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Is the picture brightening for Big Pharma at last? On Feb. 8, Herman Saftlas, S&P's Pharmaceuticals analyst, upgraded his fundamental outlook for the industry group to positive from neutral, citing new signs of life in big U.S. pharmaceuticals.
What's behind his improved outlook? Saftlas says that despite generic erosion on patent-expiring drugs, S&P expects industry profits to rise modestly this year, helped by improved new-product flow, increased drug purchases arising from the implementation of the new Medicare drug benefit, and cost streamlining. Litigation issues are looking better, he notes, and many pharmas also offer what S&P sees as attractive p-e ratios and dividend yields.
The S&P Pharmaceutical subindustry index, which consists of 25 large, mid-, and small-cap companies, has been under the weather for some time. During 2005, this index fell 5.5%, vs. a 3.8% advance for the S&P Composite 1500. In addition, this group posted a five-year compound annual price change of -7.0%, vs. a five-year gain of 1.5% for the S&P 1500. Thus far in 2006, this sub-industry index gained 2.6%, while the broader market rose 1.9%.
PATENT PRESSURE. As can be seen in the chart below, the rolling 12-month relative price performance for this group has exceeded that for the overall market and is beginning to recover, in S&P's view. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the sub-industry index's 14-year mean relative strength.
Saftlas still sees challenges for the big drugmakers. He notes that branded drugs generating an estimated $45 billion in sales in 2005 have lost or are expected to lose patent protection over the next three years. However, S&P believes much of the shortfall should be compensated by new drugs. During 2005, the FDA approved 19 new molecular entities (NMEs), and 10 novel biologicals. Saftlas expects over 25 NMEs to be approved in 2006.
Despite near-term uncertainties over pricing and patent expirations, S&P thinks pharmaceuticals remains one of the healthiest and widest-margin U.S. industries. Saftlas sees longer-term prospects enhanced by demographic growth in the elderly (accounting for about 33% of industry sales), and by new therapeutic products from discoveries in genomics and biotechnology. In S&P's view, merger cost economies and synergies should also bolster profits at many companies.
GENERIC BONANZA. Prospects for the generic/specialty pharmaceutical segment remain favorable, according to Saftlas. S&P sees a large number of blockbuster drugs losing patent protection over the next few years, providing significant opportunities for this sector. Saftlas also thinks the new Medicare drug plan will be especially beneficial for generic companies. He favors companies with rich generic pipelines, especially with first-to-file generics with the potential for 180 days of marketing exclusivity, and competence in litigating complex patent issues.
So there you have it. From both a fundamental and momentum standpoint, S&P believes the investment outlook for the S&P Pharmaceutical group is favorable over the coming 12 months. Among the Big Pharma outfits he follows, Saftlas' top picks include Johnson & Johnson (JNJ) and Eli Lilly (LLY), both of which are ranked 5 STARS (strong buy).
Source: Standard & Poor's
Industry Momentum List Update For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of February 10, 2006.
Subindustry
Construction & Engineering
Construction Materials
Diversified Metals & Mining
Fertilizers & Agricultural Chemicals
Multi-Sector Holdings
Oil & Gas Drilling
Oil & Gas Equipment & Services
Oil & Gas Exploration & Production
Oil & Gas Refining & Marketing
Railroads
Specialized Finance
Water Utilities
Glossary
S&P STARS: Since January 1, 1987, Standard & Poor's Equity Research Services has ranked a universe of common stocks based on a given stock's potential for future performance. Under proprietary STARS (STock Appreciation Ranking System), S&P equity analysts rank stocks according to their individual forecast of a stock's future capital appreciation potential versus the expected performance of a relevant benchmark (e.g., a regional index (S&P Asia 50 Index, S&P Europe 350 Index or S&P 500 Index), based on a 12-month time horizon. STARS was designed to meet the needs of investors looking to put their investment decisions in perspective.
S&P Earnings & Dividend Rank (also known as S&P Quality Rank): Growth and stability of earnings and dividends are deemed key elements in establishing S&P's earnings and dividend rankings for common stocks, which are designed to capsulize the nature of this record in a single symbol. It should be noted, however, that the process also takes into consideration certain adjustments and modifications deemed desirable in establishing such rankings. The final score for each stock is measured against a scoring matrix determined by analysis of the scores of a large and representative sample of stocks. The range of scores in the array of this sample has been aligned with the following ladder of rankings:
A+
Highest
B
Lower
A
High
C
Lowest
A-
Above Average
D
In Reorganization
B+
Average
NR
Not Ranked
B-
Below Average
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Required Disclosures
In the U.S. As of December 31, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 28.2% of issuers with buy recommendations, 61.3% with hold recommendations and 10.5% with sell recommendations.
In Europe As of December 31, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 33.8% of issuers with buy recommendations, 46.8% with hold recommendations and 19.4% with sell recommendations.
In Asia As of December 31, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 24.8% of issuers with buy recommendations, 53.1% with hold recommendations and 22.1% with sell recommendations.
Globally As of December 31, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 28.7% of issuers with buy recommendations, 59.1% with hold recommendations and 12.2% with sell recommendations.
5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis. 4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis. 3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis. 2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain. 1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.
Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.
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Stovall is chief investment strategist for Standard & Poor's Equity Research Services
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