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Drug Price Reform is Off the Table

On Thursday morning before the market opened I saw this tweet come out from one of the biotech folks that I follow.

BREAKING: Biden abandons his push to lower drug prices https://t.co/fIGujAfvn9

— STAT (@statnews) October 28, 2021

This was followed up by at least one analyst turning more constructive on biotechs:

One of the stories I remember from Reminiscences of a Stock Operator (the book) is that when the San Francisco earthquake hit, the market took a while to react because it was in a bull market.

Momentum is a strong force and the example here was that even the obvious devastation of an earthquake could not immediately topple the market.

Well, biotech stocks are in anything but a bull market. And momentum cuts both ways. The news came out and the market yawned. On Thursday you could have picked up many names at discounts to where their share price was just a few days before.

Nevertheless, in my opinion, this is very big news. My running thesis has been that the underlying “ask” behind the last 6 months of misery in biotech-land has been the specter of higher drug prices.

This article, written about a month and a half ago, put it starkly. It says that “Merck would cut its R&D efforts by nearly 50%” under the drug price reform proposal at the time.

If these sort of cuts came to pass, it would have had huge ramifications for all biotechs. Mergers and acquisitions would dry up. Money flow into the sector would slow. It is no wonder that biotechs have been down in the dumps.

So again, I think that this news, if it holds and isn’t more political gerrymandering, should be the bottom.

I bought biotechs on the news. But even I was not immune to the momentum. I bought some at the open, but not too much – just in case. Which really means, just in case biotechs keep on being biotechs.

The stocks I bought were not the same clinical stage spec companies that I’ve been playing with for the last year or so. This time I bought companies with approved drugs that generate revenue and cash.

A lot of these companies have been beaten up to 52-week lows. Even as the market has soared higher, they have not. Three of the four below are at a level that is roughly the same as their level at the height of the covid panic.

• I added one of the behemoths, Bristol-Myers Squibb (I came a hair away and should have added Abbvie though). BMY is a $130 billion company and trades at 7x next years earnings.
• I added Incyte Corp. They are a $14.8 billion company with $2 billion of cash and close to $3 billion of revenue. They are expected to grow 20% next year (they have grown at a ~20% CAGR the last 5 years) and trade at 10x next years EV/EBITDA.
• I added Vertex Pharmaceuticals, of which I am reading the book The Million Dollar Molecule right now. They are the leaders in cystic fibrosis, have a $48 billion market cap with $6 billion of cash, trade at 9.5x EV/EBITDA and are expected to grow 11% next year.
• I added PTC Therapeutics, which reported earnings just yesterday, beat revenue estimates and raised guidance, trades at ~6x sales (this is the only one of the list that is not profitable yet) and is expected to grow 35% next year.

If there are other cheap names with decent prospects, please email me!

In addition to these I already hold a bunch of clinical stage biotechs that I have held for some time.

I am fairly heavily biotech weighted. Which makes sense. It truly has been the pain-trade and I seem to gravitate to those.

We will see what next week brings. While it was a slow start on Thursday – I did notice that by end of day Friday they were beginning to pick up steam.

Markets react slowly when an earthquake makes them change direction.

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PS: In one other bit of news that is worth mentioning but not a whole post, Vidler Water, which I wrote about back and June and have been quietly sitting on, announced the sale of some credits this week.

While this sale is not a sure thing yet (it is a small amount up front with the option for a larger amount to be purchased before year-end), it could be very important to the Vidler thesis.

My only real worry about Vidler, and the reason I kept my position not super big, was that they had a lot of water credits in the Harquahala Valley, Arizona. My concern was that I read something and talked to someone else who questioned whether those credits were really worth what Vidler was saying at the time (they said a little under $400/acre-ft).

Well this deal is pricing one batch of those credits at $400 and another at $450. So if a material amount of credits sells in this deal, it vindicates the pricing. Which alleviates my concern. So I did what I had to do when something like this happens. I doubled down on my position.

Alchemy

Because I am trying to be a bit cautious about what is going on with China and energy, I have limited myself from taking too many new positions. I only want to add stocks that are unconnected, or better yet positively correlated, to it.

My two main areas of addition the last few weeks have been gold stocks and a basket of chemical manufacturers.

Gold Stocks

While I have no idea what gold is going to do, I do know that when gold miner sentiment gets very bad, the miners tend to rally. Even if it turns out to be short-lived, it is good for a trade.

Meanwhile when I look at the gold miners, they appear to me to be one of the cheapest sectors of the market.

While I’ve taken positions in Torex Gold, Jaguar Mining, Superior Gold, Wesdome (again) and Fiore Gold, I want to take another name, Argonaut Gold, as our example.

I pick Argonaut because of their milk-toast factor. There is not a more bland miner out there. Argonaut has some very boring, very low grade assets in Mexico and they are now building a large, low grade, high capex mine that is having cost over-runs in Canada.

But here’s the thing. Even Argonaut has been able to generate loads of cash of late. About $100 million of free cash flow (ex-development of the new mine) over the last 12 months.

The stock trades at ~5.5x free cash flow (ex-mine development). The mine they are building (Magino) will increase production by about 50% and lower costs for the corporate whole by 2023.

Now I have not bought Argonaut. I am a little worried about cost over-runs at Magino. They need many of the same inputs that appear to me to be in short supply. Costs are already over their 15% buffer.

But it illustrates the value. If gold doesn’t collapse (which it might, I mean who really knows) these miners appear extremely cheap and unloved.

Chemicals Trade

This is a basket trade for now, until I have fully researched these names and have a better sense of the biggest beneficiary. I added back a name that I owned a few months ago – Chemtrade Logistics. I have also added Olin Corp and Westlake Chemical. I might add Methanex.

While we are inundated with commentary telling us the worst of supply chain issues are behind us, I am less sure that these forecasts will turn out to be correct across the board.

Take for instance this news that came out of China a few hours ago.

Steel production had been curtailed through September. Production was supposed to come back beginning in October. Now they are asking for at least some production to be cut through March. This strikes me as odd if you believe the energy crisis will be over in a month.

This is good news for steel producers. If I wasn’t already nervously long Stelco and Algoma I would consider buying some steel stocks right now.

Steel and aluminum seem likely beneficiaries of China electricity cuts. But there are also some chemicals that require a lot of electricity to make. For example, note the process to make chlorine:

There are three key ingredients to make elemental chlorine; salt, electricity and water. From these three ingredients, we get elemental chlorine (Cl2), caustic (often sodium hydroxide or NaOH) and hydrogen (H2). As these three products are highly reactive, technologies have been developed to keep them apart.

Electricity is central to the process. Not surprisingly, Chinese production of caustic soda is being curtailed.

Current tight supply conditions in Asia’s liquid caustic soda may continue in the near term, as recent curtailed output in China has had ripple effects across the wider regional market.

The article goes on to say that the curtailments will continue until December at least.

Due to China’s dual control policy as well as a shortage of national energy reserves, market participants expect curbs on output to remain in place as the country heads into the winter season in December.

And remember, it is not just China. Europe is having the same problems with energy. Caustic soda prices there are going up as well.

Producers had for the most part targeted double- to triple-digit increases for Q4 compared to Q3, reflecting tight availability in the European market combined with strong global demand for caustic soda. However, in the face of large energy cost increases in September caustic soda producers have independently raised their price targets for the quarter.

KEM ONE announced an increase of 200/dmt beginning from 1 October due to erosion of margins caused by high electricity costs, according to an email to customers on 23 September.

Other producers have raised their targets from between + 100-125/dmt at the beginning of discussions to + 140-170/dmt as of the second week of October, according to sources.

The following was from KeyBank last week:

If you take a look at producers like Westlake, they should reap a windfall – at least for a while.

Westlake’s trailing 12-month FCF is $1.44 billion. The stock has an EV of $14 billion here. So 10x FCF. But that FCF is heavily weighted to the most recent quarter. They did $653 million of FCF last quarter.

Annualized that would be $2.6 billion and we are at 5x FCF. And prices are still rising, so that FCF could look even better in Q4.

Of course, these are stocks to not overstay your welcome on. If you look at Westlake, over the last 5 years FCF has averaged about $800 million. So they trade at 17x FCF on that average. Which still isn’t crazy – especially in this market.

But much like the shipping stocks there will be a windfall and then supply will come back. And the stock prices will probably fall when that happens.

I’m just not sure when that will be. It could be soon – I mean this blog thinks Europe is in the catbird seat being short natgas right now. So what do I know? If this comes to pass I am going to have to scramble out of these positions sooner than later.

But just case everyone is wrong about everyone being wrong, they seem like a nice hedge on a more troublesome scenario playing out.

Smarter Guys than Me

There are a few folks that I would put in the smart guy category. These are market participants that I assume have far greater knowledge and access to information than I do. And many of them have been tweeting about how supply chain issues resolving themselves.

Comments like this:

And I could add a bunch of others. In fact, there is a real drumbeat on fintwit that is downplaying whether the supply chain issues are passed.

I have been taking a cautious view for a while now. Not an ‘all cash’ view but more cautiously positioned. More bearish index positions, smaller sized longs, some energy longs, some inverse ETFs in China and shorts of SaaS companies (that maybe are reaching the point I should take them off) and shorts some other names sensitive to China.

If fintwit is right and supply chain issues are about to end then I probably need to reevaluate this.

I always assume I am the mark at the table. There are so many market participants that have greater access to data, greater resources and more insight than I do. If my own views are different from those I assume have greater knowledge, I want to start with the assumption that I’m wrong.

So let’s go over my position until now. My caution has been based on two legs.

First, whether China is going to slow considerably from a fallout of their property sector.

Second, whether energy supply issues are going to slow economies around the globe considerably.

There is a third leg – that we’ve gone so long without a decent correction – but that only really matters if one of the first two play out.

This is all about the second leg. Which really boils down to energy supply issues. How they impact manufacturing, prices and profits.

What I am surprised by is that so many are sure that these issues are in the rear view mirror?

Implicit in supply chain issues being behind us is that energy markets are about to heal. That oil and natural gas and coal prices are about to head back down.

Try as I might, I can’t quite see how we can know this.

I can see how it might be. Because to a large degree this is all weather-driven. If there is a warm winter across the board the problems go away and by the time the next winter hits the market could be much higher.

But how can we know what the winter holds? Particularly when it is not just one region but a whole bunch of regions that seem on the precipice of an energy crunch.

I just don’t know. I do know that if energy prices are about to slide and the supply chain heal then I’m probably not that well positioned. My energy stocks aren’t going to do well. And my SaaS shorts are going to go against me.

I’m not ready to do something about this yet. I’m not convinced I am wrong. But I am aware that people that are likely more knowledgeable than me are saying the opposite, so I better keep a very close eye on it.