Drugs still weak, but looking better
We at the Forecasts still get a lot of calls about Neutral-rated Pfizer ($19; NYSE: PFE) and Merck ($39; NYSE: MRK), former Wall Street darlings fallen on hard times.
The entire drug industry has the look of a neighborhood on the decline, full of big, expensive houses become eyesores, plagued by broken windows and yards overgrown with crabgrass. Buying into such neighborhoods before gentrification can be lucrative — but you don’t want to be the first speculator to buy a money pit. There’s still value in pharmaceutical stocks. With a few exceptions, however, it’s too early to get back in.
Yes, drugs remain an important part of the economy, and the demographic trends supporting higher prescription sales still apply.
But drug stocks, once prized for combining defensive attributes with growth potential, are not acting like their old selves.
Over the last five years, Pfizer lost more than $100 billion of market value, while Merck lost nearly $40 billion. During that period, the S&P 1500 Pharmaceutical Industry Index declined 9%, while the broader S&P 1500 Index rose 52%.
How did the mighty fall so far? Here are three contributors to the drugmakers’ downfall:
Generic onslaught: The Food and Drug Administration approved a record 440 generic drugs last year, more than double the number approved 10 years ago. In contrast, the FDA approved 43 branded drugs in 2007, less than half of the 104 accepted in 1997. Biotech firms had it even worse, with seven approvals last year, down from 45 in 1997.
Research woes: While the drug industry’s research-and-development spending remains high relative to historical levels, the companies consistently get less bang for their bucks, hurt by high-profile failures in clinical trials and a hawkish Food and Drug Administration. The number of products under development by the largest drug companies has increased by 40% from 1998 levels, but the average company has fewer drugs in late-stage testing than it did 10 years ago.
Bull market: The four-and-a-half-year bull market that started in 2003 came at a bad time for drug stocks. Pharmaceutical demand generally remains fairly steady, so drug stocks are rightfully considered defensive issues, though many have at times also qualified as growth stocks. However, against a backdrop of a strong, broad-based rally, investors became less willing to wait for firms dealing with growing competition from generics and declining research productivity.
The near-term picture for the drug industry remains cloudy. In 2007, prescription revenue rose less than 4%, the smallest increase since 1961, mostly because cheaper generics continue to take market share from branded drugs. It’s a trend likely to continue. A lack of new products and an increase in safety concerns also contributed to the slowdown in growth.
Over the next five years, at least $10 billion a year in drug sales are likely to be lost to generics. Replacing that revenue will not be easy.
Still, veteran investors know never to write off an industry permanently. At some point, the drugmakers will look good again. Here are three things we’d like to see as we search for opportunities in the group.
Friendlier FDA: In recent years, the FDA has drawn heat over health risks that cropped up in drugs approved when regulation was less stringent. In response, the FDA got much pickier. Today, regulators are being criticized for taking too long to review some drugs. Public safety remains in the public eye, and regulators must be circumspect. But any upturn in the FDA’s approval rate for new branded drugs would be a balm for the industry.
Profit growth: When cash is flooding in, cost controls just don’t seem that important. Many of the major drugmakers are conducting extensive restructuring programs, including layoffs and plant closures. The drug industry’s revenue growth has picked up in the last two years and should remain steady, if not impressive, over the next two years. But profit growth has been choppy and lagged sales growth last year. When profit growth exceeds sales growth consistently, we’ll know drugmakers are shedding excess pounds.
Continued improvement in Quadrix® scores: Quadrix has historically worked well for health-care stocks. Both the drug and biotech groups earn poor average scores, dragged down by dozens of tiny, unprofitable companies. But within the S&P 1500 Index, the average Overall score for both biotechnology and drug stocks recently topped 50 for the first time since 2003.
At the moment, we recommend two drug stocks and no biotechs. Johnson & Johnson ($65; NYSE: JNJ) has attractive 12-month potential, and both J&J and AstraZeneca ($43; NYSE: AZN) earn Long-Term Buy ratings. Both of our recommended stocks, along with two other key players, are reviewed below. For a detailed review of the product pipelines of all the drug and biotech stocks covered in the Forecasts, check out the table below.
AstraZeneca ($43; NYSE: AZN) is better positioned than many rivals to weather the industry’s pipeline slump. The company has at least 120 drugs in its pipeline, more than any other foreign drugmaker. AstraZeneca also tops all U.S. drugmakers with 10 drugs in phase III trials, the last step before approval for marketing to the public. Research setbacks have weighed on the shares in recent months, but over time Wall Street should recognize the value of a rich pipeline.
The company has also found a way to squeeze more revenue from ulcer drug Nexium ($5.2 billion in sales last year), despite its expired patent. In April, AstraZeneca reached an agreement with generic drugmaker Ranbaxy Laboratories of India, through which Nexium should face no generic competition before 2014.
Generic challenges to the antipsychotic Seroquel (more than $4 billion in sales last year) pose a threat. But the key patent on Seroquel doesn’t expire until 2011, and AstraZeneca seems to be successfully defending that patent in court. In addition, the company is finding new markets for Seroquel, softening the risks posed by competition from other branded drugs. AstraZeneca is a Long-Term Buy.
Two Johnson & Johnson ($65; NYSE: JNJ) drugs that combined for more than $7 billion in 2007 sales face generic competition this year and next, so the company has work to do. Fortunately, J&J has a deep pool of drugs under development, including four potential blockbusters slated for release over the next 18 months. In 2007, J&J had eight blockbusters, or drugs with annual revenue of more than $1 billion.
J&J’s diverse business mix offers some insulation against weakness in the drug industry. Pharmaceuticals accounted for 41% of 2007 sales and 48% of profits. The company also operates large medical-device (35% of sales, 35% of profits) and consumer-products (24%, 17%) businesses.
Drug sales fell nearly 1% in the March quarter excluding currency benefits, hurt by pressure from generic competition. Safety concerns also weighed on revenue. Between 2008 and 2009, pharmaceutical sales could fall 12% as Risperdal and Topamax for migraines lose market share to generics before new drugs gain traction. By 2012, however, at least 10 drugs with potential top sales of at least $500 million should have hit the market, making up for the decline in current pharmaceuticals. Drugmakers are often valued based on their pipelines, and J&J seems cheap at less than 15 times projected year-ahead profits. The stock is a Buy and a Long-Term Buy.
Merck ($39; NYSE: MRK) continues to run afoul of the FDA’s drug-development standards. In April, the European Union accepted its application to market Cordaptive, a cholesterol drug. Yet the FDA, contrary to expectations, rejected the application due to safety concerns. Cordaptive should eventually hit the U.S. market, but the recent FDA snub could delay the launch for a couple of years.
Merck’s pipeline should barely offset losses from generic competition over the next five years, with no major drugs likely to be launched for at least a year. By one estimate, between 2007 and 2013, the company could lose $5.8 billion in revenue because of generic competition, versus $3.7 billion in new drug sales.
Cost cuts should drive most of Merck’s profit growth over the next several years, although Gardasil has some near-term promise. Gardasil is already approved to vaccinate girls and young women against the human papilloma virus, which can cause cervical cancer. Merck’s efforts to make the drug available for women from 27 to 45 years old received a boost when the FDA marked the application for priority review. A decision could come as early as June 30. Merck is rated Neutral.
Perhaps no major drug company faces the challenges Pfizer ($19; NYSE: PFE) does. In part, the difficulty stems from the runaway success of cholesterol drug Lipitor. Last year, Lipitor’s sales of nearly $13 billion accounted for about one-fourth of company revenue and about 40% of profits. It seems unlikely that Pfizer can replace those sales and profits by the time Lipitor’s patent expires in 2010. In the 10 years from 2005 to 2014, Pfizer is expected to expose more than $30 billion in revenue to generic competition.
Pfizer believes it will start 15 to 20 projects in phase III trials in the next two years, bringing its total phase III pipeline to between 24 and 28 drugs. At least two of the late-stage drugs have blockbuster potential: Arthritis treatment CP-690 could enter phase III in March 2009, potentially launching in 2011. Already in phase III trials is obesity drug CP-945. Both CP-690 and CP-945 seem capable of eventually generating more than $1.2 billion in annual revenue, but Lipitor-esque numbers are unlikely for any of the drugs in the late-stage pipeline. And that’s the problem with the Neutral-rated Pfizer.