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JANUARY 4, 1999

Can Drugmakers Soar Again in '99? Yes

For the past few years, drug stocks have held the cure to just about any stock market malady. If your portfolio suffered a bout of earnings hiccups, a few shares of Merck -- which by last month was up more than 350% since 1994, vs. 163% for the S&P 500 -- was just what the broker ordered. If the Asian contagion infected your retirement account, Pfizer served up a suitable vaccine: It has risen 660% over the past five years, more than 67% in 1998 alone.

Miracle remedies don't remain a secret for long, and pharmaceutical shares are no exception. In 1998, whether the market was obsessing over a feared U.S. economic slowdown or over uncertainty overseas, drugs stocks attracted investors in droves. That sent the group darting off to a 45% rise by mid-December, but at the same time left the big drug names with valuations so bloated they would barely fit together in the same medicine cabinet. By the last week of December, Pfizer, whose share price swelled after the introduction of the male anti-impotence drug Viagra earlier in the year, was trading at just above 50 times estimated 1999 earnings, double the multiple for the S&P 500. Eli Lilly, meanwhile fetched a lofty 39 times Wall Street earnings estimates for 1999.

Normally, multiples that steep would cause even the most steadfast investors heart palpitations. Not here. In fact, a lot of Street players think drug stocks will be an excellent bet again in 1999. Their reasoning: The group's earnings growth should outdo that of nearly every other industry. Consensus projections peg 1999's average increase in profits for the major drug manufacturers at 23%, with a range that goes from 14% for Pharmacia & Upjohn to 30% for Warner Lambert. The S&P 500 companies, meanwhile, will be hard-pressed to show average profit gains of an anemic 5%, according to Zacks Investment Research.

LAB-COAT HEROS. Combine double-digit earnings growth with even the slightest increase in the group's p-e multiple, and a 20% gain for the year in drug stock prices isn't inconceivable and may even be conservative. "The pharmaceutical stocks outperform the S&P 500 every time their earnings growth is better, and with the index struggling to grow in the mid-single digits and at least mid-teens earnings growth predicted for the [drug] group, we're expecting a good year," says Richard B. England, a portfolio manager with the Putnam Health Sciences Trust (PHSTX).

A lot of the credit for the pharmaceutical industry's bright outlook belongs to the folks in lab coats. "In this business, the theme is pipeline, pipeline, and again pipeline," says Eugene Melnitchenko, head of research for Sutro & Co., a San Francisco investment house. "And right now there are a number of blockbusters that should help members of the group sustain profit growth." Thanks to R&D breakthroughs, the pharmaceutical industry is not only stocked with billion-dollar-a-year drugs such as Warner Lambert's Lipitor cholesterol treatment but it also has a beaker full of potential Viagras ready to come out next year. Celebrex, due to be launched by Pfizer and Monsanto's pharmaceutical arm Searle in 1999, and Vioxx, developed by Merck, are pain relievers designed to help arthritis sufferers while eliminating some of the stomach irritation associated with aspirin or similar medicines. Analysts think both could win a goodly share of a market estimated at $5 billion a year.

Two other factors behind Wall Street's infatuation with the group are its unit growth and pricing power. American Express Asset Management institutional portfolio manager Michael T. Manns says the domestic pharmaceutical companies could rack up unit sales growth in the "mid to high single digits this year," while he estimates that prices will increase 6% to 8% year-over-year. Keep in mind that people 65 and older buy more than twice as many prescriptions as the general population -- and that the trend is likely to continue as the U.S. population ages.

A few caveats do pop up, though, if you look beyond 1999. Starting with the new millennium, a number of high-profile drugs are due to come off patent, including Merck's Vasotec hypertension treatment, with $900 million in annual sales; Schering-Plough's Claritin, a $2 billion drug; and Eli Lilly's $3billion-a-year Prozac. When patents expire, generic manufacturers introduce their own low-priced versions. That's guaranteed to slash a pharmaceutical company's revenues on a treatment by 50% the first year alone, says Sutro's Melnitchenko.

VIAGRA VA-VOOM. So Wall Street's favorites tend to feature a selection of strong performers, a rich pipeline of new drugs, and few, if any, big earners nearing the end of their patent jackpot. Take Pfizer, for instance, which Value Line says should remain an industry leader in earnings growth for the next few years. The hoopla over Viagra may have died down, but Pfizer is set to reap as much as $1.3 billion from the drug next year, especially after its recent approval in Europe and an almost certain thumbs up in Japan before long.

Meanwhile, Pfizer has packed its pipeline with drugs for migraines, schizophrenia, and obesity. "In the 1980s, Merck used to set the tone for the industry, but now the lead belongs to Pfizer," says Melnitchenko. Some 19 of 32 analysts rate the company a strong buy or buy, according to Zacks, which reports that consensus estimates on Wall Street project that Pfizer's profits will grow an average 20% over the next five years. The downside: The company already trades at 51 times estimated 1999 earnings of $2.48 a share.

Thanks to the strong performance of cholesterol drug Lipitor, Warner-Lambert is another favorite on the Street, where 24 of the 28 analysts covering the company rate it a strong buy or buy. Lipitor, a pleasant surprise so far, could bring in as much as $3 billion in revenues in 1999, predicts Herman Saftlas, an analyst for Standard & Poor's. The company's Celexa antidepressant got off to a good start in 1998 as well. And although its Rezulin diabetes treatment has run into complications over liver enzyme levels, analysts say its problems are minor. Also in Warner-Lambert's pipeline are treatments for bacterial infections and osteoporosis. In 1998, Warner-Lambert enjoyed 40% plus earnings growth. That should slow somewhat, according to a survey of analysts by Zacks, but only to a solid 24% annually over the next five years.

If there's anything close to a value play in the group, it may be Merck. Currently 21 of the 36 analysts following the company rate it a buy or strong buy, and they expect its earnings to grow an average 14% annually over the next five years according to Zacks. True, the company faces the daunting prospect of losing some of its biggest earners when Pepcid, Vasotec, and other drugs come off patent. But Merck seems ready to counter. Its Vioxx arthritis and pain treatment could give Pfizer/Searle's Celebrex a run for the money, especially since Merck's drug is said to require fewer dosages (see BW Daily Briefing, 12/18/98, "The Drug That Could Pep Up Merck's Pipeline: Vioxx"). And don't forget that Merck trades at a p-e multiple of 31 times projected 1999 earnings of $4.93 a share -- a bargain compared with the overall group.

A FUND APPROACH. Another relatively cheap stock is Eli Lilly, even though Prozac will go off patent in a few years. For now, Prozac and Zyprexa, a schizophrenia drug, are boosting the company's profits -- which helps explain why analysts feel the drugmaker can sustain 17% annual earnings growth over the next five years. Evista, an osteoporosis medication, has been slow to live up to the fanfare that accompanied its debut last year. But should Evista finally take off, Lilly might end up surpassing earnings expectations, according to George Rho of Value Line. Lilly's stock currently trades at 40 times 1999 projected earnings of $2.30 a share and is rated a strong buy or buy by 18 of 30 analysts covering the company.

If you aren't comfortable betting on a particular company, you might consider a sector fund as a good way to plug into the industry's growth. The leading such fund is Fidelity Select Health Care (FSPHX), which posted a 41% total return last year and has averaged 31% over the past five years. Another fund you might look at is Putnam Health Sciences Trust (PHSTX), which had a total return of 27% last year and has averaged 26% annually over the past 5 years.

Choose well within the drug group, in short, and there's a good chance you'll find a booster shot for your portfolio.

James Anderson, who teaches journalism for the City University of New York, writes Sector Scope every other week
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