Looking Into Pharma's Profit Pipeline

If Merck is any indication, first-quarter earnings of major players could be just what the doctor ordered. The longer term is another story

by Alex Halperin

For all the news about unimpressive pipelines of promising drug candidates, and a difficult regulatory environment, pharma stocks have been defiantly buoyant of late. Year to date through Apr. 5, the Standard & Poor's Pharmaceuticals index posted a 1.9% gain, slightly outpacing the large-cap S&P 500-stock index. However, before the big guns unveil first-quarter numbers, analysts continue to express caution.

Heading into the heart of earnings season, pharma stocks received a series of booster shots. First the D.C. area outfit Medimmune (MEDI) announced on Apr. 12 that it has enlisted bankers to help it find a buyer, spurring hopes of additional tie-ups to follow (see BusinessWeek.com, 4/12/07, "MedImmune: Biotech on the Block").

But it was Merck (MRK) that really got the ball rolling on Apr. 13. The Whitehouse Station (N.J.) giant raised its earnings guidance even after a Food & Drug Administration panel voted overwhelmingly against recommending for approval its Arcoxia, a painkiller in the same class of drugs as the company's withdrawn Vioxx compound. Like Vioxx, it had provoked concerns over cardiac problems.

The earnings news—along with a favorable court decision on Vioxx litigation in Texas—propelled Merck shares to a 52-week high and boosted the stocks of major players like Abbott Laboratories (ABT), Eli Lilly (LLY), Johnson & Johnson (JNJ), Pfizer (PFE), and Wyeth (WYE), all of which are reporting earnings the week of Apr. 16.

Throwing a Wet Blanket on the Rally?

An earnings preview from JPMorgan says it expects most of the earnings from the marquee names to be in line with Wall Street expectations. It called the results "reassuring"—except that the majors have outperformed in the first quarter for the past three years.

The JPMorgan report finds that the industry faces short- and long-term obstacles like pricing concerns and patent expirations that could throw a wet blanket on the current rally. The firm predicts drug prices will rise 6% in 2007, about the same as last year but higher than in the previous year. Of the majors, only Wyeth garners an overweight rating from the firm.

Morningstar (MORN) pharmaceutical analyst Heather Brilliant is also cautious on the outlook for the sector, rating most of the stocks three stars out of five. For her, the standouts are Swiss outfit Novartis (NVS) and J&J. The latter, she wrote in a recent report, should benefit from diverse sources of revenue and impressive cash generation. Novartis, she writes, has one of the strongest pipelines in the industry and a booming generics business.

Merck Prospects Good

Brilliant thinks the Merck guidance could mean more positive surprises coming up during earnings season, but overall she remains muted on the sector's prospects. An upcoming Senate vote on a bill that would allow the government to negotiate with drugmakers over prices "could cast a pall over the industry" she says.

As for Merck, analysts are relatively bullish. Standard & Poor's reiterated its buy on the stock on Apr. 13, saying new products like Januvia, the first in a new class of diabetes drugs, and Gardasil, a vaccine for a virus that causes cervical cancer, could invigorate revenues. (Standard & Poor's is owned by BusinessWeek parent the McGraw-Hill Cos. (MHP).) On Apr. 13 the company also received an upgrade from Goldman Sachs (GS).

Even if earnings aren't thrilling for the first quarter, there are still opportunities in the pharmaceutical sector. A global report to be released on Apr. 16 by Ernst & Young finds the biotech industry in strong condition. While biotechs and pharmas often use similar technologies in drug development, biotech refers to the class of companies that have sprung up since the 1970s and tend to rely on venture capital for early funding.

Sticking With the Big Boys

In an industry where a typical business model involves many years of research and development and hundreds of millions of dollars in funding before generating product revenues, the consultancy nevertheless sees the biotech sector in a notably strong position. In 2006, it says, global public biotech companies exceeded $70 billion in revenues for the first time.

For 2007, E&Y says matching 2006 industry growth of 14% would be a conservative assumption. "We've predicted profitability for the U.S. industry by the end of the decade," says E&Y global biotech leader Glen Giovannetti. He points out that the biotech sector's 2006 net loss of almost $3.5 billion was artificially inflated by one-time expenses related to M&A deals.

These former upstarts, which range from large, profitable companies like Amgen (AMGN) and Genentech (DNA) to tiny private startups, could be where investors look for good value. Along with upside, of course, comes the greater risk inherent in the biotechs—a factor that may explain why many health-care investors continue to stick with good ol' Big Pharma.

Halperin is a reporter for BusinessWeek.com in New York.