Is AbbVie the Next Big Drug Short?

Citron Research tweeted on July 19 that AbbVie is the next great drug short.

Finally Citron released a report, supposedly one of many, that expands on why they think so.

What I can see as the crux of Citron’s argument is Humira, AbbVie’s most profitable product, benefits from two things.

  1. The suppression of biosimilar competition within the U.S. While hinting that AbbVie is using “dirty tricks” to protect its Humira Franchise, AbbVie has protected its product through legal channels. This doesn’t mean you have to agree with or like their business practices but that is much different than legality. If Citron has evidence of illegal business practices then I hope they have provided them to authorities.
  2. Part of the suppression of biosimilar competition stems from the byzantine rebating process that takes place between Pharmacy Benefits Managers, health insurance providers, and drug companies.

Trump Administration Catalyst

And now with the Trump administration, it’s assumed the suppression of biosimilar competition will end as well as the aggressive use of drug rebates. Humira U.S. sales will plummet because of these two developments.

Ending the rebate process was first mentioned in the report American Patients First by HHS. Then recently the Office of Management and Budget proposed a new rule to remove the safe harbors that PBMs use to avoid anti-kickback laws when negotiating drug rebates. And during their Q2 2018 earnings conference call, Pfizer’s CEO said that he expects the Trump administration to end the practice of rebates for prescription drug purchases.

Regarding the lack of biosimilar competition, Scott Gottlieb, FDA Chairman, outlined his plan to increase competition while speaking to the Brookings Institute.

We’re always a little skeptical of an investment thesis that relies on the U.S. government to act and to do so in a timely manner, i.e. Bill Ackman and Herbalife.

But it does seem like the FDA, HHS, and the Trump administration are motivated to act quickly on ending rebates and increasing biosimilar competition.

If they do act quickly, what is AbbVie worth in this new environment?

Bear Case

Our bear case is rebating ends by the end of this year and biosimilar competition in the U.S. comes in full force at the start of next year too.

Humira loses 50% of its U.S. Humira sales starting next year and sales continue to decline at an increasing rate over the next few years. Humira also declines in Europe starting next year as biosimilar competition increases. Sales continue to decline at increasing rates over the next few years too.

Humira Bear Case Sales

We’re keeping our expectations for the rest of AbbVie’s drug portfolio the same. AbbVie’s recent blockbuster drugs are still on patent and we only want to focus on one variable right now.

Why only 18% sales decline in Europe?

This is similar to the declines in sales for other biologics. Remicade experienced a 20% year-over-year decline in sales after the introduction of biosimilar competition. Rituxan sales declined 16% year-over-year after biosimilar competition started.

The U.S. is a larger market for Humira than Europe and we wanted to inflict a lot of pain to our model. And as Citron states, Humira is well protected by the U.S. rebating process.

Given the potential one-two punch of increased biosimilar competition and the loss of protection from the rebating process in the U.S., we reduced U.S. sales aggressively.

Margins

We’re keeping margins as is. We expect AbbVie to control costs.

A fair criticism is we should increase R&D as a percentage of sales because AbbVie needs to invest aggressively to find new drugs to replace lost Humira sales. Again, we’re trying to limit the number of variables in our model and the effect they will have. Plus, we still expect the rest of AbbVie’s drug portfolio and total sales to increase going forward and 17% of sales being invested in R&D is a large sum. AbbVie spent $4.8 billion in R&D in 2017 and is expected to spend $5.6 billion in 2018.

AbbVie Margin

In our model, we’ll use a WACC of 8.7%. We’ll also keep AbbVie’s capital structure the same going forward.

Bear Case Expected Fair Value

Given these parameters in our DCF model, we generate an equity value per share of $83.

Currently (as I’m typing this), AbbVie trades at $98 per share. If Humira lost 50% of its U.S. sales and 18% of its European sales next year our expected downside risk is 13%. Of course, if this scenario played out AbbVie would sell off well past our valuation target. That is the nature of the stock market and its immediate reaction to bad news.

But again this is our worst case scenario.

Base Case

Our bear case hinges on different branches of the U.S. government coordinating their efforts and doing so in a timely manner. It is a new administration and this time may be different, but when has the U.S. government met or exceeded expectations for timely action? There are too many entrenched and competing interests affected by both decisions for a quick resolution.

But we will expect increased biosimilar competition to come. Starting in Europe next year and then in 2022 in the U.S when the deals to delay Humira biosimilar competition end.

Increased biosimilar competition does not necessarily mean Humira sales will drop off a cliff like in our bear case scenario. Humira is a biologic, not a small molecule drug. This misunderstanding has existed since AbbVie was spun-off from Abbott Labs.

Small Molecule Drugs

A small molecule is a chemically manufactured drug that can be administered via pills and capsules. When a small molecule drug loses its patent, a generic manufacturer only has to prove that their generic drug is the exact same chemical compound as the branded drug. The generic drug does not have to undergo safety and efficacy testing. It can piggyback off the original testing for the branded drug.

Biologics & Biosimilars

A biologic is a class drugs that are based on human proteins but modified and optimized to provide therapeutic effects. Biologics are administered through injections or infusions. Biologics are manufactured using microorganisms. The whole process to create, produce, isolate, and purify the biologic is the drug. A change in any step creates a different product.

When a biosimilar is created it is not an exact copy of the branded biologic.

The biologic and the biosimilar may have the exact same amino acid chain but proteins are complicated 3-D structures. A protein is created by the folding of the amino acid chain and then modified by phosphorylation, protein clipping, and glycosylation. Different environments where the folding, phosphorylation, protein clipping, and glycosylation occur can produce two different final structures.

It is this final structure that determines if the biologic or biosimilar will be recognized as foreign or not. If the biologic or biosimilar are recognized as foreign then no therapeutic benefits will occur because the patient’s immune system will respond to the foreign protein.

Immunogenicity Switching Costs

Some people currently being treated by Humira may switch to a cheaper biosimilar but we think this number will be small.

Switching from Humira to a biologic risks immunogenicity.

If the biosimilar is recognized as a foreign protein, the immune system will produce antibodies to target the biosimilar. The patient will receive no therapeutic benefit from the biosimilar and they will have to switch back to Humira. The problem is Humira and the biosimilar are the same amino acid sequence and their final protein structure are very similar. The biosimilar antibodies could attack Humira. The patient who once had their illness under control no longer does.

If Humira has your illness under control do you want to risk losing all your progress to save some money? Some people will but we think the majority will not.

Biosimilars are competing for future patients. If the biosimilar is tried first and it works then patients will not trade up to Humira because of the same immunogenicity risks and they’ll save money.

If the biosimilars don’t work then Humira can be tried.

It is because of these factors that we don’t see Humira sales falling off a cliff like you would see when a branded small molecule drug goes off patent.

Base Case Humira Sales

Because biologics and their risks are much different than small molecule drugs, it is possible that Humira sales do not decline as expected given biosimilar competition. However, it is prudent to build our base case with the expectation that Humira sales will decline.

The table below is our base case sales growth for Humira. European biosimilars take market share starting next year. Then starting in 2022 and accelerating into 2023 U.S. biosimilar competition takes market share away from Humira.

Humira Sales Growth

Base Case Fair Value

Like before we’ll keep our expectations for the rest of AbbVie’s portfolio the same as along with their margins.

Our base case DCF model produces an expected value per share of $129.

Next Big Drug Short?

If Humira sales fell off a cliff next year by 50% the rest of AbbVie’s portfolio still has value. The downside risk we would expect is 13%.

Our base case is the status quo continues. Humira sales decline in the coming years as biosimilar competition comes online in Europe and then in the U.S. a few years later. Our base case gives AbbVie an upside potential of 31% based on AbbVie current trading price of $98 per share.

If Humira sales decline at a slower pace and/or continue to grow a few more years after biosimilar competition then the upside potential is even greater because of switching costs. Once a patient gets their illness under control with a biologic they are unlikely to switch because of immunogenicity risks.

Unless there is more to Citron’s story, we don’t see AbbVie as the next big short. Yes, we’re biased. We’ve been a long-term holder of AbbVie. But we’re not dismissing Citron’s report. When we’re presented with new information we have to look at it and ask what is the worst case scenario? The worst case scenario, as we envision it, does not look that bad. It will be painful in the short-term, but in the long-term we think the value for the rest of AbbVie’s drug portfolio will win out.