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What’s Ailing Biotech?

Summary Concerns about profitability and valuations had already infected US biotechnology stock prices in September. Increased political and media attention on rising drug costs sent the sector deeper into a decline. Evan McCulloch shares his insights on the drug-cost debate, presidential candidate Hillary Clinton’s proposal, and the fallout on the biotech sector at large. Evan McCulloch Senior Vice President, Director of Research Franklin Equity Group® Portfolio Manager, Franklin Biotechnology Discovery Fund (MUTF: FBDIX ) ________________________________________________________ We have seen some turmoil in the biotech sector over the last few weeks. What’s been driving this volatility? There’s been some volatility in the equity market at large, which has resulted in investor skittishness overall and a hypersensitivity to potential fundamental concerns. Specifically for the biotechnology sector, however, the threat of heightened scrutiny of drug prices has reared its head again. It started with an article in The New York Times on September 20 about a small private company called Turing Pharmaceuticals 1 that raised the price of an anti-toxoplasmosis drug it had acquired by 5,000%. This is very unusual for an older drug, so it was a case the media latched on to. The article was followed by a tweet from Democratic presidential candidate Hillary Clinton, indicating she thought some drug prices were excessive and that she had a plan to reduce prescription drug costs. Clinton subsequently announced her plan, which proposed that Medicare leverage its buying power to negotiate directly with drug companies. After that, other politicians jumped on the bandwagon and railed against high drug prices. The House Committee on Oversight and Reform already had been seeking to subpoena documents relating to Valeant Pharmaceuticals’ 2 price increases earlier this year on a pair of cardiovascular drugs, and it then asked to subpoena Turing Pharmaceuticals about the price increase on its drug, which treats parasitic infections. It’s interesting to note that the pricing noise has been around for a while; there have been a series of press articles on the subject going back to July. President Obama has made periodic comments about high drug prices, and Senator Bernie Sanders, who also is vying for the Democratic presidential nomination, released a plan focused on pricing which generated renewed attention. So while this is an issue that bears watching, I think it’s a culmination of sector-specific concerns about drug pricing on top of some broader market issues that has caused recent volatility in share prices. So where could this all be going? Might it result in a reduction in drug prices, in your opinion? For better or for worse, in my view the answer is no. All Clinton did was articulate a plan; it is not legislation. The price of prescription drugs is a popular topic because most people in the United States think drug prices are high, and it’s an issue that resonates well with voters. Again, this is not legislation, and if it were, it would not likely be approved by a Republican-majority Congress. Given that the Republicans seem likely to retain their majority in the House of Representatives after the 2016 election, I don’t believe any legislation can pass until 2018 at the earliest. Even if Clinton’s plan, as we currently understand it, did ultimately pass, in my view the impact would be very manageable for the sector. Most notably, according to our estimates, any cut to drug prices inside the Medicare program would be far less than the recent 15%-20% stock correction in the sector might imply. However, we do expect more market-based reforms. This public shaming process that politicians are employing will likely cause companies to moderate price increases going forward and also empower insurance companies to drive toward higher rebates and more substitution of cheaper drugs. So, we do expect some growth moderation at the margin, but it will probably be imperceptible at a sector level. In the fund, we focus on investing in companies with drugs that deliver strong clinical value and have limited competition, which seeks to mitigate the impact of some of these initiatives. Moving on to the topic of patent protection, do you have any concerns about the exclusivity provisions offered in the Trans-Pacific Partnership ( TPP ), the proposed trade agreement between 12 Pacific Rim countries? No, I don’t have any concerns about it. The TPP proposes that drugs sold outside the United States get eight years of exclusivity. Patents currently don’t protect US drugs overseas. So, granted, eight years is lower than the current 12 years of exclusivity in the United States, but eight years should be compared to virtually no exclusivity right now, as many of the countries covered in that partnership do not honor intellectual property rights. So, this provision would protect pharmaceutical companies for eight years, which would actually be a positive for the sector, in our opinion. What do you think the media is either not covering or may be misreporting about the biotech sector that you think investors should know? The media has focused on gross price increases on drugs, and that is very different from actual price increases or net price increases. In most cases, price increases are moderated through rebates to the payers, but since that’s a negotiated price, the actual price being paid by insurance plans to the drug companies is not transparent to investors or the media. In most cases, when we see a price increase, we know only about one-third to two-thirds of that price increase is realized, so the actual price increases are much lower than what is being reported in the press right now. What is your current outlook for the biotechnology space? I think fundamentals in the biotechnology sector are as strong as ever. In our view, the sector’s new-product pipeline is full, and important new treatments are advancing for cancer, Alzheimer’s dementia, and a whole range of rare genetic diseases. In cancer treatment, interest is very high in using drugs that harness the immune system to fight tumors. A number of new drug discovery technologies, like gene therapy, RNAi (RNA interference) and antisense, allow companies to target rare genetic diseases that were previously untreatable with more traditional drug approaches. For drugs that make it through the clinical trials process, the US Food and Drug Administration is working cooperatively with the sector to bring new drugs to patients, and in most situations has approved drugs that have strong value propositions for patients. Until recently, investor concern was generally constrained to stock valuations, not fundamentals. Although concerns about drug pricing power have arisen, I don’t expect any major change. And with more attractive valuations following this recent correction, we think the outlook for the sector is very positive. To get insights from Franklin Templeton Investments delivered to your inbox, subscribe to the Beyond Bulls & Bears blog. For timely investing tidbits, follow us on Twitter @FTI_US and on LinkedIn . This information is intended for US residents only. Evan McCulloch’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy. What Are the Risks? F ranklin Biotechnology Discovery Fund All investments involve risks, including possible loss of principal. The fund is a non-diversified fund that concentrates in a single sector, which involves risks such as patent considerations, product liability, government regulatory requirements, and regulatory approval for new drugs and medical products. Biotechnology companies often are small and/or relatively new. Smaller companies can be particularly sensitive to changes in economic conditions and have less certain growth prospects than larger, more established companies and can be volatile, especially over the short term. The fund may also invest in foreign companies, which involve special risks, including currency fluctuations and political uncertainty. These and other risks are described more fully in the fund’s prospectus. Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, talk to your financial advisor, call us at (800) DIAL BEN®/342-5236 or visit franklintempleton.com. Please carefully read a prospectus before you invest or send money. _________________________________________________________________ 1. As of 9/30/2015, Turing Pharmaceuticals was not a holding of Franklin Biotechnology Discovery Fund. Holdings are subject to change without notice. 2. As of 9/30/2015, Valeant Pharmaceuticals was not a holding of Franklin Biotechnology Discovery Fund. Holdings are subject to change without notice.

Great Plains Energy: Reliance On Coal Remains A Problem

Summary 80% of energy generation comes from coal. Upgrades to coal plants to maintain compliance has cost the company billions. Cash outflows in 2014/2015 related to higher capital expenditures have increased a utility with already high leverage. Management has guided down capital expenditures for the next five years, in spite of at the same time hinting at replacing 700MW of coal generation with an alternative source. Great Plains Energy (NYSE: GXP ) owns and operates power generation facilities that provide energy to nearly one million customers in Kansas and Missouri. The company has been a stalwart of the Midwest region and has long been a favorite of institutional and retail investors. Unfortunately, Great Plains has been dead money for investors for years – the ten-year return on shares is actually negative ignoring the dividends collected. Is it time for investors to give up on the company or is there meaningful returns for shareholders on the horizon? Ugh – Coal-Fired Generation Coal. I’m not a big fan of coal-fired power generation in my utility investments and unfortunately, that makes up more than 80% of Great Plains’ power production, forming the foundation of their base load generation. I will give the company credit as its facilities are newer and more up to date than most of the facilities that are still operational in the United States. The company has been taking big steps to cut emissions, at no small cost to the utility and its customers. * Great Plains Corporate Presentation Great Plains has lowered sulfur dioxide and nitrogen oxide emissions levels measurably over the past ten years through the addition of various emissions reducing technologies at its plants such as scrubbers. However, the company has yet to make progress on actually changing its energy production makeup. Most other utilities are years ahead in the addition of natural gas energy production (widely viewed as the “transition” fuel between coal and renewables) and renewables like wind, solar, and hydroelectric. While the company is currently in compliance with current mandated power generation laws in the states it operates in, there is no guarantee state regulators or the EPA do not enact stricter rules in the coming years. Coal-fired generation just makes for an easy target for activists and the government due to its dirtier nature compared to alternatives; even the cleanest coal-fired plants emit substantially more harmful gases than natural gas-fired plants. Further compounding risk, Duke Energy’s (NYSE: DUK ) coal basin issues and PNM Resources’ (NYSE: PNM ) saga with the Obama administration regarding its San Juan facility show how easily utilities (and shareholders) can get stuck on the hook for hundreds of millions of dollars with no means of recapturing the outlay through rate increases on customers. Does Great Plains have a way out, or at least an idea of how to change its reliance on coal? We do have some vague guidance from management. Investors have been told that the company will cease coal-fired operations (700MW worth) at some of its plants “in the coming years.” Beyond that, we have no detail. How many years? How will the output be replaced? All questions we haven’t gotten an answer on (and one analysts haven’t bothered to ask). I think it is likely that we see a plan similar to that with Portland General’s (NYSE: POR ) Boardman coal plant in Oregon: building a natural gas plant adjacent to the existing coal plant and once complete, flipping the switch off at one facility and on at the other. This is likely to be at least a five-year project at minimum from the date of announcement. (click to enlarge) *Great Plains Corporate Presentation Unfortunately, per capital expenditure guidance given above, we haven’t been given any signs of when this will come into place. Management is guiding capital expenditures to come down across the board over the next five years, doing so to likely assure support for their dividend growth guidance while alleviating concerns about cash flow issues, which will be touched on later. Operating Results There is something to be said for top line consistency and Great Plains has it. While Missouri and Kansas aren’t the best areas of operation, they have been steadily improving over the past several years. Regulators in both states aren’t too harsh and there are several accelerated rate case mechanisms in place to allow yearly adjustments to the rate base. Nonetheless, operations and maintenance costs have exceeded revenue gains due to the additional maintenance needed on core facilities and the transmission/distribution infrastructure. When I mentioned investor concern regarding cash flow earlier, you can see how 2014/2015 have definitely resulted in sizeable cash outflows that are not covered by operations. Investors have watched the debt rise $500M from the end of 2013 to present. Net debt/EBITDA now comes in at 4.6x, indicating a substantial amount of leverage present in the business. Further compounding pressures, Great Plains has had a large debt balance outstanding for some time. This fact, along with its relatively smaller size, has resulted in a premium on the interest rates of company debt. More than 35% of operating income in 2014 ended up going to creditors, with similar percentages likely in 2015. This can’t continue, which means that capital expenditure guidance has to come down. Conclusion Management is in a tough place. Upgrades to bring coal plants into compliance have been expensive, running into the billions. Debt remains elevated, yet further costs related to a shift away from coal are around the corner. Management has no guidance on replacing 700MW of power with an alternative source and where those funds will come from is up in the air. Great Plains also seems stubbornly intent on sticking by their 4-6% annual dividend growth targets, despite the impact of the tens of millions of dollars in additional outflows these yearly increases cause. Shares of Great Plains have underperformed and trade at a discount to peers, but this is likely for a good reason. I don’t see a compelling investment opportunity here and I would advise owners to evaluate their holdings to see if this remains a good fit within their portfolios.

Laclede Group: Aggressive New Management Is Performing

Summary Laclede doubled its enterprise value in two years via acquisitions. Debt and leverage has ballooned, but so has cash flow from operations. I’m not fully sold on recommending the shares for income investors until I see a solid bump in the dividend. The Laclede Group (NYSE: LG ) is a regulated natural gas utility that has begun making waves in the utility industry over the last several years. Through the acquisitions of Missouri Gas Energy from Southern Union in 2013 and Alagasco from Energen (NYSE: EGN ) in 2014, Laclede Group has shifted from a relatively small utility serving just a portion of the Missouri natural gas market to serving millions of customers, holding dominant market positions in both Missouri and Alabama. Shares in the company have rebounded nicely off early September lows and now trade at all-time highs. Are investors putting too much faith in the future of the company, especially given its less-than-stellar service area? Business Environment Utilities can add incremental revenue in two ways. They can either have customers consume more of the commodity, raise rates on current customers, or add new customers. The first method is unlikely, given that U.S. consumers are consuming less electricity per capita now than in prior years. The advent of energy conservation, more efficient appliances, and less household formation has ensured that the trend is going to remain in a slow slide downward outside of freak weather years increasing demand. With that off the table, utilities like Laclede Group could raise prices on consumers. Not going to fly, because as we know these are regulated operations and public utility commissions set the allowed returns. So the third option (influx of new customers) is really the only source and is something completely out of the utility’s control. This is why there is such a focus on market analytics when valuing utilities. Analysts look at all sorts of factors in the company’s service area: unemployment, average wages, past years’ population growth, etc. Sadly for Laclede, there won’t be much to like here. Missouri and Alabama rank average or below average on nearly every metric you could look at. Unemployment, salary averages, labor participation, poverty, etc. are all below average compared to other states. This scares away many investors, and rightly so. Until these states turn the corner and can draw in new inflows of people, Laclede should likely trade at a discount compared to better positioned peers. Operating Results There has been a lot of change for Laclede Group over the past three years. In fiscal 2011, the company switched CEOs to current leader Suzanne Sitherwood, who made quick work of making changes within the company. Within a few short years under her leadership, the company had sold off its propane assets, made $2.2B worth of acquisitions, and driven up profit/operating margins. Acquisition and expansion don’t come for free, however. Long term debt has spiked from $340M in 2011 to over $1.7B today. Net debt/EBITDA has expanded from a low of 2.1x in fiscal 2011 to what should be around 4x in fiscal 2015. While this is a manageable level of debt for a utility, long-time holders of Laclede should be aware that the risk profile has changed dramatically under the new management style. Excluding the impact of the acquisitions on the cash flow statement ($2.2B paid for with approximately two thirds long-term debt, one third stock offering) things actually look pretty good. Cash from operations is set to fly high in 2015, with the business generating more cash in 2015 than in the prior three years combined. Capital expenditures, like is the case for most natural gas utilities, are comparatively low and under control compared to other utilities that operate in power generation. Results here are ideal and indicative of how I want to see a utility being managed in respect to cash in/cash out. Conclusion Ballsy moves aren’t something the utility industry is known for. Laclede has bucked this trend by engaging in acquisitions that doubled its size in just a few short years. There will be growing pains associated with the acquisitions that may impact short-term results, but I think thus far it looks like company management has made the right play and acquired some solid assets that will easily be folded under the Laclede umbrella. I think investors see the potential here, which is why shares have performed so strongly. For income investors considering entering a position, however, I think this is a “show me” story. Historical dividend growth has been lackluster and I think investors considering going long should wait to see what the next dividend increase pans out to be in fiscal 2016, which should be announced over the next few months. A bump in the 5%+ range would show that management is hitting their targets while also being shareholder friendly.