The last few years haven’t been kind to big pharmaceutical stocks.
Expiring patents on key drugs, competition from generic manufacturers and rising regulatory barriers have impeded industry growth. Safety scares, which can take years to resolve, have also hit sentiment in an already out-of-favour sector.
US pharma giant Merck (MRK) has just paid $4.85bn to settle damages claims against it arising from the withdrawal three years ago of one of its most widely used drugs, arthritis treatment Vioxx, over fears it increased the chances of heart attacks and strokes.
All these headwinds have taken their toll. While the Dow Jones World Index (W1IDU) has risen 75% over the last six years, the FTSE Global Pharmaceuticals Index (GD48) is down almost 20%. AstraZeneca (AZN) has been flat since 2001, GlaxoSmithKline (GSK) has barely budged, Schering-Plough (SGP) is down 20% and Pfizer (PFE) has fallen about 30%.
But after years of underperformance, the sector looks set for a turnaround, says Citigroup strategist Darren Brooks. Stocks appear oversold, leaving valuations looking cheap even as earnings seem set to improve, giving “a reasonable probability of a break in the sector’s persistent underperformance”.
Indeed, yields on drug stocks are 20% higher than the rest of the market’s, says Nick Hassel in The Times, their best level since the 1990s. Meanwhile, dividend cover is strong, “meaning that drug makers are far less likely to cut their payouts than other income plays, such as banks”.
But because of their lack of exposure to high-growth markets, investors have continued shunning the stocks. But that’s changing, as ‘big pharma’ moves into the rapidly growing generics industry. Pfizer has launched a generic version of Zoloft, a blockbuster drug that went off patent last year, while Sansoz, the generics unit of Novartis, is growing at three times the rate of its parent company, contributing 20% of total revenues in the first nine months of the year, says BusinessWeek.
The sector is also making inroads into the biotech industry. Total biotech sales grew 20% to $40.3bn in 2006, against an 8% rise in pharma sales to $275bn. And unlike traditional chemically-made drugs, biological ones are not subject to generic competition, mainly because the US regulator, the FDA, still hasn’t figured out how to regulate generic versions of biotech drugs.
This is a serious benefit – while traditional drugs are granted 20 very profitable years of patent protection, it can take as much as ten years to get them to market and patents can be challenged. That has persuaded ‘big pharma’ to snap up smaller biotech firms, spending $76bn on deals since 2005, reports Health Care M&A Information Service.
Big Japanese companies in particular – Japan is the second-biggest market for drugs in the world – have been taking advantage of the weak dollar to get in on the action. Eisai, which makes Alzheimer’s drug Aricept, has just bought MGI Pharma in a $3.9bn deal – the biggest ever by a Japanese pharma group.
But perhaps the best thing about pharma – and especially relevant in the current climate – is that drug makers are classically defensive. People need drugs no matter how the economy performs, so firms should be able to grow earnings and dividends despite ructions elsewhere.
By 2020, the industry is set to more than double to $1.3trn. Researcher IMS Health estimates that by 2010 the market for cancer drugs alone will hit $66bn. We look below at the stocks set to benefit.
Two stocks set to benefit from big pharma’s comeback
One particularly unloved pharma giant is Pfizer (PFE), currently shedding about 10,000 jobs – 10% of its worldwide workforce – and outsourcing 30% of its staff to Asia to save $2bn. The stock hit a high of $50 in April 1999, only to fall steadily over the next six years, declining 60% to $20 by December 2005. Even now it’s just $23 a share.
Yet sales have doubled from $3.49 a share in 1998 to $6.79 in 2006, while earnings per share has more than tripled, from 67c to $2.02, according to Mike Shedlock and Brian McAuley in The Rude Awakening.
The p/e ratio, which stood at 72 back in 1998, now looks extremely cheap on just 11 times forward earnings, while the stock offers a dividend yield of 4.9%. Those worried about the weak dollar can take comfort from the fact that nearly half of Pfizer’s sales last year came from outside the US.
A potential biotech bid target could be Genzyme (GENZ:US), which specialises in treating rare diseases. Billionaire investor Carl Icahn, who this year has already pushed rivals BioGen and MedImmune to sell themselves, has just taken a small stake in the group.
While you should never buy a stock on bid speculation alone, Bear Stearns analyst Mark Schoenbaum reckons the shares are worth as much as $90, even without a bid – the current share price is around $72.