Biopharma Tie-Ups and Quebecois Weed Woes

In this week's episode of Industry Focus: Healthcare, host Shannon Jones and Motley Fool analyst Todd Campbell dig into two recent industry headlines -- first, the merger between pharma giant Pfizer (PFE -0.12%) and Mylan (MYL), a generics manufacturer best known for drawing widespread ire over their EpiPen pricing. Find out what this deal does for both companies, what will happen to existing shareholders, what Mylan shareholders should think about before they cash out, and more. On the back half of the show, they look into some recent short interest for Canadian marijuana producer HEXO (HEXO). They talk about what legal problems HEXO is running into, why the company's home base in Quebec could pose some serious trouble for them in the next few years, what investors should always remember about short reports, and much more.

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This video was recorded on July 31, 2019.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every single day. Today is Wednesday, July the 31st and we're talking Healthcare. I'm your host, Shannon Jones, and I am joined via Skype by healthcare guru Todd Campbell. Todd, how's it going?

Todd Campbell: It's going really well! How about you, Shannon? How was your trip? Did you get to see any sharks?

Jones: No sharks. Lots of surfers, though. I got to go out to California, Huntington Beach. Thank you for whoever was on Twitter, I think her name was Lisa, who reached out with some recommendations, highly recommended Huntington Beach, California. My first time out there. Got a lot of sun, saw a lot of surfers. There was the Vans U.S. Open Surfing competition happening across the street from my hotel. That was really cool! Tired but glad to be back here because, of course, as soon as I leave, we get merger news that happens, [laughs] land more stuff happening in the marijuana industry. Glad to be back, Todd! Let's just dive right in! 

For today's show, it is about merger Monday, which held true this week. News coming out of the pharma industry for pharmaceutical giant Pfizer and generic manufacturer Mylan. And then we'll also dive into the marijuana industry with more company headlines of the not-so-positive sort, and some news in the edibles space as well. 

But Todd, let's kick things off with Pfizer, ticker PFE. It announced on Monday that it's joining forces in an all-stock deal with Mylan, ticker MYL. Basically, Todd, this is a deal that marries the off-patent side of Pfizer's business with Mylan's, I guess you can call it the beaten-down generic side of their business, into one newly formed, yet-to-be named generic powerhouse. At least, that's what they hope. Todd, before we dive into the deal, what the new co will look like once this deal is actually done, let's get all of our listeners up to speed. For Mylan, it's really about what has been their bread and butter, or at least the one making the most headlines -- again, not so positive -- but EpiPen. Todd, what can you tell us about that drug? It is lifesaving, but it has attracted all the attention for all the wrong reasons, too.

Campbell: You nailed it right there, absolutely! Kicking off in 2016 as part of the presidential campaign and people talking and pushing back very strongly against runaway drug prices. One of the drugs that was front and center in that conversation was EpiPen, which is basically a shot of adrenaline that can be given into the thigh muscle for people who are suffering from life threatening allergic reactions. If you've got, say, a nut allergy or whatnot, and you happen to come into contact with nuts and you go into shock, then they can use this EpiPen to save your life. The thing that's interesting -- interesting is the wrong word. Frustrating, maybe, Shannon? [laughs]

Jones: Perfect word!

Campbell: Yeah. What's frustrating about the way that this all shook out is that Mylan is one of the biggest of the generic drug makers. EpiPen was not a generic. It was a brand medicine. But it has been around for a very long time. Epinephrine, which it's based on, was discovered way back in 1904. [laughs] That's how long the basic component to this has been known. EpiPen itself was first developed in 1980. So, 40-some odd years ago. Mylan picked up that drug back in 2007 when sales were only about $200 million. If you look at the way that prices have trended since 2009, you've seen the price for this lifesaving medication go from $100 for a two pack in January 2009 to $600 back in 2016, when everybody finally caught wind of what was going on and brought it into the spotlight. Obviously not a good look, to know that Mylan was going out and lobbying, spending big bucks, to get state legislatures to pass laws to supply EpiPen within the school systems, and then going out at the same time and increasing the price of EpiPen by seemingly an absurd amount, given the fact that there was no innovation. It was still the same pen, roughly. So, there was a degree of absurdity there. Then you look at the CEO, who actually will be stepping down as part of this combination. Her compensation had increased from $2.4 million back in '07 to about $19 million. So you had all of this dynamic get thrown into the spotlight. That really took a toll on shareholders, because the share price collapsed. Despite all the king's horses and all the king's men trying to put Humpty Dumpty back together again, the stock has been continually disappointing for investors. And probably not too shocking that a deal like the one that just got announced actually got done, given that Mylan's stock was trading at a 0.75X price to book ratio before this deal was announced, and trading at less than 1X sales.

Jones: Which is amazing! Mylan's share price, it's down almost 75% off of its highs back in 2015. It's certainly not been the only generic drug manufacturer of its kind to take some hits. Really the entire industry has been trying to save itself, if you will. You've seen a lot of consolidation, a lot of these mergers happening. Teva is another example, a company, I think it's down almost, I want to say over 80% since maybe July of 2015. They've been hammered for a number of different reasons, which we'll get into in a second. 

But before we do, let's just talk about what this new combined company will look like. We've talked about EpiPen. For Pfizer, this is their off-patent drug division, also known as Upjohn. It sells things like their cholesterol drug Lipitor, blockbuster there; Viagra; Celebrex. Mylan is bringing more than 7,500 products, including some biosimilars, generics, some brand name and over the counter products as well. Combined, this will be selling products in about 165 markets, with expected revenue $19 billion to $20 billion. Potential expense savings of a billion dollars annually by 2023. Free cash flow expected to be more than $4 billion. 

Essentially, you've got Pfizer, who has been in a series of steps to divest and move away from its core and what it wants to focus on, which is the innovative medicine division, and less of this generic battle that's been ongoing for the past several years. In many ways, you've got two now joining forces to create one combined company, which we'll find out what the creative name will be very soon here, Todd.

Campbell: [laughs] Yeah, they said it's going to be announced sometime before the deal closes, whenever that is. Mylan investors are going to have to vote in favor of the deal for it to go through. Pfizer's investors will not. The new company is going to end up taking on $12.5 billion in new debt when it's formed. I think it's $12.5 billion, $12 billion or $12.5 billion. That will flow back to Pfizer, so it's possible that maybe some of that shows up in the form of a special dividend, or help support Pfizer's dividend at some point down the road. 

But Pfizer is contributing about $8 billion of that expected $20 billion in pro forma sales next year. Mylan's contributing the other $12 billion. As you mentioned, it's going to create a very interesting company, with big, global reach. One of the things that two companies are hoping is, Mylan has a really big presence in North America and Europe, especially through some of these new biosimilars that it's been launching. I think what they're hoping is that Upjohn having a really big exposure to Asia Pacific, including China -- I think Asia Pacific accounts for about 30% of Upjohn's sales, and 40% of that 30% is China. I think, when you look at having that greater distribution, and then leveraging the drugs that Mylan is bringing to the table, I think they're hoping that that's going to allow it to continue to generate out modest revenue growth going forward. I think if you look at the guidance that they outlined in their slide deck, they actually used the term moderate. Everybody defines "moderate" differently, but to me, moderate means, say, a 5% per year grower, something along those lines. I think the real key here is going to be the cash cow nature of this business. 

You highlighted that they're saying about $4 billion in free cash flow. That's what they're anticipating right out of the gate. That's a tremendous amount of money, obviously, in free cash flow. And they're saying that, right out of the gate, 25% of that, or $1 billion, is going to go right back to NewCo investors in the form of a dividend. I think that if you can get modest growth from leveraging Mylan's product lines into these other emerging markets, and then maybe some new products that are making their way through the pipeline -- one of the other things they said, too, Shannon, was that they anticipate about $3 billion in additional new product launches by 2023. You've got $20 billion going to $23 billion. Obviously, that's going to create more free cash flow, higher dividend.

So, I think for investors, the decision here is, it doesn't mean a lot to me as a Pfizer shareholder, because it's going to get spun off, and maybe that just means it creates a top line revenue headwind that I'll have to make sure that I model so I'm not surprised come 2021 when things start to drop off. But, OK, Pfizer's going to get some money, so maybe I'll stick around. It's not going to mean much to me. Then for Mylan, you need to decide whether or not you think that you should just cut bait and accept your losses in the stock and move on, or take the one share for every share of Mylan that you're going to get in NewCo, and then just hope that the modest growth and the dividends end up making you back your money over time.

Jones: If you remember, back in 2015, wasn't it Teva that actually was attempting to buy them out? I think it was about a $40 billion buyout deal. That did not pan out. When you look at this deal, based on Monday's close, right now, it values Mylan at about $11 billion. For Mylan shareholders, if you're looking at this deal, maybe I just go ahead and take what I can right now if you don't think that this consolidated company with the combined forces plus synergies, cost savings, and all of that, will make sense long term. But quite a dramatic drop back from 2015. 

You brought up the emerging market space. It think that's important. In China, you do have a lot of low-quality generics. In China, consumers do tend to gravitate more now to brands where they can trust. Upjohn was created in hopes of capitalizing on that growing market there in China. To me, that entire market there is extremely interesting and one to watch. 

But I think all in all, for Pfizer, this is really about being able to focus on those innovative medicines. They actually did the recent Array BioPharma acquisition for $10.6 billion recently to really focus in specialized cancer treatments and, again, try to come away from generics and things that are going off-patent. 

For the generic business, though, there have been so many headwinds. First and foremost, you have so many companies right now that are trying to stave off generic competition. Todd, you and I have talked about it a number of times on the show. They're getting really creative for how they stave off generic competition. This is creating a lot of headwinds for a lot of these generic companies, which is really driving a lot of them to merge, join forces, and really leverage their size to negotiate and bargain on pricing. There was one stat, delaying generic competition for even as little as six months could be worth $500 million in sales for a blockbuster drug. So, the incentive for a lot of these branded companies to be creative and stave off competition is certainly there. You have Indian makers also grabbing market share. Todd, you talked about the pricing pressure. You have a lot of middlemen right now who are also joining forces and really being able to negotiate and bargain prices there as well. And even the FDA has been trying to help in some ways, aiming to cut drug review cycle times down to open up the door for more generic competition. But all in all, these are companies that are hurting, so by being able to join forces, they can leverage their size and scale to find those cost savings and hopefully gain some market share. 

We'll have to see what this one. Anytime I see big biopharma mergers, I'm always a little bit skeptical only because they tend not to work out. All the potential savings in synergies never tend to pan out the way that we expect. So I'm a little skeptical on this one, but I can't blame them for trying.

Campbell: Yeah, and I would just simply add that as an investor, make sure you think about the reason that you got into this stock in the first place if you happen to be a shareholder of Mylan. For me, for example, I own shares. My decision is going to be, why did I get into it, and what's the future look like once it combines with Upjohn? I got into it because I really believed that biosimilars could be a needle-mover from Mylan. Now it's a much larger company. The biosimilars have been a little bit slower to be adopted than I modeled originally. I did not buy this for the potential for dividend growth. So I'm going to have to make a decision on whether or not I want to adjust my thesis, which is dangerous; or punt my shares at a loss. I think it's very important for investors -- that's why we always say, keep a diary so you can go back, take a look at the reasons behind why you bought the stock, and then see if you're willing to accept changing your thesis. I don't think thesis, maybe, that you had back in 2016 is going to be the same for what drives the stock forward from 2020 to, say, 2030.

Jones: Yeah, totally agree, Todd. It's so important to keep a journal, and really important to go back and check your thesis. When these mergers happen, when you see major changes, it's always about going back to that journal to figure out, why did I invest in this in the first place? So glad you brought that up. We'll have to see what you do here, Todd. I'm curious to see what you decide to do with those shares. Keep us posted!

All right, Todd. In the news, we've got the marijuana companies again making headlines. This time it's HEXO Corp, ticker HEXO. It's the latest marijuana company to come under the gun, this time the brunt of a short seller attack. Todd, before we get into the short seller claim, it seems like this summer has been one just mired in scandal and conflict. Last week, we talked about CannTrust. Now it's HEXO. I'm not terribly surprised just given the infancy of the industry itself and trying to emerge out of the legal illicit market into the legal limelight. But it just seems like the hits keep on coming.

Campbell: Yeah, these companies are trying to move too fast, perhaps. You can't blame them for wanting to. It's a major market opportunity. There's a lot of money at stake. In Canada alone, the market is worth about $6 billion Canadian dollars per year. The vast majority of that is still done illegally, although you can now buy recreational use marijuana throughout Canada as of last October. What's really interesting or important for investors to bear in mind is that, yeah, OK, you had a lot of excitement leading up to the opening of the recreational market last fall. You had that buy the rumor. Now you're at the point where you're selling the news, meaning that, you have a slowdown, you had supply shortages at the beginning of the launch of the recreational market, then you had a slowing in month over month sales in the first quarter relative to the last quarter of last year. And then, of course, we covered last week CannTrust's debacle, where they were caught growing marijuana in unlicensed rooms. That's still shaking out. But their CEO, as we said last week, needed to be shown the door. He sure enough was and is no longer with the company. They announced today that they are actually going to explore strategic alternatives. So, I mean, it's a ripe environment, I suppose, for short sellers to take aim and say these companies are young and they're making mistakes, let's see if we can get out in front of this and capitalize it and make some money on the short side. 

Shannon, we've talked about this, I'm sure, at one point or another -- whenever you're reading any kind of report, if it's from a sell side report, you need to know that they might have a relationship with the company that, although it's not supposed to, could be influencing how many these analysts put a buy rating on a company, for example. And if you look at a short seller's report, you say, OK, well, what's their skin in the game? I think it's interesting, our colleague Sean Williams had written an article at the beginning of this month, talking about the big surge in short interest at HEXO. Probably not surprising that some of those shares that were recently sold short were sold short by the company that issued this short report on HEXO. I'm sure we're going to get into what it was that the short seller was saying. I'll let you tee that up, Shannon.

Jones: Yeah, absolutely! The short seller basically alleged that HEXO ran these aggressive product promotions on Snapchat, the social media platform, and potentially violated Canadian marijuana advertising regulations. These regulations do prohibit advertising in any way that associates a product or brand with what they call glamour, recreation, risk, excitement, or daring behaviors. I like that language there. The short seller also questioned whether minors were exposed to these ads on the Snapchat platform. Of course, short sellers always have their own agenda. But I do think from a regulatory side, especially after seeing the debacle here in the United States with Juul, the smokeless tobacco cigarettes, e-cigarettes, and how they were marketed to minors, I am not surprised to see short sellers, or really anyone, jump on any company that in any way, shape, form, or fashion could be targeting -- whether intentionally or not -- minors. 

So, that was the allegation. HEXO did respond, saying that they are, of course, very diligent about adhering to the rules and regulations surrounding cannabis promotion, both federally and within the province. It did say it doesn't advertise on Snapchat or run any promotional campaigns in its home province of Quebec, where it's based; and it does have an agreement with Snapchat to ensure its ads are only seen by adults in provinces where they are permitted. So, HEXO is fighting back on this. 

But of course, like you mentioned, and I think it's an important point, short seller interest ran very high leading up to this report, so not terribly surprising. But I think it's par for course, especially when you saw just how explosive many of these top-tier, second-tier companies like HEXO exploded onto the scene and the returns. It was more a matter of time before the short sellers came out and made their attacks.

Campbell: Yeah. If you look at HEXO, HEXO has a lot of moving pieces. The Quebec angle is very important to understand, listeners. Quebec accounts for the majority of HEXO's sales. I think 90% currently. Although they are now expanding into other provinces, Quebec is still a big driver, and they have a preferred supplier agreement with Quebec that is a big driver of their sales right now. One of the things that's important to recognize, especially for us here in the U.S., is that Quebec's approach as a state government to regulating cannabis has been much stricter than Canada as a whole. The federal rules, or the national rules, have been a little bit looser than what Quebec has put into play. That's something that listeners need to recognize. It could be that Quebec then looks at this, and if it finds that maybe HEXO did go up to that line, and maybe dip its toes over the line when it comes to advertising -- it seems like they want basically black and white ads with no imagery, no anything, right? They just want sawdust-like advertising for this stuff. If they decide that they did cross the line on that, what could end up happening? Does that put their supply agreement in jeopardy? What could that mean for the company going forward to its revenue? This is a company that had gross revenue of about $15 million last quarter Canadian. That's a revenue run rate of $60 million on gross. And they were projecting -- up until now; they haven't obviously affirmed this after this revelation -- they were projecting that fiscal year sales would reach Canadian $400 million. $60 million run rate to $400 million run rate in the next year. There was a lot of excitement behind that. And then, of course, there's other components that we're going to get to in a second, I'm sure, Shannon, right, talking about the relationship that they have with Truss, which is the joint venture they did with Coors. They've been betting big on this whole concept of moving marijuana from dried flower to being used as an ingredient in other consumer goods products.

Jones: And that is really, I think, the key moving forward for HEXO, with their cannabis-infused beverages. As Canada prepares for the second wave of legalization, as it's being called, with derivative markets that could be signed into law in October, although we probably won't see anything on shelves until December at the earliest at this point. HEXO was the first major cannabis producer to ink a deal with a brand name beverage company. That was Molson Coors Brewing. This is potentially a $3 billion market. For HEXO, they have this hub and spoke strategy. For them, they have plans to partner with a deep-pocketed friend, if you will, for all of their products, including edibles, vapes, health and wellness. Of course, this somewhat limits their upside potential. But for them, it also offsets some of the downside risk as they are able to sign more people partners. We'll have to see if that continues beyond Molson Coors. But for them, it's really been about this derivative markets. They signed a number of deals in preparation for this, particularly in preparation for edibles, which is important also from a Quebec front, because Quebec recently announced that they are actually banning certain types of edibles when legalization happens -- specifically, they are wanting to ban any sort of edible that could be attractive to minors. We're talking about your sweets, your chocolates, your pot-infused brownies, candies, ice cream, even, and even additives that would alter the smell or flavor of products. As you mentioned, Todd, Quebec is probably the most restrictive when it comes to regulations related to the industry. So no surprise that they are coming out now and saying basically, even if it's legal federally in Canada, we're going to be much more restrictive and make sure that minors are protected. Even topicals won't be allowed for sale in Quebec currently; that could change. Quebec has been one to come out with these proposals that do tend to be much more restrictive, and then they tend to become more flexible later on. 

But we'll have to wait and see what that looks like moving forward. But for HEXO being based out of Quebec, having now potentially this overhang on the regulatory front from advertising and also the province stating that they're going to be banning certain types of edibles, I think you've got more question marks for a company that all in all has been one of the better companies within the industry overall.

Campbell: Yeah, these big bets and investments they've been making to boost their capacity, I think they're targeting 150,000 kilograms of annualized capacity once everything's all said and done. I think they produced 10,000 last quarter. So these are huge investments that they're making. And a lot of these are for those derivative products that now, in Quebec, where they have the best brand recognition because of their big market share, they may not be able to launch those. This is going to be very interesting. If you look at their earnings conference call, they must have mentioned Fortune 500 consumer goods companies 10 times.

Jones: At least.

Campbell: Crazy! This is this is a huge, huge bet for them. And now you have Quebec coming out and saying, listen, we're not only going to be very restrictive; if it tastes good, we don't want you selling it. What's that going to mean for some of these beverages? I don't know if you've ever taken CBD drops, but I have, and they do not taste good on their own.

Jones: They do not taste good, I can confirm.

Campbell: Yes, they are not good-tasting. So, what's this going to mean for the beverages and Truss? Are you going to put CBD drops inside of water and then sell it on the store self? That's not going to taste good. They don't want you putting additives like colors or flavors or sweeteners or anything like that. It'll be very interesting to see how Truss navigates. Is this game over for HEXO? No, I don't think so. I think this short selling report on the advertising, maybe that's going to be a slap on the wrist kind of thing. We did see their co-founder and chief brand strategist or whatever walk away from the company earlier this month. No idea if there was a relation to what's going on now. But, something to be aware of. Maybe there is a little bit of smoke that could indicate fire on that front. But I don't think that's a deal breaker, not to the degree it was with CannTrust, at least not at this point. And then, you do still have plenty of opportunities for HEXO to market products in the U.S. They're thinking they could launch U.S. products in eight states next year, using hemp as their source for CBD. There's still plenty of running room in these other provinces, although Quebec is the second-largest market in Canada. You still have the opportunity in Ontario and other places.

Jones: Yeah. A lot to watch here. I'm with you. I think the short seller report is more noise than newsworthy at this point. I do think they'll probably get some sort of slap on the wrist. Although with CannTrust, I would not be surprised if Health Canada was a little bit more heavy-handed to send a message to a lot of these cannabis producers holistically. But all in all, for HEXO, the bigger question is, what do they do strategically with Quebec? And then, how do they start to pivot? And really, this will be a long string of news and headlines that we'll see within the industry. Again, you've got these companies trying to figure out regulators, regulators trying to figure out these companies. It's all coming together at a head right now. I suspect the latter part of this year, we'll continue to get more negative noise more than ever as the hype cycle starts to wear off. But if anything, if you're an investor in this space, this could also present some compelling buying opportunities for the companies who are doing it right, who are following the regulations, and for those who are cementing their way strategically, both in terms of the hemp CBD strategy and even from a regulatory strategy here in the U.S. on a state-by-state level. 

A lot to watch here. We'll certainly keep everybody up to date. As for us, that'll do it for this week's Industry Focus! Thanks so much for tuning in! As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is being mixed by Austin Morgan. For Todd Campbell, I'm Shannon Jones. Thanks for listening and Fool on!