The following commentary was originally sent to Action Alerts PLUS subscribers on Aug. 7, 2016, at 9:06 p.m. ET. (Since our posting advising subscribers not to buy BMY on weakness, the shares are down another 5% today after several downgrades and a mass consensus estimate reduction.)
Checkmate, meet irony.
On Friday, Bristol-Myers Squibb (BMY) announced that its oncology drug Opdivo failed to hit its goal of slowing tumor growth in previously untreated patients with non-small cell lung cancer. In a pivotal first-line (1L) lung cancer study -- Checkmate-026 -- wiped $20 billion of the company's value in one fell swoop.
The failed trial is among the biggest single blows by a major pharma player in recent history, considering Bristol had gotten to an early and dramatic lead in immuno-oncology, capturing 80% of the targeted PD-1/PD-L1 (or programmed death ligand 1) market. Opdivo is an antibody that operates as a bodyguard protecting cancer-attacking T-cells from being disabled by PD-1 and PD-L1 proteins, freeing healthy cells and allowing the immune system to effectively fight the tumor. Bristol's seemingly insurmountable leadership with Opdivo, which generated nearly $1 billion last year, 70% higher than Merck's (MRK) second-fiddle Keytruda, was dismantled in brutal, public fashion.
Having spent the weekend trying to make sense of how an industry juggernaut could screw up so badly, we believe the downside surprise was in part product of Bristol's own reckless ambition, pride and, to some extent, greed. We would not be buyers on weakness, as we believe shares remain overvalued after the selloff given heightened risk, uncertainty and lack of visibility into future earnings.
An example from the game of chess is quite fitting. Bristol's Checkmate-026 was an avoidable blunder that occurred not as a result of lack of sophistication, but out of an emotionally-charged mentality that led senior executives to make an unnecessarily risky bet in an attempt to one-up its competitors once again in a field where it had everything to lose and nothing to gain, given its existing leadership. Needing only a draw to remain untouchable, it went for checkmate and left its own king exposed.
In professional chess, only a handful of games end with checkmate. In the vast majority of tournament matches, one player resigns when the situation is hopeless, even if the prospect of a checkmate is still several moves away, In fact, there is something of a convention. A player who waits until the bitter end of a checkmate is considered either too incompetent to realize that a checkmate was in the making or too arrogant to believe that the opponent can achieve it.
Bristol-Myers merely needed a draw in order to not only maintain, but extend its lead in lung cell therapy. It had every reason to design the pivotal Checkmate study for success, even if it meant narrowing the patient population. Instead, it designed its study around a hurdle that was as unnecessary as it was bold. By making the goalposts quite insurmountable (in order to apparently beat Keytruda), all it needed to do was set an achievable cutoff level of under 50%, rather than a 10x higher hurdle of 5%. It set itself up for potential failure. And as a result, Bristol-Myers' downward revisions will likely persist, with Merck positioned to take the lead in first-line lung cancer, with a cohort of other competitors such as AstraZeneca (AZN:NYSE) and Roche, which are pursuing monotherapy and combination trials.
The failed test means that Opdivo will likely lose the majority of its $5 billion projected sales for first-line lung cancer treatment in 2020 (out of $11 billion total projected sales for the drug). We believe what gave BMY the early lead will now give Merck the upper hand: ease of use. Oncologists and their patients are likely to shift their focus towards the less financially risky option of Keytruda, especially given its relative pricing advantage.
Fortunately, we do not own Bristol-Myers for the portfolio and have avoided the temptation of chasing shares since adding it to the bullpen. We certainly had no idea that it would fail its pivotal trial, yet had become uncomfortable with the stock's parabolic upside re-rating. This is a situation where discipline is key.
Instead of chasing BMY, we pulled Comcast (CMCSA) , PepsiCo (PEP) , Visa (V) and Procter & Gamble (PG) out of the bullpen and into the portfolio. BMY's investment thesis is not over, yet its irreversible bet diminishes the lucrative, sticky leadership its peers envied from a wide distance. One move later and Merck is set to take the lead.
The BMY investment thesis has been predicated on strong performance in Opdivo and Eliquis (cardiovascular), with the obvious risk being the company's overexposure to two drugs, one of which has been called into serious question. Total sales growth is now expected to decelerate from 13% year/year in 2016 to 7% in 2017 to 2.5% in 2018, with EPS estimated to decelerate from 27% growth this year to 6% growth in 2018.
Bristol is down but not out, but will likely have to increase its R&D spending in order to catch up in the oncological arms race it once pioneered. News that Bristol's Orencia therapy was excluded from Express Script's preferred drug list also takes forward estimates down. The results of one trial have taken BMY from a powerhouse to a risky, binary biotech. In utter irony, the future of its Opdivo franchise rests largely on the results from its Checkmate-227 trial.
Given the heightened risk profile, more binary nature of outcomes, and reduced estimates, we would not be buyers of BMY at current levels. Shares are trading at the high-end of its peer group (24x next year's earnings) even after the 16% selloff. We believe a risk-adjusted re-rating to the downside is deserved in the near term. Meanwhile, Merck appears relatively attractive, having been handed a gift-wrapped early Christmas present in unexpected fashion.
We await color from Merck before making a recommendation, yet would use this as a teaching lesson in the fatal flaw that is arrogance. Unmatched leadership that takes nearly a decade to attain can be unwound from the result one blunder. Checkmate, indeed.