What Ails You?

Wall Street worshiped large pharmaceutical companies for much of the past two decades, and for good reason: The big pharmas had it all — rock-solid balance sheets, strong earnings and a seemingly endless pipeline of novel drugs.

More recently, the sector has been on the sick list; it significantly underperformed the overall market in 2004. Investors who are wary of big pharma investments have good reasons to be. But this does not mean that the sector is to be avoided at all costs. Indeed, for savvy, well-informed investors, now might be a good time to jump in.

There is little doubting that the pharmaceutical industry has issues. The Merrill Lynch Pharmaceutical HOLDRs Trust (PPH), an exchange-traded fund comprised of 21 large pharmaceutical stocks, dropped almost 7 percent last year, and many individual stocks fell much further.

The sector's woes became front-page news last September when industry giant Merck withdrew Vioxx, its $2 billion Cox-II painkiller, after it was linked to elevated cardiovascular risks. Ten weeks later, Pfizer announced its top-selling arthritis pain reliever Celebrex, another Cox-II drug, was also linked to increased heart attack risk.

Both stocks plunged on the news, as investors assessed the likely impact and potential legal costs. Richard Evans, an analyst at Sanford C. Berstein, predicts Merck could be on the hook for up to $38 billion in damages. Other analysts peg the total at between $10 billion and $18 billion. And while some experts believe Pfizer's potential liability will be less, it's still likely to cost the company several billion dollars. This and other pharma-related troubles do not mean the sector is to be avoided at all costs, but they do mean that investors need to be savvier about their picks.

Lawyers Not the Worst of It

Massive tort litigation is only one of the pharmaceutical industry's problems. Most companies also have dwindling product pipelines, with few innovative new drugs on the horizon.

“Many large pharmaceutical companies have focused too much of their research efforts, either on line extensions and ‘me-too’ products or large blockbuster drugs that often don't pan out,” says Jeff Martini, an industry consultant and former Shire Pharmaceuticals Group executive. “As a result, there aren't many exciting drugs coming to market in the next few years.”

The problem isn't easily fixed. New drug development is a lengthy and expensive process. Bringing a new drug to market costs roughly $800 million and can take 15 years. Moreover, according to Bain & Co., only one new compound reaches the market for every 13 put in trials.

“It's unlikely we'll see a new product cycle before 2008,” cautions Barring Coughlin, a CFA and founder of Colorado Springs, Colo.-based Coughlin Associates, which provides investment outsourcing services to financial advisors. “And without a pipeline of innovative new drugs to drive future growth, it's unlikely pharmaceutical stocks will outperform the market anytime soon.”

Upcoming patent expirations are another problem. Over the past few years, drugs with more than $30 billion in sales have come off patent, exposing them to fierce competition from low-cost generic competitors. But the real damage is just beginning. According to research firm Datamonitor, over 30 of the nation's 57 largest-selling drugs will lose patent protection by 2008, representing sales of over $60 billion. These drugs include blockbusters like Pfizer's Zoloft, Bristol-Myers Squibb's Pravachol, and Merck's Zocor, which accounts for roughly 20 percent of Merck's annual revenue.

“Patent expirations are going to really hurt some of the large pharmaceutical companies,” cautions Derek Taner, who manages the Franklin Global Health Care Fund in San Mateo, Calif. “Fortunately for investors, patent expirations are like icebergs: You can see them coming and get out of the way.”

When Cheap Drugs Are Bad

Declining prices are another industry concern. Pharmaceutical companies have traditionally enjoyed strong pricing power. But beacause managed-care providers account for over 70 percent of U.S. retail drug sales, they have tremendous pricing leverage. Though pharmaceutical companies have always offered these providers moderate volume-based price discounts, they have rarely allowed prices to fall below Medicaid's “best price” threshold.

But some experts believe it's only a matter of time before the powerful managed-care providers drive prices below this artificial Medicaid price floor for good. “If that happens it would be a catastrophe for many large drug companies,” Martini says.

Some experts also speculate the new Medicare prescription drug legislation will help reduce prices as new participants enter the system and become eligible for Medicare price discounts. Martini disagrees.

“While there may be some additional discounting as new participants enter the Medicare system, many of these people will simply be moving over from state programs that already receive discounts,” he says. “To the extent the new Medicare legislation does negatively impact drug prices, its effect on industry profits should be more than offset by increased volume.”

Mood Elevators for the Industry

There are other bright spots for the industry as well. “For example, pharmaceutical stocks have historically done well when short-term interest rates rise,” notes Taner. The falling U.S. dollar could boost large pharmaceutical firms, many of whom have sizeable overseas operations.

Demographic trends could also help the industry. Over 33 percent of all U.S. prescriptions are written for patients 65 years of age or older, and that population segment is set to nearly double over the next 25 years. This trend could have a downside, by triggering “renewed calls for federal drug price regulation,” says Kevin McCloskey, vice president and senior portfolio manager for the $1.4 billion Federated Stock Trust in Pittsburgh, Pa.

Given the generally bleak industry prognosis, are there any large pharmaceutical companies worth owning right now? Coughlin doesn't think so. “These are wonderful companies, with attractive dividends, generally selling at reasonable valuations,” he says. “But it's too early to buy them. Until there's a catalyst to propel these stocks higher, there's just not much money to be made in the sector.”

Taner agrees it may be a bit early to jump in with both feet, but he does see some selective opportunities for patient investors. “Merck is interesting from a long-term perspective, given its yield and strong financial position. And several European companies like Novartis AG and GlaxoSmithKline are also attractive since they don't suffer from the same problems plaguing their U.S. counterparts.”

McCloskey also points to Pfizer as a value play. “Pfizer is trading at 12 times next year's estimates, which is the cheapest it's been since the late 1980s.” But he thinks investors need to be careful. “Celebrex isn't the only issue facing Pfizer. It also has an upcoming patent trial on its blockbuster Lipitor drug. A loss could devastate Pfizer, since Lipitor accounts for roughly 20 percent of its revenue.”

Big pharma used to be a safe bet for investors, but now the industry is facing huge challenges and an uncertain future. Though no speedy recovery is on the horizon, value investors with a little patience could do quite well if the industry can ultimately cure its many ills.

In Search of a Cure