PPH ETF Investors To Be On Top Of Regulatory Developments (NASDAQ:PPH)

Published on the Value Lab 24/8/22

The VanEck Vectors Pharmaceutical ETF (NASDAQ:PPH) is one of the more well-known ways to get broad exposure to global pharma, although mostly U.S. pharma. In the current economic environment, it is almost taken as a given that pharma offers resilience and margin power to sustain returns to investors. However, while pharma stocks continue to be somewhat interesting, it is an industry that has constantly been in the sights of U.S. regulators looking to control affordability. While nothing is written in stone yet, and the pharma lobby can exploit weaknesses in the law, investors should be aware that these risks are becoming more material, and that could lead to permanent effects on these companies’ cash flows. The urgency isn’t high, but investors in PPH and pharma broadly should be aware of some of the risks.

Medicare Negotiations

The first thing, and this one is already now in place, is that Medicare, which is the health insurance in the U.S. for people 65 or older, can now negotiate on the price of drugs it purchases for the health system on behalf of the covered population. This was part of the Inflation Reduction Act now signed into law. It only applies to drugs that have no generic competition, and for the 10 most costly drugs to the system starting in 2026, ’15 in 2027 and 2028, and 2029 and each year thereafter’.

“Democrats have received extremely good news: for the first time, Medicare will finally be allowed to negotiate prescription drug prices, seniors will have free vaccines and their costs capped, and much more,”

Chuck Schumer, Senate Majority Leader

There were other attempts to cap out-of-pocket costs for consumer under private health insurance for insulin, but this was blocked. These caps could still become applied to people under Medicare, but we await news on this particularity for now. There is also now an inflation rebate that can be applied to the prices Medicare will on certain drugs under certain conditions that limit the pricing power of drug companies. This appears to mean that drug prices would be liable for any excess pricing over inflation that Medicare would pay in those cases, which are for drugs with no generic competition that cost covered people under Medicare more than $100 or more per year. Again, just Medicare not the whole commercial market, and not in all cases.

66% of the population is still not covered by Medicare, so there is plenty of market where there are no rules still in the US on setting prices. Moreover, drug companies might be able to raise prices for younger people if margins are pressured among the old. Finally, this all starts in 4 years, and things could change in the meantime in all sorts of unforeseeable legal ways. Nonetheless, we would expect that the rebates will do quite a lot to many drugs, since really a lot of drugs cost seniors more than $100 per year, and we think that if the law functions as intended, larger companies and larger drugs will get hit. So watch what’s in your portfolio, and understand how big key revenue drivers are in senior markets, and how big those revenue drivers are relative to other drugs that seniors take.

Whether these measures will reduce drug prices is not clear. Other things in the bill might do a better job. But, as investors, our concern is our holdings, and it should be yours too. So whenever a drug costs customers a lot per year, realize the pricing is limited by inflation. Moreover, large drugs could be pressured by Medicare (so not smaller newer drugs, don’t worry) unless the next administration doesn’t go aggressively into achieving savings. Drugs like Keytruda from Merck & Co. (MRK) are presumed to be awaiting hits from this.

Tax the Rich

There are other things in the bill that are general, like a 1% excise tax on share repurchases, that really makes us wonder how the effects on markets broadly will be felt. But there are plenty of things that continue to target drug manufacturers directly. There is now a minimum 15% tax on companies that are domestic corporations on domestic profits but have used tax planning strategies to pay less or no tax. This applies to drug manufacturers. Tax planning strategies include all sorts of accounting choices that reduce tax bill. In theory, depreciation would have been limited in its ability to produce tax savings if it weren’t for final amendments demanded by Senator Sinema, because companies under this bill would have to pay the higher of 15% of tax on book income, reported to shareholders in filings, or the normal tax paid of 21% on taxable income minus various deductions and other tax breaks. Perhaps this would affect companies’ ability to use a chosen amount of NOLs in a given year too, if they qualify as a manufacturer or other stated under this bill.

In any case, for any manufacturer that operates domestically in the U.S., and there are many drug companies with almost all their revenue coming from the U.S., effective tax rates below 15% will become rarer, unless depreciation or other exempted tax breaks are being used. This element of the bill is supposed to produce the biggest government savings.

Conclusions

Large-cap pharma is what is being targeted here. If you have niche exposures and no huge blockbusters, or if you’re invested in biosimilars, you’ll have less to worry about. But do keep in mind whether your companies have a lot of senior customers.

For PPH investors, plenty of stocks in the portfolio could be affected. We mentioned Merck’s Keytruda, that’s 5% of PPH. Bristol Myers Squibb (BMY) is likely under the gun with some of its drugs, as it in fact competes with Keytruda. Same with AstraZeneca (AZN) and Roche (OTCQX:RHHBF, OTCQX:RHHBY), although I don’t know how effectively they’ve tackled that treatment area. Perhaps GSK plc (GSK) will have to worry about some of their vaccine portfolio, although it all loses exclusivity sooner than this legislation comes into effect. AbbVie (ABBV) is less exposed with Humira’s reign over and several new drugs splitting the spoils in that treatment area.

These are the things you should consider. If as an ETF investor you don’t have the details on the constituent parts, perhaps err on the side of caution and pass on this ETF as we would. PPH is skewed in a typical ETF value-weighting towards exactly the companies that might have to concern themselves over this. Remember, the legislation only kicks in, in 2026, but it does matter, especially if they can’t raise prices for people under private health insurance to offset the greater protection of Medicare-covered seniors.