read a human genome has dropped from millions of dollars to hundreds of dollars in the last 20 years alone. Perhaps the most high-profile breakthroughs were the recent COVID-19 vaccines, some of which are based on new mRNA technology, which is now being leveraged to treat cancer, arthritis and other ailments.

Smart Business Models Still Drive Success

New pharmaceuticals can take up to 12 years from concept to market, with smaller companies comprising a larger and growing share of the industry’s pipeline (Display). While drug development will continue to be driven by large and small firms alike, the exciting science is encouraging new company formation and attracting funding for drug development, as evidenced by the growing pipelines at smaller biotech firms.

Proportion of Total Drug Industry Pipeline by Company Size

About 92% of all new drugs are produced by companies outside the top 25 based on market cap, a 10% jump in a decade.

Past performance and current analysis do not guarantee future results.
As of October 26, 2022
Source: Pharmaprojects and AB

That’s why we think the industry is only in the early stages of translating the latest promising discoveries into practical treatments. Consequently, research and innovation will grow, not wither, and the companies that provide the picks and shovels to support them will remain compelling investment opportunities.

These include enablers behind biomedical research, like specialized facilities, clinical trial services, and testing equipment and chemicals. Companies that innovate in how treatments are taken, such as transdermal patch makers, should also benefit. And when medicine is easier to self-administer, broader adherence rates significantly improve, which can lift an entire sector. We also look to pockets of the pharma industry less tied to policy winds, especially life-science research at the academic and industrial levels—areas not likely affected by drug price caps.

Most importantly, the new law doesn’t change the fact that long-term investment growth is largely tied to a company’s business model—not the science or political climate behind it. With new guardrails on pricing, bottom lines will need extra scrutiny along with innovative approaches to manage costs while pursuing meaningful R&D. It should be possible to do both and pass the pricing benefits on to customers. For example, the technology sector has exponentially innovated for years, while costs to consumers have declined significantly.

Like any industry, healthcare and especially pharmaceutical investing comes down to research and analysis. That means putting emphasis on high-quality, sensibly priced companies with high or improving returns on capital and strong reinvestment capabilities.

The full weight of the Inflation Reduction Act won’t be felt for years, but as it stands, millions of Americans are expected to benefit from more affordable access to essential medicines while federal budgets get a break. As we see it, the new law isn’t all bad for pharma companies either. Firms that focus on bottom-line efficiency with innovative approaches to R&D should prosper under it, and investors who can find them should benefit from durable drivers of long-term growth.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

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