The health care sector is about to get bumpy with some stocks flourishing while others fall on hard times.  Just in the past week we saw a totally different set of reactions to earnings reports as shares of Cerus Corp. (Nasdaq: CERS) sidestepped bad news and rallied while Emergent BioSolutions (NYSE: EBS) and Novo Nordisk (NYSE: NVO) broke down after disappointing investors.  I introduced this new dynamic in the premiere issue of Breakthrough Tech Profits and I’ll tell you more as to how events are progressing in the next few paragraphs. But rest assured, a new macro dynamic is slowly ramping up and is about to start making a big impression on the health care sector as analysts wake up to the new reality.  

Upgrade – Buy Cerus Corp. (Nasdaq: CERS) $7-$9.

Cerus Corp. (CERS), the maker of the Intercept system for blood infectious agent neutralization, delivered an earnings miss on August 3^rd but ended the week making a 52-week high because its product has the potential to be a game changer for the blood transfusion industry, especially in the era of the rapidly emerging Zika virus threat.  Cerus reported a loss of 18 cents per share while analysts were expecting a loss of 17 cents per share. Revenues of $9.3 million were 5% above 2015’s second quarter. Guidance for the full year is still for $37-$40 million on product sales and the balance sheet had $89 million at the end of the quarter.

The key to the stock’s ability to shrug off the bad news is that the company is reaching a significant growth period.  According to the company’s CEO, the number of U.S. blood centers using the Intercept System for platelets has increased to 14 from 6 in May 2016 with an additional 16 blood centers under contract and in different stages of implementing the system.  As these centers come on line, revenues and sales should start to grow.  The company is working closely with the Red Cross, which has a 40% global market share as a blood and blood product distributor, and is using what they learn from that experience to model further rollouts in the future.  CERS has also received approval to increase prices for its platelet and processing kit to $650 per unit by the U.S. Medicare related pricing mechanism. 

The company has also received a $181 million government funding contract which will allow it to speed up its studies and accelerate the likely implementation of Intercept for use in red blood cells, pending FDA approval.  FDA approval for red blood cell transfusion use of Intercept could be the Holy Grail for CERS as it could provide over $1 billion in revenues per year based on a 20% share of a market composed of 13.5 million red blood cell transfusions per year, assuming a $650 per kit cost.  The company is projecting an 18 month time frame for a key FDA study and approval submission for red blood cell transfusion.  The company projects possible approval of Intercept for red blood cells in Europe by late 2017.

Buy Cerus Corp. $7-$9

EBS Gets Blindsided by Government Contract Uncertainty

Emergent BioSolutions Inc. (EBS), a vaccine manufacturer and defense contractor reported a second-quarter loss of $10.9 million (-18 cents per share – GAAP), after reporting a profit in the same period a year earlier.  Estimates were for a loss of 17 cents.  The company recently spun off its conventional biotech operations now known as Aptevo (Nasdaq: APVO) and disappointed investors when it received a smaller than expected government contract for its BioAnthrax vaccine.  

In my August 5 Flash Alert in which I issued a sell signal I noted: “My big concern is that over the past two quarters EBS has failed to execute cleanly and it looks as if their best days are past for now as they seem to have way more on their plate that they can handle.” The company’s conference call offered further insight into the recent troubles but it does not change my negative opinion at this point. Company CEO Dan Abdun-Nabi noted:  “due to the lack of clarity on the current and potential new HHS contracts, we will continue to temporarily postpone our financial guidance for 2016.” That means that EBS still doesn’t really have much of an idea as to how much revenue it will generate in the future.  And that means that the stock may be as good as dead money for at least another quarter or perhaps even longer, especially if the expected resolution of the government contract, scheduled for the September-October time frame doesn’t meet expectations.

Sell Emergent BioSolutions

Correction:  In my August 5 Flash Alert I cited “accounting gimmicks” referring to EBS’ earnings report.  The remark was based on an early news report that did not provide details about the earnings beyond the numbers.  The company’s conference call reported both GAAP and “adjusted numbers.”  GAAP numbers are reliable.  There are no gimmicks in this earnings report.

Novo Gets Wakeup Call But Won’t Be Alone

Novo Nordisk (NYSE: NVO), a global leader in the treatment of diabetes, got clobbered on August 5^th and could be headed lower in a hurry as CVS-Caremark (NYSE: CVS) and Express Scripts (Nasdaq: ESRX) are not including several of its key drugs in their respective formularies.   As a result, the company cut its forward growth rate from 8-9% to 5-7%.  Novo has lost coverage for its recent blockbuster drug Victoza and two of its insulin products due to costs in the last few weeks as well as falling short of expectations for Victoza in a congestive heart failure trial.  Novo is a well-run company with excellent products that is clearly a victim of circumstances.  But it won’t be alone in the new world of rapidly evolving cost cutting as Medicare moves toward payment bundling methods of payments to doctors, hospitals, and vendors. 

Sell Novo Nordisk.

Payment Bundling: The Medicare Time Bomb

When Medicare cuts payments everyone feels it.  And payment bundling, the practice of providing one payment for a given set of services to a central provider, such as a hospital, means that anyone who works at or for that hospital will be paid from the single bundled payment the hospital receives from Medicare.   I want to make this very clear: Under bundling payment plans, if a Medicare patient has a hip replacement at XYZ hospital, the hospital will receive a fixed amount to provide all services related to that hip replacement for three months. That one payment will include all services, physicians, physical therapists, medications, bandages, and food that the patient receives during its stay.  More important, if the patient has complications and the hospital bills for the services to treat the complications, it will be fined by Medicare and may lose its accreditation if it proves to have more complications than normal.  This new reality gives companies that operate outside hospitals, and whose products are versatile and indispensable, a great opportunity.  If bundling is successful, it will eventually reshape the market over the long term.  But in the short term it will shrink the amount of money that’s available in the system causing a great deal of disruption and confusion.

Welcome to the New World of Healthcare Investing

The three stocks above are primary examples of the side effects of bundling.  For Cerus, bundling has been a positive because the company is currently outside the system and its product niche, the protection of the blood supply, is a significant advance in public health. As a result, it has received sizeable support from the U.S. government in the manner of grants.  EBS, on the other hand, has had its funding cut directly while Novo has had its money line cut indirectly as CVS and ESRX who receive government money to manage Medicare prescription plans are not willing to let high drug prices cut into their already decreasing money pool as, you guessed it, the government is decreasing what it pays them to manage the plans.

Once bundling becomes the norm, it will increase the volatility of any healthcare-related company’s stock as the effects spread and investors have to factor in the potential effect on any company.  Medicare has already rolled out a bundling program for hip and knee replacements, and recently announced upcoming bundling initiatives for heart attacks and hip fractures.  These price reductions for services and products will eventually hit the medical equipment sector for prosthetics, pacemakers, and related items as well as roll through the entire food chain and ecosystem.  Medicare’s goal is to have a large chunk of the health care system “bundled” by 2018.

You can argue the politics of bundling until the end of time but you can’t ignore the effects it is already starting to have on the health care sector and what potentially lays ahead.  More than ever, investing in healthcare and biotech is going to be a stock by stock situation and portfolio management in this sector is likely to involve more trading, hedging, and the use of options and other derivatives such as ETFs.

In my own practice I am already seeing that orthopedic surgeons are not performing as many surgeries as they did just a few months ago on Medicare patients.

Disclosure:  I own CERS, and no longer own shares in NVO and EBS.

Portfolio Summary

Recent Changes:

Cerus Corp. (CERS) – Buy up to $9. This stock was initially recommended 11/16/15. Bought on 11/16/15 at $5; 8/05/16 closing price was $7.30. Dr. Duarte owns shares in CERS.

Medidata Solutions (MDSO) – HOLD.  Raise Sell Stop $48 from $45. Bought on 3/7/16 at $36; 08/05/16 closing price was $54.21.  Dr. Duarte owns shares in MDSO.

Sell Emergent Biosolutions (EBS) – Buy up to $43. Bought on 5/16/16 at $39.44. 

Sell Novo Nordisk A/S (NVO) – Bought at $55 on 12/21/15; 7/22/16 closing price was $55.63.  Dr. Duarte owns shares in NVO.