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Investment strategy

What does the US Inflation Reduction Act mean for pharma?

Should investors be worried that pharma price cuts in the United States will make the sector less attractive?

Dr. Tilman Dumrese, Senior Equity Analyst
Reading time
4 minutes

President Biden’s administration recently published the first list of ten drugs whose prices must be negotiated by 2026 under the Inflation Reduction Act (IRA) passed in 2022. Let’s take a look at the implications of the new law for the drug makers directly affected, the wider pharmaceutical industry, and also of course, for investors.

Top market, top prices

US President Joe Biden signs the Inflation Reduction Act of 2022, a USD 737 billion act focused on lowering healthcare costs
US President Joe Biden signs the Inflation Reduction Act of 2022, a $737 billion act focused on slowing climate change, lowering health care costs and creating more clean energy jobs © Bonnie Cash/UPI/laif

The US healthcare system is by far the most expensive in the world. According to the World Health Organization (WHO), a total of 18.8 percent of US GDP was spent on healthcare in 2020, or USD 11 702 per capita. Prescription drugs cost up to 40 percent more in the US than in Europe, which makes this market extremely profitable for the global pharma industry. (Unfortunately, the US system is also far more complex in terms of pricing and patient reimbursement.)

Three ways that the IRA affects prescription drug prices

The Inflation Reduction Act is a broad-based, multi-billion dollar law designed to reduce inflation, although it also includes other measures, e.g. to combat climate change. The Act works to limit drug prices in three main ways:

  • In future, just like in Europe, pharma companies must negotiate drug prices with health insurers. Medicare, the federal health insurance program mainly for people over age 65, can now negotiate the prices of the ten most expensive drugs and insulin products that are no longer covered by patent exclusivity. The new prices of the first batch will apply from 2026. But it doesn’t stop there. By 2030, the number of drugs approved for price negotiations is expected to reach 80.
  • The Inflation Reduction Act also introduces price caps. In future, price increases will be limited to the rate of inflation. This applies not only to Medicare but also to private health insurance. Manufacturers who do not comply will face severe penalties.
  • The law is also intended to close gaps in healthcare provision in the US, urgently needed as vast numbers of Americans still do not have health insurance.

What does this mean for blockbuster manufacturers?

To get an idea of the impact of the new law on companies with drugs whose prices will be renegotiated, let’s take look at the heart drug Entresto, produced by Swiss pharma giant Novartis.

Medical capsule production line
"Prescription drugs cost up to 40 percent more in the US than in Europe, which makes this market extremely profitable for the pharma industry," notes LGT Senior Equity Analyst Tilman Dumrese. © istock/SweetBunFactory

Global sales of Entresto hit USD 4.64 billion (9 percent of Novartis’ total sales) in 2022. About half of this, USD 2.35 billion, was generated in the United States, and half of this in turn was via the Medicare prescription drug program (Part D). This means that Entresto represents about 2 percent of Novartis' total sales, which will be affected by the price cap from 2026.

Positive sector performance

In both the US and Europe, the pharma sector has posted a positive performance over the last five years. In Europe, the sector significantly outperformed the market as a whole. In the US, the pharmaceutical sector lagged somewhat behind the overall market. But we believe this was mainly due to the extraordinarily strong performance of index heavyweights from the technology sector, the so-called "glorious seven mega-companies" (e.g. Meta Platforms and NVIDIA), which in some cases gained over 100 percent.

But as Entresto is due to lose its patent protection anyway between 2025 and 2027, and generic competition is likely to enter the market, the company was already expecting a significant decline in Entresto sales and a fall in its importance. Although price reductions will have an impact, they are likely to be manageable for existing medicines. Manufacturers are used to dealing with product lifecycle fluctuations.

Falling prices - but rising volumes in future

Biochemistry, research and innovation for modern medical treatment of diseases and ailments in the laboratory
© istock/Sean Anthony Eddy

In the long term, the picture for new drug prices is likely to be more complex. Patent-protected, small-molecule drugs are exempt from price negotiations for nine years after approval, and for 13 years in the case of biopharmaceuticals. So there should not be an immediate, significant impact. However, this will change significantly from the end of the decade or the start of the 2030s, when drugs that are still new today come under the legislation.

How will pharmaceutical companies react? The simplest way would be negotiate significantly higher launch prices for new drugs, although it’s impossible to predict whether this will be enforceable.

While pessimists are asking if the development of new drugs will be worthwhile at all, it’s important to note that the steady aging of society is highly likely to increase the demand for medicines in the long term, so falling prices should be offset by rising volumes.

More ready and able to innovate

We can also assume that the brake on prices will push the pharma sector even harder to innovate. Although the level of innovation is already high today, there is still significant potential, not least through new technologies, including those based on artificial intelligence (AI), which show great promise for speeding up drug discovery and development.

Prescription drugs at a pharmacy in Albuquerque, New Mexico
© Paul Ratje/The New York Times/laif

As for the second effect of the IRA, ruling that price increases must not exceed inflation, this should only have a limited impact, with just a slight dampening effect on  growth.

Big pharma still has significantly higher margins compared to other industries.

On the third point, the expansion of insurance coverage, we do see a growth-enhancing effect from the increase in the number of insureds, but this is unlikely to have much of an impact on pharma bottom lines due to the price cap.

Pharma remains an attractive investment

Tilman Dumrese, LGT Senior Equity Analyst
Tilman Dumrese, LGT Senior Equity Analyst

In summary, while there may be a slight slowdown in growth in the medium term, Big Pharma still has significantly higher margins compared to other industries. Efficiency gains in drug development, particularly through using AI, should keep these margins above average.

We believe that current valuations based on P/E and EV/EBITDA do not reflect either the significantly higher profitability or the above-average earnings outlook of the pharmaceutical sector. Supported by demographic change, above-average visibility, and solid cash flows, and despite the slight medium-term slowdown in growth, drugmakers should remain a worthwhile investment for the long term.

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